Sunday, September 27, 2015

A choppy bottom

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bullish (upgrade)

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. 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 model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

My inner investor: Still buying weakness
This will be a somewhat abbreviated post compared to past weeks.  Not that much has changed from my inner investor`s point of view since my last post (see Why this is not the start of a bear market). To briefly recap, I analyzed the market in four dimensions and here are my conclusions:
  • Technical:  Very bearish.
  • Sentiment: A crowded short, which is contrarian bullish. Who is left to sell?
  • Macro: Mixed, mildly bullish.
  • Fundamental momentum: Was mildly bullish, but has weakened to neutral.
My conclusion was that US stock prices have limited downside and this is not the start of a bear market. My inner investor therefore remains in a buy on weakness mode.

Here are the updates.

Sentiment remains a crowded short
Virtually every few days I see another item come across my desk showing an off the charts reading in bearish sentiment. The latest comes from Mark Hulbert, who reported that a purified version of his Hulbert NASDAQ Newsletter Sentiment Index, which is "purified", or adjusted for market action, is showing extreme levels of bearishness, which is contrarian bullish.

In the meantime, Barron`s reports that "smart money" corporate insiders continue to buy heavily.

Macro fears are falling
Here is the summary of New Deal democrat`s weekly review of high frequency economics, indicating that the "forces of darkness are gathering" in the form of non-US (read: EM inspired) weakness, but the US economy remains highly robust, as exemplified by the blow-out GDP report last week.
This week marked the most stark bifurcation among the data in a long time. Consumer-related indicators - mortgages, oil and gas, jobless claims, and consumer spending - all remain positive. But those portions of the US economy most exposed to global forces, including the US$, commodities, and industrial production and transportation, have all turned firmly negative. Two out of the three employment metrics have now also turned either firmly negative or neutral. I remain focused on housing and cars. Although the forces of darkness are gathering, so long as those two most leading sectors of the US economy remain positive, so do I.
The US economy shows no signs of rolling over into recession, which would be a bull market killer. That's one key reason why I remain constructive on equities longer term.

As well, an optimistic note can be found by waning market anxiety. The St. Louis Fed Financial Stress Index has fallen three weeks in a row and it remains below zero, which is considered to be a "normal" level of stress.

Most of the stress reduction comes from falling rates of financial volatility, both in the form of bond and stock market volatility.

The source of the most recent market angst is said to come from the risk of a emerging market meltdown because of a Chinese slowdown. However, a glance at the relative performance of EM bonds show that they are outperforming US high-yield.

Bottom line, the fear of financial contagion is falling.

An uncertain Earnings Season
There is, however, a blemish starting to appear in the bull case. The latest update from Factset shows that forward EPS ticked down by -0.15% in the week after climbing steadily for the last few weeks (annotations in red and estimates are mine).

Factset also shows that the negative pre-announcements are slightly below historical norms, which could indicate that the weakness in forward EPS is part of the the warnings season game. We all know how that game is played by now. Companies guide downwards in order to lower the bar when they actually report earnings so that they can beat expectations.
At this point in time, 108 companies in the index have issued EPS guidance for Q3 2015. Of these 108 companies, 76 have issued negative EPS guidance and 32 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the third quarter is 70% (76 out of 108). This percentage is below the 5-year average of 72%.
Is falling forward EPS just statistical noise, pre-Earnings Seasons guidance or the start of a negative trend? A one week pause is no reason to panic, but it is something to keep an eye on as Earnings Season progresses.

My inner trader: A seriously choppy market
As my inner investor looks ahead bullishly to year-end and 2016, my inner trader is conflicted about short-term market direction. He believes that the market is in the process of making a bottom, much like it did in 1998 and 2011. Here are the SPX charts of that period (via Chris Ciovacco):

The patterns are similar - the stock market made an initial bottom and then chopped around for a few weeks before falling back to test the old lows. Once the second test was complete, stocks resumed their uptrend.

Given the kind of recent volatility that we have seen in the stock market, the chart of weekly prices that I usually show of my Trend Model trading signals does not come anywhere near to capturing the daily ups and downs of the market and the signal. The Trend Model was designed for trending markets, but any recent market trends has instead been replaced by a choppy market in the past few weeks in the manner of the market bottom of 2011.

The current environment has been more favorable to an approach of fading strength and weakness. I have come to rely more on the excellent charts at IndexIndicators. Short-term indicators (1-3 day horizon) such as % of stocks above their 10 dma have recently shown an oversold reading. Regardless of any signs of short-term momentum, I would be wary about pressing short positions.

Longer term (1-2 week time horizon) indicators such as net 20-day highs-lows also flashed an intra-day short-term oversold reading on Thursday.

A better representation of the choppiness of the current environment is to zoom in from a weekly price chart above with an hourly chart that pinpoints the recent trading signals of the last few days.
  • September 17: I tweeted that I was flipping from long to short on the reaction to the FOMC decision (red down arrow). 
  • September 22: I tweeted that I was scaling back my short positions as the market was getting oversold on short-term indicators (first blue up arrow).
  • September 23: I tweeted that I was taking a modest long position, as the market had become oversold on a 1-2 week view (second blue up arrow).

At the end of the week, price momentum is tilted to the downside as rally attempts failed but the market is oversold. My inner trader is in a low conviction long trade and he is watching a couple of unfilled gaps that have the potential to fill very quickly next week. If both get filled, then we could easily see a test of the SPX 2000 level. Otherwise, there is decent support at the 1900-1915 zone.

The market remains range-bound short-term and mildly oversold right now, but declines have been on high volume and advances have been on weak volume. This conditions are highly indicative that a test of the August lows is still ahead in the days to come.

The current market pattern is consistent with past market "crashes" and bottoms. If history is any guide, then we still have a few weeks of choppiness ahead before the stock market can stage an enduring rally into year-end.

Next week will feature a number of potentially high volatility events with binary outcomes. First, the Catalan elections this Sunday have been positioned by the governing party as a referendum on independence and early results indicate that the secessionists are close to a majority. In addition, John Boehner's surprise resignation as the Speaker of the US House of Representatives is a wildcard in the uncertainty leading to a possible government shutdown. Current consensus thinking suggests that Boehner will cobble together a coalition of House Republicans and Democrats to continue to funding the government, but the debt ceiling fight will be a much tougher fight later. Finally, the market will be on edge Friday as the Employment Report gets released - a much watched indicator in light of the Fed`s close decision not to hike interest rates in September.

Volatility is here to stay, at least for the next few weeks.

Disclosure: Long SPXL


cosimodemedici said...

Greatly percolate and enjoyyourcomments Why does the VW scandal not show on your radar .it seems to me to perhaps be a catalyst for further concerns about how reliable corporate profit announcements are and what accounting and industrial dark work lies behind published earnings figures

Anonymous said...


can you please give the base period of the S&P "Crash" Performance analysis?


PropagandistHacker said...

a very CHOPPY bottom...and deep, too.

Cam Hui, CFA said...

Cosimodemedici -

How does the ethical lapses of VW compare to:
1) The LIBOR fixing scandals?
2) The robo-signing scandals, both on mortgage origination and foreclosures?
3) BP Deepwater Horizons blowout in the Gulf of Mexico?

Did any of those events bring down the stock market, or were they excusable because they were the work of a "few bad apples"?

Just wondering...