Sunday, July 30, 2017

No one rings a bell at the top, but...

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.

The message from sector leadership
It is said that no one rings a bell at the market top, but a review of sector leadership shows that late cycle inflation hedge sectors are poised to assume the mantle of market leadership (see Nearing the terminal phase of this equity bull), which would be the signal for a blow-off in inflationary expectations. Such an event would be the trigger for the Fed to become more aggressive in its rate normalization policy, and raises the risk of a policy mistake that could push the economy into recession.

If investors are looking for a bell to ring at the top, then there are signs that someone is slowly ascending the bell tower.

Consider the Relative Rotation Graphs, or RRG chart, of the market today. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

Wayne Gretzky famously said that his secret was to skate where the puck is going to be. Using that principle, the top left hand quadrant shows the sectors that are the likely emerging market leadership. These groups, with the exception of Financial stocks, are all in the inflation hedge and resource extraction industries, namely Energy, Metals and Mining, and Materials.

In short, the message from the evolution of sector leadership indicates that the market is poised for a blow-off in inflationary expectations, which will likely prompt a response from the Fed.

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

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