Sunday, December 17, 2017

Five steps, where's the stumble?

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.

What happened to 3 steps and a stumble?
As expected, the Federal Reserve raised rates by a quarter point last week and re-affirmed its dot-plot projection of three more quarter-point hikes next year. What happened to "three steps and a stumble"?

The old Wall Street trader's adage of "three steps and a stumble" refers to the stock market's reaction to Fed rate hike cycles. At first, stock prices don't react to the Fed raising rates, but eventually the market succumbs to the economic cooling effects of monetary policy, and a bear market usually begins after three rate hikes. Hence, "three and a stumble". The chart below from Ned Davis Research shows the effects of this rule on the Dow. Historically, the DJIA has declined a median of -17.9% from sell signals to NDR market bottoms.

Historically, the sell signals have been fairly prescient, though sometime early. This expansion cycle has been unusual in that the Fed began raising rates two years ago. We have seen five consecutive quarter-point rate hikes, so where's the stumble?

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

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