A sector review reveals animal spirits at work

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

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.


Here comes the animal spirits

Josh Brown composed an insightful post last week entitled, Trump’s Singular Accomplishment:

I mean this without a trace of sarcasm, not being a fan of the President’s or pretty much anything he stands for…

Donald Trump’s singular accomplishment, in my view, is the ignition of Animal Spirits in the stock market and the real economy. Small business confidence measures shot up from the week of his inauguration and have remained elevated ever since. PE multiples expanded throughout the course of the year, which was not solely due to his tax policy – it was also about his swagger and I-don’t-give-a-f**k persona.

Indeed, the animal spirits in the stock market began to run wild starting in September, when the weekly RSI became overbought and stayed overbought. My former Merrill colleague Walter Murphy called this a “good overbought” condition, where the market continues to advance while remaining overbought. Since 1990, there have been two episodes when the market flashed a series of overbought readings. One lasted 10 months, the other lasted 14 months. In both instances, stock prices were significantly higher afterwards.
LPL Research quantified the “good overbought” effect on market returns using data that went back to 1950. They found that past episodes of weekly RSI above 80 has been bullish for equity returns, though the sample size is still low (N=13). The table below from LPL, which I edited and annotated, shows that the excess return from the price momentum effect fades out after six months. The incremental return from six to twelve months when when weekly RSI > 80 is not significantly different from the “at any time” returns.

This week, I review the sector leadership of the stock market. The analysis reveals a late cycle market characterized by price momentum leadership, and expectations of increased capital expenditures, as well as emerging leadership from inflation hedge sectors.

A sector review

The analytical framework for sector leadership analysis is the rotation cycle. Here is how an idealized cycle works. In the initial phase of an expansion, central banks lower rates to boost the economy, and the market leaders are the interest sensitive stocks. As the cycle matures, leadership rotates into consumer stocks, followed by capacity expansion, which leads to capital goods sector leadership. The late phase of the cycle is characterized by tight capacity and rising inflation, which is an environment where asset plays and commodity extraction industries outperform.

There is an important caveat to this form of analysis. While the market cycles thematically parallel economic cycles, they are different. Market undergo mini-cycles of changes in sentiment whose length are much shorter than economic cycles. Nevertheless, the broad principles of market cycle analysis remain valid today.

With that in mind, here is a review of the sectors of the market, starting with the market leaders first. Each of the charts shown will show the relative performance of the sector to the market on the top panel, and the relative performance of the equal weight sector to the equal weighted market in the second panel. In some cases, the equal weighted analysis can be revealing as it can show the breadth of the leadership in the sector.

Technology: The momentum play

As the animal spirits have run rampant, technology stocks have been the primary beneficiary of this trend. Both the float and equal weighted sectors are in well defined relative uptrends, and the bottom panel shows the strong relative uptrend of momentum stocks that draw mostly from the technology sector.

As long as technology and price momentum remain strong, I am inclined to stay intermediate term bullish.

Financials: Breaking out, but…

The financial sector is another heavyweight sector in the index. While the equal weighted sector has staged a relative breakout (bottom panel), the relative performance of this sector has historically been correlated to the yield curve (top panel). The divergence between the strength in these stocks and the flattening yield curve makes me somewhat cautious. However, Reuters reported that analysis from Wells Fargo states found that banks pay the highest effective tax rate at 27.5%, and therefore they should benefit disproportionately from the lower corporate tax rate.