Sunday, January 22, 2017

Could "animal spirits" spark a market blow-off?

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 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: Risk-on*
  • Trading model: Bearish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

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.

Trump's challenge
Now that Donald Trump is the President of the United States, the real work of his administration begins. In inauguration speech, he invoked the spirit of Horatio Alger as a way to take America to new heights:
Finally, we must think big and dream even bigger. In America, we understand that a nation is only living as long as it is striving...

Do not allow anyone to tell you that it cannot be done. No challenge can match the heart and fight and spirit of America. We will not fail. Our country will thrive and prosper again.
Ray Dalio of Bridgewater Associates was optimistic about this "can-do" attitude of Americans:
This new administration hates weak, unproductive, socialist people and policies, and it admires strong, can-do, profit makers. It wants to, and probably will, shift the environment from one that makes profit makers villains with limited power to one that makes them heroes with significant power.
Despite inheriting an economy that is in the late stages of an expansion, Dalio believes that the incoming president can spark a second wind of growth by reviving the economy's "animal spirits":
This particular shift by the Trump administration could have a much bigger impact on the US economy than one would calculate on the basis of changes in tax and spending policies alone because it could ignite animal spirits and attract productive capital. Regarding igniting animal spirits, if this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge.
Bob Shiller went further and postulated a speculative stock market blow-off, followed by a crash (via The Telegraph):
America should brace for a final blow-off surge in stock markets akin to the last phase of the dotcom boom or the “Gatsby” years of the Roaring Twenties, followed by a cathartic crash and day of moral judgment, according to a Nobel prize-winning economist.

Prof Robert Shiller said the psychological “narrative” behind Donald Trump is powerful and likely to carry Wall Street to giddy heights before the aging business cycle finally rolls over.

“I think there will be a Trump boom for a while. Stocks look high, but they are not yet super-high. In 2000 the (Cape Shiller) price-earnings ratio was over 45 and we may see a repeat of that,” he told The Daily Telegraph.
For investors, the stakes are high. Under this scenario, a Trump inspired "animal spirits" revival could spur the SPX to its point and figure target of 2523 or more.

The question is, can Trump spark the "animal spirits" to Make America Great Again?

The full post can be found at our new site here.

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