Timing Model Update

By: | Sun, May 18, 2008
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Timing attempts to provide market equivalent returns over the long term, with a substantial reduction in variability of returns. The two components of the Timing program are EZ+Macro and Fear/Greed. This system trades rarely and splits its allocations between ETFs tracking the S&P 500, the intermediate-term U.S. Treasuries, and cash.

System recap is presented first this week, followed by extended commentary and charts.

System Summary

Information is as of the close on May 16, 2008.

EZ+Macro

My charts are relatively wide, and this site is best viewed at 1280×1024. If the chart is truncated in your browser, click on it to view it in full size.

EZ Trend is still down, but note that the divergence has reversed and the quicker-moving trend is now rising, and the slower-moving trend has stabilized. If this continues, the trend signal will shift before too long.

Macro Trend is still bullish for Treasuries. This comes into play only if the EZ Trend is not up. Note that this trend may be reversing as well.

Fear/Greed

The Fear/Greed model signaled a buy for the U.S. stock market in early November, and a sell in December, as the $VIX relative to actual volatility fell to a historically low level. For most of the last five months, the current level of sentiment, as measured by the $VIX relative to actual volatility, has been at levels historically associated with complacency. In the scale of the chart, 80% of the readings since 1990 have been between the red and green lines.

Model Allocation

Based on beginning with a $100,000 portfolio at inception. The portfolio weights are shown behind the ticker symbol, and are rounded to the tenth of a percent.

S&P 500 SPDRs (SPY) 26.2% weight
iShares 7-10 Year Treasury Bond Fund (IEF) 24.1% weight
Cash 49.6% weight

Returns

Based on beginning with a $100,000 portfolio at inception.

Equity: $98,956.35
Gain, Last 4 weeks: 0.59%
Gain, Year to Date: -2.35%
Gain, Since Inception on 11/12/2007: -1.04%

These returns include the recent May distribution from IEF of $0.28 per share. This system has been approximately 50% allocated to cash since December 21, 2007, and I have not been including gains from cash interest in the returns.

Changes To Model Allocation

There are no changes to the model allocation since this previous message. It is listed below:

S&P 500 SPDRs (SPY) 25.0% weight
iShares 7-10 Year Treasury Bond Fund (IEF) 25.0% weight
Cash 50.0% weight

Tracking

There are no changes to track.

Commentary

My intuition is that the U.S. stock market has set up for an intermediate-to-long-term bottom, as discussed much earlier, but the Timing system is mechanical, and will be tracked based on the signals it generates. The system went 50/50 stocks/cash on December 21, 2007, and then on January 18, 2008 went to 25/25/50 stocks/bonds/cash.

My charts are relatively wide, and this site is best viewed at 1280×1024. If the chart is truncated in your browser, click on it to view it in full size.

The drop in implied volatility relative to actual volatility, shown in the Fear/Greed chart, above, is similar to a wide range of other sentiment indicators that many other timing systems are tracking. While this is bothersome from a contrarian standpoint, it's interesting to note what actual volatility has done over the past several months - it's been in a steady climb for the past year, ever since the late February market "crash" in 2007, with a decided break of the trendline taking place just in the last month. Perhaps the decline in implied volatility is related to a correct judgement by market participants that actual volatility has peaked?

Undoubtedly most of the slide from October 2007, and most of the increase in volatility since February 2007, has been part and parcel of the "recession trade." In the chart below, note that the two largest-range days in the last five years were in February 2007 and in January 2008. Note also that the January 2008 spike was also the single largest volume day in the last five years.

Remember Jerome Kerviel, a 31-year old trader who worked in Société Générale's Delta One products team in Paris, who was responsible for a colossal loss of over $7 billion? The psychological implications of that week, for the overall market, are extremely important. Not only was that slide to the bottom in price accompanied by huge volume, there was a sense of "what's next?" Everyone seemed to wonder what shoe would drop next, which financial institution would collapse next, how big their write-downs would be, and how bad the economy was going to get. Until Jerome was exposed, many participants wondered who was doing all the selling in the DAX, and what they knew that no one else knew. That's the thought pattern that prevails in markets when action is seen but intentions and reasons are unknown - they know something! Let's follow them! Thus is was with this selling. The exposure of the European index futures selling in late January as nothing more than a colossal screw-up by one bank's risk control unit made a lot of participants realize they had bought into, or rather, SOLD into, an overblown orgy of fear.

January was the turning point for the markets.

In the following chart, the lower-volume (but still high, historically speaking) retest in March set up a double-bottom, and the selling into that lower low was nowhere near as intense as the action in January. The action since March has violated downtrend lines from various points on the slide, and led to prices above support and resistance lines that go back to February 2007. While recent action has been lower in volume than early in 2008, we must remember that 2008 contained this massive capitulation bottom and a retest of that bottom! The "low-volume action" that many pundits complain about is actually elevated volume compared to historical averages, and there's some serious accumulation going on here.

Based on the percentage of S&P 500 stocks trading above their 200 day moving averages, I suspect that the index overall has more room to run in the intermediate to long term.

However, even though the recent action above the index's 100 EMA has been constructive, the 2-day RSI suggests that an immediate entry may suffer through a short-term pullback.

Also, the percentage of S&P 500 stocks trading above their 50 day moving averages is fairly high.

Summary

The best risk/return, although highest volatility, entry opportunities have passed; those were at the bottom in January and the retest in March. Today does not present as good an opportunity, because of some short- and medium-term "overbought" conditions. I suspect that the broad movement off of the retest in March will segregate itself by sector, with leadership emerging and some lagging sectors falling below their 50 day moving averages, and the index working off its "overboughtness."

In regards to the Timing model portfolio, it will continue to follow its mechanical signals. If the price action proceeds as I anticipate, it will switch to a higher long percentage in the next few weeks, and will only move into its highest exposure if there is a significant spike in fear, which I don't see happening anytime soon.

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