What Today's Trend Following Sell Signal Implies For The Months Ahead

Summary:  With SPX closing below its 10-month moving average, a sell signal for a popular trend following system triggered today. This system has handily beaten the long-term performance of just holding SPX.

So what happens next? Using data from the last 38 years, there is an even chance that SPX reverses direction and moves higher from here over the months ahead. But the October low - or very close to it - appears likely to be retested in November.

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After rising every month for 6 months since the end of March, and in the process gaining more than 10%, US equities fell hard in October. SPX dropped 7%, NDX 9% and small caps 11%.

This was the third worst month since the bull market started 116 months ago in March 2009; only May 2010 (flash crash) and August 2011 (European debt crisis) were worse.

The fall was enough to trigger a sell signal in a popular trend following system.

Trend following dispenses with the debate about recessions, the actions of the Fed, corporate earnings, valuations, China, investor sentiment, market breadth, and all the rest. It focuses purely on price and implicitly assumes that it reflects the most useful information available.

How does it work? As described by Meb Faber here, investors stay long when SPX is above its 10-month moving average (MMA) at month end and move to cash when it closes below. That's it. The system's long term track record is excellent (red line), handily beating the SPX (blue line) and 80-90% of professional investors (more on that here). Enlarge any chart by clicking on it.

Weekly Market Summary

Summary:  US equities are down 10% from their all-time highs just 5 weeks ago. The trend in equities has turned bearish, and that is not something that should be taken lightly. The evidence pointing to a major top being formed has further increased. But the set up for higher prices, at least before a significantly lower low, appears to be very strong. This is not a certainty, but it is a high probability.

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After falling 4% two weeks ago, and then closing a bit higher last week, US equities this week again fell 4%. They are down about 10% for the month of October. The nearly 10% gain in 2018 at the end of September for SPX is now all gone. Small caps have been hit the hardest and are now down 3% for the year (table from alphatrends.net).  Enlarge any chart by clicking on it.

Weekly Market Summary

Summary:  Equities fell 4-5% last week and have given up most of their 2018 gains so far in October. This might feel like the start of a bear market, but that is the least likely outcome.

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US equities fell 4-5% last week. The nearly 10% gain in 2018 at the end of September for SPX has been reduced to just 3%. Small caps have been hit the hardest and are now barely above their level at the start of the year (table from alphatrends.net).  Enlarge any chart by clicking on it.

October Macro Update: Economic Data Suggests US Equity Bull Market Will Continue

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely. The largest risk to the economy is the escalation in trade war rhetoric.

The bond market agrees with the macro data. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (arrows). The lag between inversion and the start of the next recession has been long: at least 8months and in several instances as long as 2-3 years. On this basis, the current expansion will likely last into mid-2019 at a minimum. Enlarge any image by clicking on it.

Fund Managers' Current Asset Allocation - September

Summary: Fund managers came into 2018 very bullish, with cash levels at 4-year lows and allocations to global equities at 3-year highs.

9 months later, global equity allocations are nearly the lowest since November 2016. Moreover, cash balances are high. Globally, investors are relatively bearish. How can this be?

The reason is mostly outside of the US. While US equities are at all-time highs, both European and emerging markets are down in 2018. That has impacted investors' regional allocations in an important way.

After being out of favor for 17 months, fund managers are now overweight US equities by the most since January 2015. It's at an extreme, and the US should underperform.

Fund managers are now underweight emerging market equities by the most in 2-1/2 years; the region is now a contrarian long.  Europe is neutral, as are global bonds.

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Among the various ways of measuring investor sentiment, the Bank of America Merrill Lynch (BAML) survey of global fund managers is one of the best as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

Our sincere gratitude to BAML for the use of this data.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Overall: Relative to history, fund managers are overweight cash and underweight equities. Enlarge any image by clicking on it.

Within equities, the US is overweight while emerging markets in particular are underweight. This is a significant change from the past year.

A pure contrarian would overweight emerging markets equities relative to the US and underweight cash.