Sunday, October 28, 2018

How this Bear could be wrong: Exploring the bull case

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Neutral*
  • Trading model: Bearish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.

How I could become bullish
Three weeks ago, I explored the likelihood of a recession in 2020 and concluded that while my panel of recession indicators were not bright red, they were flickering (see A recession in 2020?).

I have been increasingly cautious about the equity outlook since August (see 10 or more technical reasons to be cautious on stocks and The macro risks that keep me awake at night). My call for caution has been correct so far. The latest update from John Butters of FactSet shows that the market is not responding to good news during Q3 earnings season. Stocks that beat expectations saw their prices fall at a level that was last seen in 2011. This is all occurring when the EPS and sales beat rates are either average or slightly average compared to their 5-year averages.

The negative stock price response to EPS beats cannot be attributable to a negative overall tone to the market. As the chart below shows, companies that have beaten expectations performed slightly worse than ones that reported in-line, while companies that disappointed were punished.

Here is what's bothering me. A recent Bloomberg article indicated that two-thirds of business economists expect a recession by the end of 2020. .A 2020 recession is becoming the consensus call, and being in the consensus makes me highly uncomfortable. While I recognize that recessions have historically been bull market killers, what if the consensus is wrong?

Here are some possibilities that could turn me bullish. While I remain cautious on stocks and these do not represent my base case scenarios, any of these outcomes could make me more constructive on equities.

The full post can be found at our new site here.

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