Cam Hui | Jun 29, 2015 04:23AM ET
Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bearish
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. 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 model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.
Update schedule: I generally update Trend Model readings on weekends and tweet any changes during the week at @humblestudent.
After the posts that I had written in the last week, where I examined the bull and bear case for stocks (see And now for something completely different: The Hegelian Dialectic) and a discussion of the possible causes of the current low equity volatility environment (see Will the quants blow up the market again?), I realized that I should be approaching the market in a different way. Instead of trying to forecast market direction, I should be trying to forecast the volatility regime.
As the chart below shows, US equities have been in a very tight trading range for all of 2015. As of the close Friday, the SPX was up a whopping 2% from year-end, with lots and lots of whipsaws. As an indication of the choppy market, I have marked with arrows the extraordinary number of instances the SPX has crossed its 50 day moving average. Further, the top panel shows the RSI(14) indicator, which is an overbought/oversold measure. This indicator has not flashed an overbought (over 70) or oversold reading (under 30) all year. In fact, it has stayed in a range even tighter than the more traditional 30-70 upper and lower bounds.
These are the characteristics of a low volatility equity market environment. Though volatility has spiked in other markets, such as the fixed income and foreign markets, the realized volume of US stocks remains low. The key question then becomes, "Will this continue?"
When trying to forecast volatility, it is helpful to think about scenarios, one where volatility stays low and another where it breaks out.
On the one hand, macro risks are high as the weekend ends, with Greece on the verge of default and the Chinese stock market on the verge of meltdown, which argues for a breakout in volatility and the start of a correction. On the other hand, the US macro and fundamental outlook has been improving, which is supportive of a rebound in stock prices.
Since the main focus is the direction of US equities, let us begin by assessing the US outlook. As an overview, the Atlanta Fed Nowcast of 2Q GDP growth has advanced to 2.1%, which is a significant improvement of 0.7% seen in mid-May.
Last week also saw better than expected retail sales data. As John Butters of Factset also brought good news. Forward EPS continues to advance and, as the chart below shows, forward EPS estimates have been highly correlated with stock prices (annotations in red are mine).
What about Greece? Butters showed that Greece was not mentioned in a single earnings call. In fact, eurozone countries were far down the list mentioned as issues in company earnings calls, which indicates that a Greek default or Grexit has little direct contagion effect on US corporate earnings.
From a technical perspective, here are the charts of the S&P 500 and major European averages on Friday after the close, but before the news of a Greek referendum hit the tape. The Euro Stoxx 50 had been rallying and testing its 50 dma, which is an indication that the eurozone is weathering the Greek crisis well. The UK's FTSE 100 could also be construed as being in turnaround mode.
Bottom line: The Trend Model was on the verge of a trading buy signal. Even minor improvements in stock prices in the US and Europe would have moved the needle to bullish. Based on this analysis, US equities have room to rally in the absence of tail-risk.
As US stock prices have descended last week, such a bullish interpretation translates to a rally and therefore a likely continuation of the low volatility regime, where stock prices rise but get capped by other factors.
As investors are well aware, the world is not without risks. The two immediate tail-risks that face the markets come from China and Greece.
The Shanghai market nosedived 7.4% on Friday and it is now down over 20% on a peak-to-trough basis, which puts it into bear market territory. The development was not a surprise (at least to me) as there have been reports of widespread insider selling . The stock indices of the regional exchanges of China`s major Asian trading partners (Hong Kong, Taiwan, South Korea, Singapore and Australia) staged rallies last week, but all were unable to break through their 50 dma, which would be indications of renewed strength.
The bearish and high volatility implication of these charts is that Mr. Market remains concerned about the outlook for Chinese growth. Should the Chinese stock market implode further, we could see a leakage of financial contagion spread throughout the region.
On the other hand, the PBoC reacted by cutting interest rates (via his own negotiating team in Brussels) by announcing that he would be calling a referendum on July 5 to put the latest eurozone proposals to a vote. There are a number of problems with that course of action.
The last point is of immediate concern for the financial markets. It means, at the very least, capital controls and, at worst, the vaporization of the Greek banking system. Yves Smith at FT Alphaville ), showed that Greek contagion is far more ring-fenced than it was in 2012. In particular, the second chart (figure 11) hints at the ECB turning on the QE and OMT taps to counteract any Greek contagion effects.
Indeed, the latest ECB statement on capping Greek ELA at current levels ended with this ”whatever it takes” paragraph (emphasis added):
The Governing Council is closely monitoring the situation in financial markets and the potential implications for the monetary policy stance and for the balance of risks to price stability in the euro area. The Governing Council is determined to use all the instruments available within its mandate.
While history doesn't repeat itself, it does rhyme and we can also look to the Cypriot crisis as a guide as to what might happen next. As the chart below shows, the farther a region was from the epicenter of the crisis, the more insulated the market was. US equities (top panel) didn't respond at all to the imposition of Cypriot capital controls and the resolution of its banking system. Greece was the most exposed (see bottom panel) and Europe (top panel) was somewhere in the middle.
As the Cypriot capital control episode showed, the Greek and European markets fell initially on the news and bottomed soon afterwards. US markets barely reacted at all. The Cyprus example suggests that volatility will likely breakout, but in the form of upside volatility.
One last thing. Buying Europe and shorting US equities a week ago;
All of those trades were profitable. On Friday, he dipped his toe in on the long side on the basis of a bet on a low volatility range-bound market, the news that Greece was inches away from a deal, the "oversold" readings of the market by 2015 standards:
…and a longer term analysis indicating that the NYSE Summation Index (bottom panel) and NYSE common stock only Summation Index (middle panel) were turning up. These readings are highly suggestive that the bulls will see tailwinds for the next few weeks.
As my inner trader watches the event-driven volatility in the week ahead, he will keep his position commitments light. He will evaluate the market action using the framework of the two possible volatility regimes as well as his own risk control parameters.
Will we see SPX RSI(14) break out, either on the upside or downside? If the SPX were to sell off hard, will it break the key support level of the 150 dma at 2078, which has put a floor on the market for the last couple of years?
As I write these words, equity futures are deep in the red, but Sunday night futures markets have a way of changing dramatically by Monday's open. This coming week`s market will be full of twists and turns (and I haven`t even mentioned the US Employment report on Thursday). Should you chillax, or panic and sell everything?
The market will not seem so chaotic as long as you have a plan. Keep commitments light, define how much risk you want to take and don't go overboard on your positions. Good luck.
Disclosure: Long TNA
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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