Cam Hui | Dec 07, 2014 11:33PM ET
Trend Model signal summary
Trend Model signal: Risk-on
Trading model: Bullish
The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:
Update schedule: I generally update Trend Model readings on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.
h3 My inner trader takes the stage/h3As the year draws to a close, I thought that I would do something a little different and allow my inner trader to outline his trading plan for December. Next week, my inner investor will have his chance to address his views for 2015.
You may recall that last week (see Trust (the bull), but verify (the trend)), even though the trend remained bullish, I had "called an audible" and gone to cash because I was unsure of the market reaction to the drop in oil prices. The OPEC decision had occurred over the US Thanksgiving holiday and, while the US markets were open Friday, many major market participants had gone away and volume was light. By Wednesday, I was sure enough about the trend that I dipped my toe back on the long side:
As my inner trader surveys the landscape, he continues to see a global uptrend in equities. The Chinese stock market has gone parabolic.
Even though that kind of advance is unlikely to be sustainable at the current pace (see tweet below from Tom Orlik), the other Greater China markets, namely Hong Kong, South KoreaI and Taiwan, are also in solid uptrends.
The picture also looks bullish in Europe. Despite Mario Draghi's hemming and hawing last week about whether the ECB is ready to proceed with QE, European markets have been rising and the STOXX 600 is now testing an important resistance level. The advance is supported by confirmation from the 14-day RSI. The German DAX (not shown) staged an upside breakout from resistance last week, which is another positive sign for European stocks.
In the US, the S&P 500 tested an intra-day all-time-high on Friday and pulled back from resistance. Unlike the STOXX 600, this index is seeing a negative divergence from RSI-14. Longer term, however, the advance appears to be healthy in the context of a continued uptrend and a recovery from a V-shaped bottom.
Despite the negative divergence seen in the SPX, I would not be too quick to get overly bearish. The Dow broke out to an all-time-high on Friday with confirmation from its RSI-14.
On a more cautionary note, the chart below shows the Rydex Bear-Bull asset ratio (middle panel), as well as the Bear-Bull flow ratio (bottom panel). Both ratios are important indicators of investor sentiment. The asset ratio is a barometer of how much bullish and bearish investors have committed to their directional bets, but it could be misleading if viewed in isolation. Imagine that investors committed $X to the bull side and $Y to the bear side; there were no cash flows and the stock market went up by 10% during this period. The bear-bull asset ratio would fall to reflect the increase in stock prices but an observer might see misinterpret this as contrarian bearish because it had fallen 20% (+10% for bulls and -10% for bears). That`s why it`s important to view this in the context of the bear-bull cash flow ratio as well.
In the chart, I marked with vertical lines instances the dual conditions where 1) the asset ratio has reached a new low and 2) the flow ratio has also reached a low, indicating possible excessive bullish sentiment among Rydex investors. I further color coded the lines where the blue lines indicate that the stock market continued to advance and the red lines indicated future declines.
As the chart shows, we got a signal recently where both the asset and flow ratio reached a crowded long extreme. However, the track record of this indicator shows that it is not perfect and it can have relatively long lags before a decline can begin - this seems to be a characteristic of many sentiment indicators.
h3 A hawkish Fed?/h3Another reason for caution is the possibility of some market turbulence ahead from the FOMC meeting due on December 17. Notwithstanding the blowout surprise from the November Jobs Report, that report made the trend very clear - the economy continues to recover in a manner consistent with Fed expectations.
Unless we see significant signs of economic weakness in the months to come, the Fed should start to raise rates in June. In a recent Pension Partners created a chart that described this pattern well and it seems to be a reasonable road map to use.
Tactically, current conditions suggest approaching the market as a market of stocks, rather than a monolithic stock market. It suggests either remaining modestly long, or using a long-short strategy of emphasizing market leaders, which reflect the optimism of a growing economy, on the long side while either avoiding or shorting laggards, which could be vulnerable to tax-loss selling.
The chart below shows the relative performance of a number of market leaders relative to the SPX (via SPDR S&P 500 (ARCA:SPY)). The top panel shows the Healthcare sector (via SPDR - Health Care (ARCA:XLV)) and its component industries (IBB, IHI, PJP, IHF) which have all outperformed the market for much of the year, and the semiconductor stocks (via the SOX Semiconductor index) on the bottom panel.
Speaking of semiconductors, I would also like to mention the post from Andrew Thrasher who believes that semiconductors have replaced Dr. Copper as a leading barometer of the global economy. In that context, the emergence of semiconductor stocks as a leadership group should be regarded as intermediate term bullish.
As for the laggards, small cap stocks have been roughly flat for the entire year and underperformed the SPX more or less all year. This pattern is suggestive of continued small cap underperformance for the next couple of weeks, followed by a typical seasonal small stock rally into January.
Resource stocks are also the most likely candidates for tax-loss selling in December. The top panel of the chart below shows the absolute performance of the Energy sector as well as the Metals and Mining stocks. The bottom panel shows the relative performance of the oil service and exploration and production groups relative to the already disappointing Energy sector. The Energy sector averages are dominated by the integrated oils like Exxon Mobil Corporation (NYSE:XOM) and Chevron Corporation (NYSE:CVX), whose profitability are cushioned by their downstream refining and marketing operations. The oil service and exploration and production companies have no such protection. They are more vulnerable to oil price weakness and therefore further weakness from tax loss selling.
As the year draws to an end, I would expect that these weak sectors and groups, such as small caps, energy and mining stocks, to weaken and then stage a snapback rally in the last week of the year. My inner trader is watching market conditions and preparing for such a possibility. In the meantime, he is nervously long with relatively tight stops.
Next week, I will discuss how my inner investor views the challenges and opportunities for equities in 2015.
Disclosure: Long SPXL, BIB
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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