Sunday, December 30, 2018

How to spot the bear market bottom

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 a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don't buy if the trend is overbought, and vice versa). 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: Sell 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.

Bottom spotting
The outsized daily swings in the major US equity averages tell the classic story of a bear market. Normal bull markets simply do not experience consecutive multiple daily moves of 2% or more.

The market's panicked price action is highly reminiscent of past panics in 1962, 2002, and 2015. In those cases, the market bounced, and made a lower low several months later. In all cases, stock prices were higher a year later.

My base case scenario calls for an initial  low, rally, followed by choppy price action, and a final  low within 6-8 months. The most recent exception to this rule was 2001-2002, when stock prices cratered in the wake of the 9/11 attack, but made the final low just over a year later. Arguably, the 2002 low was distorted by the 9/11 shock, and the market made a double bottom in 2002 within the space of three months.

At this point, market psychology is becoming its own reality, and psychology may wind up dominating intermediate term market action. This week, I go bottom spotting as I offer a checklist of the signs of a market bottom, and try to estimate the downside risk posed by the current bear market.

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

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