A house on fire?

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: 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.


Buy the dip, but not yet
We had some minor excitement in our household in the last week. We were at a show when I received a frantic text message that the neighboring building was on fire. Fire fighters were spraying our building as a preventive measure. Mrs. Humble Student of the Market rushed home to rescue the family dog. The house next door was burning to the ground and we were ordered to evacuate. We discovered the next day that our unit suffered water and smoke damage, and it would take several weeks to fix. While the whole episode was disconcerting, it was not a total disaster.

I am now living in a hotel and writing this publication on an older rescued laptop, so please forgive me if I am not up to my usual witty and erudite self.

As the stock market turned south last week, some traders were behaving as if their own houses were on fire, instead of the neighbor's. Morgan Housel recently penned a timely article entitled It's hard to predict how you'll respond to risk:

An underpinning of psychology is that people are poor forecasters of their future selves. There is all kinds of research backing this up. Imagining a goal is easy and fun. Imagining a goal in the context of the realistic life stresses that grow with competitive pursuits is hard to do, and miserable when you can...

The same disconnect happens when you try to forecast how you’ll respond to future risks.

How will I respond to the next investing downturn?

[...]

You will likely be more fearful when your investments are crashing and more greedy when they’re surging than you anticipate.

And most of us won’t believe it until it happens.

CNBC had a similar perspective. Investors have been so used to a low volatility environment where stock prices have risen steadily. When the market environment normalizes, it raises the risk of a sharp short-term selloff should long positions in weak hands panic:

Market volatility has been low, meaning that stock prices have been stable for a long time.

Some investors have interpreted this as a sign of current market risk and that there could be a sudden correction in stock markets, meaning many people could be about to lose vast sums of money.

Should the stock market crater from here, don't panic. This is not the start of a major bear market.

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