How much danger is the stock market rally in?

by Troy

With the stock market rallying to its 61.8% retracement, our medium term market studies are mixed. They are no longer consistently bullish. And while the odds favor a pullback/retest right now, it is not impossible for the market to go higher before making a pullback/retest.

Meanwhile, the economic data is mixed. This means that while long term risk:reward favors the downside, there is still the possibility that the stock market will make new highs.

Source: Investing.com

The economy’s fundamentals determine the stock market’s medium-long term outlook. Technicals determine the stock market’s short-medium term outlook. Here’s why:

  1. The stock market’s long term risk:reward is no longer bullish.
  2. The stock market’s medium term is mostly neutral (i.e. next 3-6 months)
  3. The stock market’s short term has a slight bearish lean.

We focus on the long term and the medium term. Let’s go from the long term, to the medium term, to the short term.

Long Term

While the bull market could keep going on, the long term risk:reward no longer favors bulls. Past a certain point, risk:reward is more important than the stock market’s most probable long term direction.

*”Bear markets” = 33%+ declines that last >1 year. E.g. 2007-2009, 2000-2002, 1973-1974, 1968-1970.

Some leading indicators are showing signs of deterioration. The usual chain of events looks like this:

  1. Housing – the earliest leading indicators – starts to deteriorate. This has occurred already
  2. The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long term topping process. We are in the early stages of this process, but the deterioration is not significant.
  3. The labor market deteriorates some more, while other economic indicators start to deteriorate. The bull market is definitely over.

Let’s look at the data besides our Macro Index

Housing is weak. New Home Sales rallied in November 2018, but based on preliminary estimates, New Home Sales will fall again for the next month’s reading. (The November 2018 New Home Sales data was delayed by the government shutdown).

Historically, New Home Sales trended downwards before recessions and bear markets began.

The inflation-adjusted net value added of nonfinancial corporate business is trending sideways. This is a typical late-cycle sign.

But most importantly, the labor markets are no longer improving. Considering that the labor market is already “as good as it gets”, this is worrisome.

For example, Initial Claims and Continued Claims are trending sideways. In the past, Initial Claims and Continued Claims trended upwards before bear markets and recessions began.

This is not an immediate long term bearish sign for the stock market and economy. But if this persists, long term bulls really need to be careful.

The Unemployment Rate is very low, and is starting to tick upwards.

With the S&P below its 12 month moving average and the Unemployment Rate above its 12 month moving average, this is a long term bearish sign for stocks. In the past, this is how bear markets and recessions started.

Consumer Confidence was very high, and is now starting to deflate. High Consumer Confidence isn’t a problem because it can remain high for a long time (just like how “extremely overvalued” can remain “extremely overvalued” for a long time). But once it starts to deflate, watch out.

Here’s what happens next to the S&P 500 when Consumer Confidence falls by more than -18 over the past 4 months, while still above 100 (i.e. late-cycle)

The ECRI’s Weekly Leading Index is trending downwards.

This is more long term bearish than long term bullish for stocks.

Conclusion: The stock market’s biggest long term problem is that as the economy reaches “as good as it gets” and stops improving, the long term risk is to the downside.

Economic deterioration is not significant yet, so the “bull market top is in” case is not that clear right now. We’re in a “wait and see the new economic data” mode. But if you are a buy and hold investor, now is bad time to buy stocks.

There will be a flood of economic data over the next few weeks now that the government shutdown is temporarily over.

Medium Term

*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

Our medium term market studies are mostly mixed. However, >50% of them point to the high probability of a pullback/retest.

Many traders are wondering “will a pullback/retest even happen, now that the S&P has rallied so much”?

As we stated on Friday:

Yes, it’s true that most of these 15-20% declines are followed by a pullback/retest at the 50% retracement level.

HOWEVER, not all of them do. A few are followed by a pullback/retest after the S&P has rallied even more

Here are the historical cases.

