Sunday, February 12, 2017

A blow-off top, or a wimpy top?

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 the 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 mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

So many questions, so few answers
Regular readers know that I have been calling for a cyclical market top in 2017 (see The roadmap to a 2017 market top). Outside of the risk of permanent loss from war or insurrection, severe bear markets have been mainly associated with economic recessions. My analysis has been based on the likely path of the US economy, and the timing of the next recession.

My base case, call it the "blow-off top" scenario, goes something like this:
  • The economy, which is in the late stages of an expansion, starts to overheat.
  • Investors and traders get enthusiastic about growth and bid stock prices up to unrealistic levels (hence the "blow-off")
  • The Fed responds by raising rates to cool off the economy, but find it's behind the curve...
  • Which results in a recession and bear market.
The blow-off top scenario would see the SPX reach the 2500-2600 level this year as it tops out.

I have been considering an alternative, call it the "wimpy top" scenario, where the market may have topped out already.
  • The economy, which is in the late stages of an expansion, starts to overheat.
  • Investors and traders get enthusiastic about the prospects for cuts cuts and deregulation under the Trump tax reform plan, which is what has happened so far.
  • Tax reform gets tied up in Congress and gets delayed until 2018.
  • Trump appoints hawks to the Federal Reserve board (now there are three vacancies with the resignation of Daniel Tarullo).
  • The new Trump appointed Fed governors, composed of hard-money advocates, becomes more aggressive, tightens monetary policy, and pushes the economy into recession.
  • An equity bear market is the result.
The wimpy top scenario is based on a double whammy of fiscal policy disappointment and a pivot to a more hawkish Fed policy. In that case, Current stock index price levels are roughly as good as they get.

The key differences between the two scenarios are the likely path of fiscal and monetary policy. Those are the big questions to which we have no answers. This week, I explain the risks and offer some suggestions of how to watch which scenario is the more likely one to unfold.

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

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