Sunday, January 5, 2020

Trading the market melt-up

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 Asset Allocation 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 a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don't buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

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 receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.

Melt-up hangover ahead?
Back in mid-December, I rhetorically asked if the stock market was undergoing a melt-up (see Is the market melting up?). At the time, the jury was out on that question. Today, we have the answer. The market is exhibiting the classic signs of a blow-off.

CNBC reported that even the perennial bullish Ed Yardeni, who had a SPX 2020 year-end target of 3500, was openly worried about an air pocket.
″[A] 10% to 20% [correction] would be quite possible if this market gets to 3,500 well ahead of my schedule,” he said.
What should traders and investors do? If we were to use the late 2017 and early 2018 episode as a template, there are definite indications that the market has overrun its rising trend line and a soaring net new highs to lows, which are signs of a melt-up. By comparison, the advance in the summer of 2018 was far more orderly. From a technical perspective, there are not the same warnings of an imminent market top that we saw in early 2018. In January 2018, the market broke down without any negative RSI divergences, but did see a negative NYSI divergence. Today, there are neither RSI nor NYSI negative divergences, which could mean that this rally has more room to run.

The market's risk-off reaction to the killing of Qasem Soleimani certainly presents a challenge to the bulls. Iran has vowed to retaliate for the targeted assassination, and the geopolitical risk premium has spiked as a result. Are we headed for a melt-up hangover? We discuss the bull and bear cases.

The full post can be found here.

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