The stock market crashed and retraced 48% before retesting in 2011. The S&P was under its 200 dma

The stock market crashed and retraced 57% before falling even more in 2008. The S&P was at its 200 dma

The stock market crashed and retraced 49% before falling even more in 2001. The S&P was at its 200 dma

The stock market crashed and retraced 50% before retesting in 1998. The S&P was at its 200 dma

The stock market crashed and retraced 52% before making a pullback in 1990. The S&P was at its 200 dma

The stock market crashed and retraced 35.2% before retesting in 1987. The S&P was far under its 200 dma

The stock market crashed and retraced 53% before falling to new lows in 1982. The S&P was at its 200 dma

The S&P crashed and rallied straight to new all-time highs in 1980

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The stock market crashed and retraced 59% before falling to new lows in 1973. The S&P was above its 200 dma

The stock market crashed and retraced 50% before falling to new lows in 1969. The S&P was at its 200 dma

The stock market crashed and retraced 33% before retesting in 1967. The S&P was far under its 200 dma

The stock market crashed and retraced 42% before retesting in 1962. The S&P was far under its 200 dma

The stock market crashed, rallied to almost a new high, crashed even more, and then rallied straight to new all-time highs.

The stock market crashed and retraced 60% before falling to new lows in 1937. The S&P was at its 200 dma

The stock market crashed and retraced 50% before falling to new lows in 1930.

Conclusion:

  1. Most of these “crash and rally” patterns stall at the 50% retracement level or 200 day moving average
  2. It is not impossible for the S&P to rally straight to new all-time highs. This happened in 1980.
  3. It is not impossible for the S&P to rally to almost a new all-time high before making a pullback/retest. This happened in 1957, and to a lesser extent 2015-2016

So what is the point?

“Crash, rally, pullback/retest” patterns come in all shapes and sizes.

While most of the pullback/retests happen at the 50% retracement level, a few of them occur only when the S&P is near all-time highs.

So despite the nonstop rally, a pullback/retest is still likely.

VIX

While no one knows for certain if the S&P will make new all-time highs, VIX is likely to trend higher. Historically, VIX and the S&P both trend higher at the end of a bull market. Stock market tops are very volatile, with massive up and down swings.

VIX has closed below its 200 dma for the first time in 3 months

While this isn’t necessarily bearish for the stock market, it’s a medium term bullish sign for VIX itself.

The S&P is has gone 6 consecutive weeks in which its weekly CLOSE was higher than its weekly OPEN, while still under its 40 weekly moving average (i.e. 200 day moving average).

Here are similar historical cases, and what the S&P did next

You can see that a lot of cases are overlaps, so let’s only look at the first case in 1 month.

This is not consistently bearish for stocks, even though the sample size is small (n=5)

The stock market’s crash in December and rally in January were equally historic. The S&P fell more than 9% in December and rallied more than +7% in January.

Such reversals are rare. From 1950-present, these marked the bottom of massive 50%+ bear markets.

But before 1950, this was more bearish than bullish (i.e. happened within massive bear markets)

Seasonality favors stocks in 2019. There’s a common saying “as January goes, so goes the rest of the year”.

Here’s what happens next to the S&P when it goes up more than 7% in January.

As you can see, stocks tend to go up 6 months later. But remember: seasonality factors are of tertiary importance. Seasonality can break at any time.

The “risk-off” move in January 2019 is encouraging. Risky assets like stocks and oil did well, while safe haven assets like the USD fell.

Historically, this happened 4 other times. This kind of price action has been consistently bullish for stocks 6-12 months later.

As of Thursday, the S&P is now more than 1 standard deviation above its 50 day moving average, for the first time since October 2018.

Historically, this was bearish for the stock market 2-3 months later

REIT’s are massively outperforming the stock market right now. From 1999-present, this only happened during the 2000-2002 bear market

As of Tuesday, the S&P was above its 50 dma for 8 consecutive days, for the first time in 3 months.

These “first sustained breakouts” usually fail 2-3 months later

Emerging markets are rallying significantly after a horrific 2018. EEM (emerging markets ETF) is up 6 weeks in a row.

This is neither consistenlty bullish nor bearish for emerging markets

Short Term

The short term is extremely hard to predict, even when you have an edge. Many random and unpredictable factors impact the short term. That’s why we focus on the medium-long term and mostly ignore the short term.

Out of the “best 6 months of the year” (November – April), February is the worst.

Here’s a popular chart on Twitter.

Is this a bearish sign for stocks? Or is this just an example of recency bias, something that all humans (including you and I) are prone to?

Here’s what happens next to the S&P when XRT (retail ETF) falls more than -0.2% over the past 10 days, while the S&P increases by more than 1.3%.

It seems that these “divergences” have no consistent impact on the stock market. Sometimes bullish, sometimes bearish. Overall, not much different than a coin toss.

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