Sunday, January 15, 2017

Main Street bulls vs. Washington bears

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*
* 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.

Bifurcated opinions
Opinions are starting to split badly on the market and the economy. Main Street has become more upbeat on the economic outlook. The NFIB small business survey showed that optimism surged in December, though Renaissance Macro pointed out that optimism has not translated yet into a significant upswing in sales growth.

The preliminary January report of UMich consumer confidence shows that it is elevated, though opinions are reportedly split along political lines:
The post-election surge in optimism was accompanied by an unprecedented degree of both positive and negative concerns about the incoming administration spontaneously mentioned when asked about economic news. The importance of government policies and partisanship has sharply risen over the past half century. From 1960 to 2000, the combined average of positive and negative references to government policies was just 6%; during the past six years, this proportion averaged 20%, and rose to new peaks in early January, with positive and negative references totaling 44%.
Chart via Calculated Risk:

By contrast, I am seeing signs of doubt from political circles that Trump will be successful with his pro-growth agenda, even among Republicans. Traditional approaches to sentiment analysis states that the public tends to be slow. When the public finally latches onto an economic theme, it is indicative of a contrarian top (or bottom). On the other hand, the improvement in business and consumer confidence can be signals of broad based economic strength.

So who is right? Main Street, or Washington?

The stakes are high
Here is what's at stake for equity investors. As we enter earnings season, Factset shows that forward EPS continues to rise, which is indicative of Street expectations of broad based cyclical strength.

However, broad based cyclical upturn can only get you so far. This Factset chart also shows that forward P/E ratio is elevated and expensive compared to its own history. Current forward P/E is based on bottom-up derived earnings based only analyst expectations of economic conditions without the Trump fiscal plan. That's because you can't make estimates when you don't have the details of the proposals. A top-down analysis suggests that the Trump tax cuts could add roughly 10% to forward earnings, which would bring down the forward P/E ratio to more reasonable levels (annotations are mine).

To rephrase my previous question: Who is right about the expectations for the Trump tax cuts? Main Street or Washington?

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

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