Sunday, January 8, 2017

How Trump/Navarro could spark a market crash

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: Bearish (downgrade)*
* 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 will also receive email notices of any changes in my trading portfolio.

How the market could crash
At the end of 2016, WSJ reporter Greg Zuckerman made a tweet with ominous implications. Hmm...what happened in 1929?

Here is how a market crash can happen. Donald Trump's appointment of Peter Navarro, the author of Death by China, represents the biggest source of policy tail-risk for the capital markets. Bashing China may be satisfying for Trump supporters, but the Chinese economy is increasingly fragile (see How much 'runway' does China have left?). Impose tariffs on Chinese goods, and you risk a Chinese economic slowdown that drags the world into a synchronized global recession.

While a crash is most definitely not my base case, the scenario of collapsing trade flows from a Chinese hard landing would first tank the Asian economies, followed by Europe, whose banking system are still over-levered and have not fully recovered from the Great Financial Crisis. Under such circumstances, an equity bear market would be a 100% certainty, and a market crash would be within the realm of possibility.

It's hard to estimate the actual probability of a US induced China hard landing scenario. However, we should get better clarity as the Trump team moves into the West Wing of the White House in the coming weeks. In addition, President-Elect Trump may give us some clues on trade when he holds his press conference on Wednesday.

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

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