How the trade war is effecting the stock market

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by Troy

The stock market fell today, and there is evidence of the trade war across many markets. The U.S. stock market has outperformed other stock markets during this trade war. Today’s headlines.

  1. Lots of gaps
  2. Large drop in sentiment despite small drop in prices
  3. Emerging markets “leading” indicator
  4. Industrial metals “leading” indicator
  5. Treasury yields “leading” indicator
  6. Bond sentiment is extreme
  7. Building Permits is weak

Lots of gaps

The S&P 500 has made a lot of big overnight gaps over the past 3 weeks, and most of these have been gap downs. There are many different ways of looking at how “extreme” these gaps are.

For example, here’s the # of overnight gaps that are < -0.5% over the past 3 weeks.

By this measure, this is the most extreme, ever. Don’t pay too much attention to these big gaps, which is probably related to the trade war (foreign selling, American buying?)

Here’s another way of looking at the day vs. night difference. This is the difference between the S&P’s returns over the past 15 days vs. the past 15 nights. In other words, all of the losses have occurred during the night and all of the gains have occurred during the day.

Historically, this is slightly bullish for the S&P over the next 9 months.

Sentiment

AAII Bullish sentiment has fallen a lot over the past 2 weeks, even though the S&P is only down -2%. This is a rather large drop in sentiment despite a small drop in prices. Exaggerated trade war fears?

You’d think that such a sharp drop in bullish sentiment is bullish for stocks. It isn’t.

It’s mostly bearish, especially over the next week.

“Leading” market based indicators

A lot of market analysis these days looks something like this:

  1. Overlap the S&P onto another indicator/market that has had a decent correlation over the past 2 years.
  2. Show how the S&P is “diverging” from this other indicator/market. Better yet, trigger that recency bias and show “the last time this happened, stocks crashed”.
  3. Sell the crash crash crash narrative.

Here’s an example. This overlaps EEM (emerging markets ETF) with the S&P. “The last time this happened was before the October-December stock market crash!”

The divergence between the S&P and EEM is probably related to the trade war.

Here’s what happens next to the S&P when EEM rises less than 3% over the past 5 months while the S&P rises more than 10% (divergence!!!)

Here’s what happens next to EEM.

This overlaps Industrial Metals with the S&P. “The last time this happened was before the October-December stock market crash!”

The divergence between the S&P and Industrial Metals is probably related to the trade war.

Here’s what happens next to the S&P when Industrial Metals falls over the past 5 months while the S&P rises more than 10% (divergence!!!)

And lastly, here’s the 10 year Treasury yield vs. the S&P. “Interest rates are falling! Divergence!!!”

Here’s what happens next to the S&P when the 10 year yield diverges from the S&P.

Moral of the story: “divergences” happen all the time. Correlations break down.

Bond Sentiment

Bond sentiment is quite extreme, with most investors betting that interest rates will keep rising and bond yields will keep falling. Here’s the U.S. JP Morgan Treasury Investor Sentiment Index

The easy thing to do is automatically assume that bond prices will fall (and interest rates will rise) because this indicator is “too high”.

Here’s what happens next to the 10 year Treasury yield when the U.S. JP Morgan Treasury Investor Sentiment Index reaches +19

Here’s what happens next to the USD

Here’s what happens next to gold

Building Permits

Housing remains one of the weak points in the U.S. economy. Building Permits is still below its 12 month moving average.

Here’s what happens next to the S&P when Building Permits is under its 1 year moving average for at least 9 of the past 12 months.

Forward returns are worse than random on all time frames. This mostly happens near or around recessions and bear markets. Hence why we think that in a most optimistic scenario, this bull market will last throughout 2019 and end in 2020.

Read Certain parts of the market are being hammered. What this means for the S&P

We don’t use our discretionary outlook for trading. We use our quantitative trading models because they are end-to-end systems that tell you how to trade ALL THE TIME, even when our discretionary outlook is mixed. Members can see our model’s latest trades here updated in real-time.

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
  2. Most of the medium term market studies (e.g. next 6-12 months) are bullish.
  3. The short term (e.g. next 1-3 months) is very noisy right now. There is no clear risk:reward edge in either direction. Some short term market studies are bullish, and others are bearish.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.

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