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S&P 500 Market Timing - September 29th 2015

|Includes: SPDR S&P 500 Trust ETF (SPY)

I don't believe that anyone can perfectly time the market. With that disclaimer, I also believe that the market gives various indications before a bear market hits. Sometimes you can discern the signals in advance - other times you cannot. Even if you are correct, knowing how to act on the signal is another story. What are the signals telling us right now?

My Simple Market-Timing System

The market-timing signals that I use are fairly simple. I will have a negative sentiment if any 2 of these signals are true. If less than 2 signals are true, my sentiment remains positive.

  • The S&P 500 price is trending downwards
  • The aggregate S&P 500 earnings forecast is trending downwards
  • The unemployment rate in the United States is trending upwards

On September 21st 2015, I alerted investors who subscriber to the Transcendent Stock & ETF Portfolios service on Seeking Alpha that the market-timing signal had turned negative. What conditions led to this call?

Condition 1: Negative Price Action

First, let us tackle the obvious one. The S&P 500 index price has been trending downwards for some time now. Look at the chart below.

S&P 500 Daily Price Chart

The first condition was met when the daily price for the S&P 500 fell below its 100-day moving average - which is the blue line. This happened in August.

Supplementary: You may also notice the trend-lines which are the parallel upwards sloping green lines. Although this isn't included in the market-timing signal, I find it very useful to draw long-term trends above and below the price action. A downtrend usually has a sharp downward break of the bottom trend-line which is often followed by a small upwards rally. Sometimes the rally succeeds but other times the price hits the underside of the trendline, waffles, and then drops down hard.

My stance would turn particularly negative if the S&P 500 ETF (NYSEARCA:SPY) fell below 182, a level which is providing some price support. But this is my personal bias and not really part of the market-timing signal.

Condition 2: Negative Earnings Estimate

The second criteria considered is the S&P 500 earnings estimate. Below is the aggregate analyst earnings estimate(current year) for the S&P 500 since 1999.

S&P 500 EPS Analyst Estimate for Current Year

I will zoom in on the recent estimation of the S&P 500 EPS.

Market-Timing Signals

I filled in the green circle at the beginning of July where the short-term moving average (5 week) EPS estimate crossed above the medium-term moving average (21 week). This suggests an optimistic trend where earnings are being revised upwards. The signal crossed back down for a negative sentiment on September 19th.

This second negative condition flipped my sentiment to bearish.

Condition 3: Unemployment

When unemployment rates spike, the market often drops. This US unemployment chart clearly shows that since 2010 the rate has been steadily dropping. This is a bullish indication. However, the other 2 bearish signals create an overall negative sentiment.

USA Unemployment Figures

How I Use Market-Timing

Few people have the desire or the will to go 'all in' or 'all out' of the market. If you have ever missed a rally because your indicator was wrong - you probably won't be making that mistake twice. As well, transaction fees and slippage can erode your capital if you over-trade market-timing signals.

I prefer to employ 'soft market-timing'. Unless you are a buy and hold investor, you should have buy and sell criteria. Every week, review any potential buy and sell recommendations. During periods of bearish sentiment, I execute the sell recommendations but not the buy recommendations. This slowly converts your portfolio to cash in the event of an extended downturn, yet you are still partially invested if the market reverses. As well, you do not need to sell all your holdings at once - just the weakest ones on a weekly basis.

Here is an example of one portfolio compliments of Portfolio123:

Portfolio123 Stock Screening and Backtesting Chart

The top window represents portfolio performance from May 2008 to 2009. The second window shows maximum portfolio drawdown - which is the maximum loss when counting from the previous high. The third window shows the amount of capital invested, which goes down as the portfolio raises cash when the market-timing indicator is bearish.

Market-timing is not for everyone. Even those willing to experiment with this practice may prefer a compromise of progressive selling, such as outlined above, rather than an all-or-nothing signal that is rarely acted on.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.