Even in a worst case scenario, the stock market will probably rally soon

by Troy

Our U.S. stock market outlook is simple:

  1. This is still a bull market, which probably has almost less than 1 year left. Fundamentals continue to favor the bull market and the Medium-Long Term Modelremains bullish.
  2. The medium term is bullish. This is just a correction, and risk:reward favors the bulls right now.
  3. The short term leans bearish (although this lean isn’t as strong as it used to be).

Let’s analyze the stock market’s price action by quantifying technical analysis.

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

Even in the worst case scenario (i.e. this is the start of a bear market)…

Let’s assume that we’re wrong. Let’s assume that this isn’t still a bull market – it’s the start of a bear market. What’s the worst case scenario?

The stock market market fell rapidly over the past 3 weeks. As a result, its 5 weekly standard deviation is more than 3.5x greater than 3 weeks ago. (You can see this via the expansion in Bollinger Bands).

Here’s what happens next to the S&P 500 (historically) when its 5 weekly standard deviation is more than 3.5x greater than 3 weeks ago, while the S&P is below its 5 weekly moving average.

As you can see, the recent decline is a standard correction in a bull market. There were only 2 historical cases in which this was the start of a bear market:

  1. January 2008
  2. March 1969

In both of these “worst case scenario” situations, the stock market still rallied in the next 1-3 months!

More signs of a medium term rally

Here are some more signs that the stock market will rally in the next 3 months.

VIX has now been above its 20 weekly moving average for 2 consecutive weeks. In other words, volatility spiked and remains elevated.

Here’s what happens next (historically) when VIX is above its upper Bollinger Band for 2 consecutive weeks.

As you can see, VIX usually mean-reverted downwards…

… while the U.S. stock market went up in the next 3 months.

The S&P went up 3 months later in all but 3 cases: June 2002, September 2008, and July 2015. The 2002 and 2008 cases clearly do not apply to today: they occurred when the U.S. stock market had already crashed more than 30% and was deep in a bear market/recession. Different context.

Yesterday I said that the Put/Call ratio was very high. While this has been a short term bullish sign for the stock market in 2018, over the past 20 years it has been neither consistently bullish nor consistently bearish for the stock market.

Emerging markets and China crash: get ready for a rally soon

As you probably already know, emerging markets and Chinese stocks have crashed this year.

Everyone is afraid of “contagion” from EM and China to the U.S.. However, we’re starting to see signs that the EM and China crash is exhausting itself. They could fall more in the short term, but the medium term risk:reward is starting to turn bullish.

*Please take my thoughts on EM and China with a grain of salt because I focus on the U.S. stock market.

EEM’s (emerging markets ETF) 14 weekly RSI has fallen below 33. In other words, EEM is oversold according to standard momentum indicators. Historically, EEM tends to go up 1 year later.

But using RSI isn’t always the best way to measure how “oversold” or “overbought” a market is. Hence we resort to other measures.

The Chinese stock market crashed more than -2% to a 2 year low on Thursday. That is often a sign of “capitulation selling”.

And sure enough, China surged more than 2% on Friday.

This kind of “capitulation selling” + strong reversal often results in a short-medium term bounce.

Here’s what happens next to the Chinese stock market (historically) when it crashed more than -2% to a 2 year low, and then rallied more than 2% the next day.

As you can see, the Chinese stock market tends to make a 1 month bounce….

… and historically, this never led to “contagion” to the U.S. stock market in the long term. The U.S. stock market always went up 9 months later.

Moral of the story: Chinese and emerging market stocks are getting close to or are already at a short-medium term bottom. When this happens, it’s unlikely for doom-and-gloom “contagion” to spread to the U.S.

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