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What Do The Market Models Say - Part II image

Good Morning. Although the S&P 500 is just a couple points off the all-time high set on August 2, there is an awful lot of chatter about stocks heading lower from here. There really isn't much in the way of new justification for the anticipated dance to the downside as the discussions continue to focus on "taper talk," the budget showdown, the slowdown in China, the election in Germany, more woe for Greece, and the fact that September has historically not been kind to the bulls.

The chartists aren't exactly upbeat either right now as there is a lot of talk about the "Hindenberg Omen(s)," the Dow's break below important support, and the potential for a head-and-shoulder top forming on the S&P 500. And as I mentioned in yesterday's missive, it just feels like something bad is going to happen.

So, given the fact the summer doldrums have definitely arrived, we thought this would be a good time to finish up our look at our key market models.

To review, our Weekly Environment Model is comprised of ten individual inputs, which can be broken down into the categories of tape, trend, sentiment, economic, monetary, and the overall risk environment. As I stated yesterday, we give the majority of the model weight to tape and trend indicators (60 percent) while the "external" factors account for 40 percent of the model. This is due to our view that the price/tape action of the market should be the final decider during important market moves and act as a solid stop-loss when things get funky.

In yesterday's missive, we reviewed the tape and trend indicators which were positive and neutral respectively. Thus, this morning we will look at the sentiment, economic, and monetary components as well as the risk environment indicators contained in our weekly market environment model.

The Economic Model

Believe it or not, the stock market is not always driven by the state of the economy. This is especially true during the expansion phase of the economic cycle. However, when the economy is making a turn, stock traders tend to focus heavily on the outlook for the economy. On that note, it is important to recognize that it is the outlook going forward that the stock indices tend to discount and not what the data says is happening at the present time.

Our economic model is comprised of fifteen economic indicators. Although the model does produce buy and sell signals, we prefer to utilize the model readings or modes. The key to this approach is there should be a sizable disparity between the positive and negative readings. For example, when the economic model is very positive (i.e. readings above 80%), the S&P 500 has gained ground at an annualized rate of nearly 24% per year over the past 48 years. On the other end of the spectrum, when the model reading is very negative, the S&P has lost 23% per year. A similar spread can be seen when the model is moderately positive and moderately negative (+11.1% per year vs. -9.0% per year). As such, this model is a nice addition to our environment model.

The current reading for the economic model is low neutral. However, it should be noted that the reading is less than 1% away from a moderately negative reading this week.

The Monetary Model

The saying "don't fight the Fed" was originally designed as a reminder to investors to stay in tune with the overall direction of interest rates. Of course, that was before the invention of ZIRP, QE and the rest of the alphabet soup of acronyms used to describe today's monetary policy actions by central bankers around the world.

While there have definitely been periods of time in history where it has paid to go contrary to the general direction of rates, including the monetary environment as in input to a stock market model will help more often than not. The monetary model we employ is a true "model of models" as there are eight inputs to the monetary model, with several of the inputs being groups of indicators or models themselves.

Like the economic model, we use the monetary model on a "mode" basis, meaning the model is rated positive, neutral, or negative. Over the past thirty years, when the monetary model has been positive, the S&P 500 has advanced at a rate of more than 25.4% per year. But when the model negative, the S&P has fallen at a rate of 8% per annum.

The current reading of our monetary model is neutral. History shows that stocks have performed a bit below average when the monetary model in this mode with the S&P's mean return coming in at 4.7% per year.

The Sentiment Model

As I opined last week, stock market sentiment is a tricky business. The basis behind this category of indicators is that by the time investor sentiment becomes excessive in one direction or the other, it means that investors have likely already taken action. For example, when sentiment becomes overly positive, it is a decent bet that all those who wanted to buy stocks have already done so. Therefore, there may be less demand for stocks going forward, which, in short, means that the market is susceptible to a negative catalyst.

Unlike my favorite sentiment indicator that I wrote about last week, the indicator we employ in our weekly environment model is a bit longer-term in nature. This too is a "model of models" as the sentiment model employs a total of seven indicators in order to produce the model reading.

Once again, we like to use the "mode" approach here. The S&P has gained ground at a rate of 35.5% per years since 1982 when the sentiment model is positive and has lost ground at a rate of nearly 17% per year when the model is negative. Therefore, this is another model worth paying attention to each week.

Currently, the sentiment model is negative. In short, the component indicators suggest that there is too much optimism in this market.

The Risk Model

The final input to our Weekly Market Environment Model is a combination "model of models" that focuses primarily only the overall risk/reward environment. Once again, we use a "mode" approach in order to give the overall Market Environment Model some teeth when it moves from positive to negative. For example, our risk environment model sports an average annualized return of 28.3% when positive and -23.8% when negative (going back to 1982).

The current reading for the model is... neutral. And the average gain per year in this mode has been 8.1% per year.

Summary: When you add up all the +1's, -1's and 0's, the current Market Environment Model score is +3. What's interesting is that readings of +3 and above are positive while readings of -3 and below are negative. So, the model is positive this week, but just barely. Thus, there is not much room for error at the present time.

From a subjective point of view, I think the current reading is about right. The overall environment is still positive, but only slightly so. Should the tape or trend weaken from here, the environment would be downgraded to neutral. And if this were to occur, it would be a sign to take less risk and wait for the environment to improve.

Finally, I made this same point yesterday but it bears repeating. The important thing to remember about the reading of the weekly environment model is that it is not designed to "predict" what is going to happen next in the market. In sum, the goal is to identify what "is" happening in the current environment so that we may position our accounts accordingly.

Turning to this morning... After finishing lower in four of the last five sessions, it appears that stocks on Wall Street may attempt to rebound a bit this morning. Strong gains in Japan based on talk of overhauling the corporate tax system and decent data across the pond have produced positive results in the vast majority of foreign markets. Not surprisingly, traders in the U.S. are following suit at the moment. However, there is new data on the state of the U.S. economy scheduled for release this morning.

Positions in stocks mentioned: none


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