Sunday, November 6, 2016

Don't be fooled, Election 2016 isn't the Brexit referendum

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 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. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • 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 any changes during the week at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

It's all about the election
I have some terrible news to report. As a result of the change from Daylight Savings to Standard Time this weekend, the entire world will have to endure the US election for an extra hour.

All kidding aside, I could see the market anxiety rising all of last week. It wasn't just the market action, which had taken on an increasingly risk-off tone as the week went on. It wasn't the rising bearishness on social media. The biggest indicator of concerns over electoral uncertainty occurred when I saw that the traffic on my last post (see Trading the Trump Tantrum) was roughly triple the usual rate.

Despite some half-hearted rally attempts, the SPX ended the week testing its 200 day moving average (dma), and oversold on a number of key metrics. Traders are treating next week's US election as the same kind of market moving event as the Brexit referendum. There is one key difference. The market was relatively sanguine going into the UK vote and expected a favorable outcome. By contrast, the market is positioning for a bearish outcome, even though the polls show that the bullish scenario, namely a Clinton win, as the more likelyt scenario.

Market analysis in the face of event risk involves answering the following questions:
  • How would the market likely behave in the absence of tail-risk?
  • How are market participants positioned ahead of the event?
  • What are the likely bullish and bearish scenarios after the event?
The full post can be found at our new site here.

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