Does Citigroup's Panic/Euphoria Model Work?

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Citigroup’s Panic/Euphoria model, featured in the July 8 commentary “Don't Miss Your Chance to Catch a Bull Market,” fell into panic territory at the end of June 2011.  According to the model’s originator, Citigroup strategist Tobias Levkovitch, this indicates a roughly 90% probability that equity prices will be higher in six months and a 97% chance of gains in 12 months.

In contrast, my model, as explained in “Improving on Buy and Hold: Asset Allocation using Economic Indicators” generated an initial sell signal early in May 2011 and forecasts a declining market from the middle of August 2011 onwards.

Citigroup’s model should not be relied upon to predict market direction. For example, the historic chart of the model for the 2007 and 2008 period incorrectly signaled positive forward returns for the market early in 2008. Now, the current chart has been modified so the model looks as if it had correctly indicated negative forward returns in 2007 and 2008.

The Panic/Euphoria model

The model uses the Market Sentiment Composite, a measure of investor sentiment. This metric tracks the mood of investors, which is then translated into a probability of the market's advancing or declining over the near term and over the next 12 months.

It is supposed to be a contrarian indicator that produces a bullish signal when market sentiment is overwhelmingly negative, and vice versa. The model’s methodology is undisclosed, and no statistical data is available to support the claim that the Composite value is an indicator for the 12-month forward return of the stock market. For example, Citigroup does not disclose the correlation coefficient used to measure the strength of the linear dependence between the Market Sentiment Composite and the 12-month forward return.

Figure 1 shows the Panic/Euphoria model. There are two horizontal lines: the upper green line (the euphoria line) and the lower red line (the panic line). When the Market Sentiment Composite (the blue line) is below the red line, this is considered bullish, and it signifies a positive 12-month forward return for the market. And conversely, when the Composite is over the green line, it signals a negative 12-month forward return.

In order to test whether the Panic/Euphoria model can provide useful trading signals for the stock market, I have superimposed buy and sell signals for the S&P 500 on the Panic/Euphoria chart. Buy signals are assumed to occur when the Composite penetrates and falls below the red panic line (in expectation of positive forward returns), and sell signals should occur when the Composite rises above the green euphoria line (in expectation of negative forward returns). This is shown in figure 1.

Panic/Euphoria chart