As the stock market retreats from all-time highs, perhaps this is the start of the pullback/correction that everyone’s been waiting for. I don’t know – I don’t focus on the short term. With that being said, here are some bullish and bearish factors for the stock market.
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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.
Outside reversal
The S&P made an outside reversal today. An outside reversal occurs when the market gaps up and then sells off throughout the day, creating a higher HIGH and lower LOW. This is typically seen as a bearish candlestick pattern.
Here’s what happens next to the S&P when it makes a 1 year high on the intraday, and then closes below the previous 6 days’ close.
*Data from 1962-present.
There’s a slight bearish lean over the next 2 weeks.
*I wouldn’t take the 12 month forward returns too seriously in this case. It doesn’t make much sense to use a 1 day candlestick to predict 1 year forward returns.
ISM
Today’s big economic news-of-the-day was ISM.
Here’s a scary looking chart.
So how bearish is this? Surely the stock market can’t rally when ISM PMI is falling?
First, let’s look at the ISM PMI’s long term chart. You can see that by design this indicator is meant to swing within a range.
Here’s what happens next to the S&P when ISM PMI falls more than -1% over the past 4 months while the S&P rallies more than +15%.
It’s clear that this happens quite often coming out of a lot of big corrections and bear markets (i.e. declines that exceed -20%).
Housing remains a weak point
The housing market – a key leading indicator for the economy – remains somewhat weak. We outlined this in our weekend post.
Here’s some additional data on total construction spending and residential construction spending.
While this may “look” bearish, it’s clear that this is not a perfect indicator.
- Sometimes there are false signals (e.g. 1995)
- Sometimes this occurs too early with a long lead time (e.g. 2006)
- The historical data is extremely limited.
NAAIM
NAAIM represents active managers’ exposure to the stock market. And right now, active managers are quite exposed to the stock market.
Is this bullish/bearish for stocks? Let’s take a look at the data.
We can’t use a criteria such as “what happens next to the S&P when it rallies more than 20% over the past 19 weeks and NAAIM exceeds 90”. That’s because the “S&P rallies more than 20% over the past 19 weeks” portion of the study is always bullish. Hence narrowing down the cases for “NAAIM exceeds 90” will only return a subset of an already 100% bullish study.
So here’s another way of looking at the data. Here’s what happens next to the S&P when it is more than 6% above its 40 week moving average while NAAIM exceeds 90.
*Data from 2006 – present
Short term is mostly random, although there is a bullish lean 6-12 months later.
*Take this study with a grain of salt. NAAIM historical data is limited.
SKEW:VIX
SKEW measures potential financial risk whereas VIX measures volatility. The SKEW:VIX ratio tends to move inline with the stock market
- Stocks up = financial risk up and volatility down = SKEW:VIX up
- Stocks down = financial risk down and volatility up = SKEW:VIX down
It’s not often that you see the SKEW:VIX ratio’s correlation with the S&P breakdown. This is probably because VIX is trending higher with the S&P right now, as we noted yesterday.
You can see that the “last 2 times this happened was before the January 2018 vol-mageddon and Q4 2018 stock market crash”.
But let’s look at the data holistically. Here’s every single case in which the SKEW:VIX 20 day correlation with the S&P fell below 0.12
Not consistently bullish or bearish on any time frame.
4 months
The S&P has rallied 4 months in a row from a 12 month low.
It’s interesting to note that while this has been consistently bullish after 1950, it was mixed pre-1950. The stock market’s price action changed around the WWII period.
30 year – 5 year
Right now the 2 main macro problems are housing and the yield curve. Here’s the 30 year – 5 year yield curve, which continues to steepen.
I’ve said in the past that a steepening yield curve is far worse than an inverted yield curve. A steepening yield curve tends to happen as the economy slides into a recession and the stock market slides into a bear market. Investors run for safety and bid up long term bonds while the Fed cuts short term rates, causing the yield curve to steepen.
Anyways, the 30 year – 5 year yield curve has steepened for 7 months in a row, the longest streak since 1977.
Similar historical streaks usually occured at the end of recessions and bear markets:
- December 1991
- September 1992
- September 2002
However, looking for a monthly streak isn’t the best way to describe a steepening yield curve. E.g. if the yield curve steepens for 3 months, flattens for 1 month, and then steepens another 3 months, it breaks the streak.
Hence, it’s better to simply look at the 30 year – 5 year yield curve’s 7 month rate of change.
The 30 year – 5 year yield curve has steeepened by 0.4% over the past 7 months. Over the past 20 years, this has only happened:
- Now
- September 2015
- August 2007
- September 2000
(Insert scary music)
But once again, let’s look at the data holistically.
Overall, not a terrific sign for the stock market 6-9 months later, but not consistently bearish either. The 30 year – 5 year yield curve isn’t the most predictive part of the yield curve.
Stocks vs commodities
If you want to be popular in the finance community, you generally need to be bearish on stocks and bullish on commodities. Why? Because stocks have gone up “too much” over the past decade and commodities are “too cheap”.
Here’s the S&P
Here’s the CRB Commodities Index
The problem with comparing stocks and commodities on a long term basis is that stocks generally outperform commodities in the long run. That’s what happens when you compare a productive asset which can grow its earnings (i.e. stocks) with an unproductive asset like commodities (e.g. 1 barrel of oil will always = 1 barrel of oil).
That’s why it’s better to look at the S&P:CRB ratio on a medium term time frame. With the stock market up significantly over the past 4 months and commodities like gold languishing, the S&P:CRB ratio has spiked.
Here’s what happens next to the S&P when the S&P:CRB ratio is more than 9.4% above its 1 year moving average.
Here’s what happens next to the CRB Index.
Here’s what happens next to the S&P:CRB ratio.
Corporate earnings and stocks
And lastly, I would like to touch on a common misconception among the financial community.
If you want to be popular in the finance community, you need to say “sell U.S. stocks, buy emerging markets! U.S. stocks are expensive and emerging markets are cheap!” This is because value investing is a popular form of investing in the financial community.
But here’s the kicker. Do you know why the “buy emerging markets because they’re cheap” crowd have been wrong for years?
Because something that’s “cheap” is often cheap for good reason.
The stock market and economy/corporate earnings move in the same direction in the long run.
Check out U.S. corporate earnings growth over the past 10 years.
Check out emerging markets corporate earnings growth over the past 10 years, priced in local currency and the USD.
It’s clear that the U.S. stock market trends upwards with U.S. corporate earnings, and emerging markets trend sideways with emerging market corporate earnings.
The same scenario applies to individual stocks. Growth stocks like Google always have higher valuations than value stocks like AT&T. Investors pay more for growth.
Read The stock market will “eventually” fall and volatility will “eventually” spike
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. When our discretionary outlook conflicts with our models, we always follow our models.
Conclusion
Here is our discretionary market outlook:
- The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
- The medium term direction (e.g. next 6-9 months) has a bullish lean.
- We don’t predict the short term because the short term is always extremely random, no matter how much conviction you think you have. Focus on the medium-long term.
Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.
