Financial conditions will tighten soon. What this means for stocks

by Troy

 

With the yield curve inverting and the economy in the late-stages of its expansion, financial conditions will tighten over the next few quarters. This is not yet a long term bearish sign for stocks, but will be very soon.

Go here to understand our fundamentals-driven long term outlook.

Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day.

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are blindly “guessing” the future.

Financial conditions will tighten

Financial conditions remain very loose. In the past, financial conditions tightened before bull markets ended.

Banks have not yet tightened lending standards, but will probably do so soon. From Jamie Dimon (JP Morgan’s CEO):

Jamie Dimon has a message for his employees and investors: When the time comes, J.P. Morgan Chase will rein in loan growth at the nation’s biggest bank.

“We tell our management that we have no problems seeing loan books shrink,” Dimon said in the earnings conference call. “Remember, Warren Buffett used to say in the insurance business, and sometimes this is true in the loan business, [there are times] when you’re better off having the sales force go play golf than make new loans. We are not going to be stupid.”

Still, when the next analyst, Betsy Graseck of Morgan Stanley, asked Dimon if his salespeople were “playing golf all day yet,” Dimon responded with a sharp “No.” 
Dimon’s remarks match what we see in the data. Financial conditions have not yet tightened, but will soon. This is not yet a long term bearish sign for the stock market and economy, but will be soon when financial conditions tighten.

Defensive sector

While defensive sectors like XLU (utilities sector) outperformed during the stock market’s Q4 2018 crash, they have been underperforming now that the stock market is rallying.

Here’s what happened next to the S&P when the S&P went up more than 10% while XLU went up less than 3%

*Data from 1998 – present

As you can see, even in the context of a bear market, this happened during bear market rallies and were medium term bullish for stocks (i.e. 6 months later)

NASDAQ

After a very long and persistent downtrend, the NASDAQ has finally closed above its 50 daily moving average.

Here’s what happens next to the S&P when the NASDAQ closes above its 50 dma for the first time in 3 months.

*Data from 1971 – present

Here’s what happens next to the NASDAQ when the NASDAQ closes above its 50 dma for the first time in 3 months.

As you can see, the stock market leans bearish over the next 2 months. This is because most crashes are followed by a bounce and then a retest of the lows.

Macro Context

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Russell

Like the NASDAQ, the Russell 2000 could soon break above its 50 daily moving average for the first time in a long time.

Here’s what happened next to the S&P when the Russell closed above its 50 dma for the first time in 3 months.

*Data from 1987 – present

Here’s what happened next to the Russell 2000 when the Russell closed above its 50 dma for the first time in 3 months.

You can see that this is much more bullish than the NASDAQ’s breakout. Why?

The Russell’s price action is different than that of larger cap indices like the S&P, NASDAQ, and Dow. As a small cap index, the Russell tends to go straight up and straight down, often without retests.

VIX

VIX has fallen many days in a row as the stock market has rallied.

Is this a short term bearish sign for the stock market? Does it mean that VIX will rise in the short term (i.e. mean-revert)?

Here’s what happened next to the S&P when VIX fell at least 11 of the past 14 days, while the S&P was below its 200 dma

*Data from 1990 – present

It does appear that this is a small short term bearish sign for the stock market (1 week forward). It is not exceptionally short term bearish, so I wouldn’t pay too much attention to this.

Here’s what happened next to VIX.

Click here for yesterday’s market study

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is no longer bullish. This doesn’t necessarily mean that the bull market is over. We’re merely talking about long term risk:reward. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction is still bullish  (i.e. trend for the next 6 months). However, if this is the start of a bear market, bear market rallies typically last 3 months. They are shorter in duration.
  3. The stock market’s short term has a slight bearish lean. Focus on the medium-long term because the short term is extremely hard to predict.

Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.

 

 

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