Sunday, December 9, 2018

A Bear Market is now underway

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: Bearish*
  • Trading model: Bullish*
* 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.

The Ultimate Timing Model flashes a sell signal
Over the years, I have struggled with the problem of integrating technical analysis into an investment process. Trend following systems that employ one or more moving averages work well longer term, but they have the disadvantages of being slow (by design), and they can produce false positives which whipsaw during trendless periods.

The chart below shows how a simple 200 dma as a buy and sell signal would have worked for the SPX in the last 20 years. The good news is it kept you out of major bear markets, but at the cost of numerous whipsaws, which are circled.

I am indebted to the blogger at Philosophical Economics who suggested a macro overlay to trend following systems (see Building the ultimate market timing model). Major bear markets generally occur under recessionary conditions. Why not ignore moving average signals until your macro model is forecasting a recession?

This "Ultimate Market Timing Model" is ultimately beneficial for long-term investors. If you could cut off the left tail of the return distribution and avoid the really ugly losses, you could run a slightly more aggressive asset mix and receive a higher expected return with lower risk. For example, if the standard risk-return analysis dictates a 60% stock and 40% bond asset mix, you could change it to a 70/30 mix with this model, and get downside risk similar to the 60/40 portfolio. To be sure, this system isn't perfect, and anyone using such a model will have to incur "normal" equity risk, and it would not have kept you out of the market in the 1987 Crash.

Stock prices have been weak for several months. Today, any flavor of moving average system would produce at best a neutral signal, and at worst a sell signal. At the same time, I have been maintain a Recession Watch suite of long leading macro indicators designed by New Deal democrat to spot recessions a year in advance. My latest review (see 2019 preview: Winter is coming) shows that the macro models are flickering red, indicating a slowdown in 2019, but I am not ready to call a recession yet using conventional macro analysis.

However, good modelers also know the limitations of their models, and other factors that are not captured by the Recession Watch indicators are sufficiently negative for me to call for a recession to start in late 2019 or early 2020. The combination of weak stock prices and a recessionary call therefore changes my Ultimate Market Timing Model to a sell signal.

The current drawdown for the SPX from its peak is about 10%, which represents an acceptable level of equity risk for a long-term asset allocation model for patient money. Investment oriented accounts should move to a maximum defensive posture. Tactically, the market is very oversold and poised for a relief rally. Investors should take advantage of any strength to reduce equity risk. Traders may want to position themselves for the anticipated advance into year-end.

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

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