Sunday, December 24, 2017

A sector review reveals animal spirits at work

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: Bullish*
  • 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.

Here comes the animal spirits
Josh Brown composed an insightful post last week entitled, Trump's Singular Accomplishment:
I mean this without a trace of sarcasm, not being a fan of the President’s or pretty much anything he stands for…

Donald Trump’s singular accomplishment, in my view, is the ignition of Animal Spirits in the stock market and the real economy. Small business confidence measures shot up from the week of his inauguration and have remained elevated ever since. PE multiples expanded throughout the course of the year, which was not solely due to his tax policy – it was also about his swagger and I-don’t-give-a-f**k persona.
Indeed, the animal spirits in the stock market began to run wild starting in September, when the weekly RSI became overbought and stayed overbought. My former Merrill colleague Walter Murphy called this a "good overbought" condition, where the market continues to advance while remaining overbought. Since 1990, there have been two episodes when the market flashed a series of overbought readings. One lasted 10 months, the other lasted 14 months. In both instances, stock prices were significantly higher afterwards.

LPL Research quantified the "good overbought" effect on market returns using data that went back to 1950. They found that past episodes of weekly RSI above 80 has been bullish for equity returns, though the sample size is still low (N=13). The table below from LPL, which I edited and annotated, shows that the excess return from the price momentum effect fades out after six months. The incremental return from six to twelve months when when weekly RSI > 80 is not significantly different from the "at any time" returns.

This week, I review the sector leadership of the stock market. The analysis reveals a late cycle market characterized by price momentum leadership, and expectations of increased capital expenditures, as well as emerging leadership from inflation hedge sectors.

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

No comments: