Sunday, June 18, 2017

Risks are rising, but THE TOP is still ahead

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: 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.

Four steps, where's the stumble?
Wall Street traders know about the "Three steps and a stumble" adage, which states that the stock market tends to suffer substantial setbacks once the Fed takes three tightening steps in a row. Now that the Fed has raised rates four consecutive times, where`s the stumble?

Despite my recent post which suggested that the odds of a hawkish rate hike was high (see A dovish or hawkish rate hike), my social media feed was full of misgivings that the Fed is in the process of making a serious policy error like the 1937 rate hike cycle, where the central bank tightened the economy into a recession.

Another policy error that occurred in recent memory is the Jean-Claude Trichet led European Central Bank's policy of tightening into the Great Financial Crisis.

Similar kinds of concerns are rising today. There are preliminary signs of a weakening economy, and the Fed's willingness to stay the course on its rate normalization policy in the face of soft inflation statistics is raising anxiety levels.

While I believe that recession risks in 2018 are rising, my base case scenario still calls for one last blow-off top in stock prices before the equity party comes to a close. Current concerns about the Fed tightening into a weakening economy can be summarized by this chart of the Citigroup US Economic Surprise Index (ESI), which measures whether macro releases are beating or missing expectations. As the chart shows, ESI has been weak, and the 10-year yield has declined in sympathy. But ESI is already at very low levels. How much worse can the macro picture get before it rebounds?

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

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