Is the stock market about to trigger a classic sell signal?

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by Troy

The stock market fell again today, and is sitting right ontop of its 200 day moving average. Meanwhile, the S&P has had a very strong relationship with the 10 year yield this year. Today’s headlines:

  1. S&P, Dow, and NASDAQ breaking their 200 dma’s
  2. Relationship between stocks and Treasury yields
  3. Put/Call ratio spike
  4. Weakening S&P breadth
  5. Weakening NYSE breadth
  6. May has been weak (seasonality)

Go here to understand our fundamentals-driven long term outlook. For reference, here’s the random probability of the U.S. stock market going up on any given day.

The Dow, S&P, NASDAQ and their 200 day moving averages

The Dow, S&P, and NASDAQ have either fallen below their 200 day moving averages or have almost fallen below their 200 dma’s. Hence why headlines like this are popping out right now. From Market Watch:

The Dow has closed below its 200 dma, while the S&P and NASDAQ are close.

Here’s what happens when you use the 200 day moving average as a buy/sell signal. We apply the following rules to the Dow, S&P, and NASDAQ

Buy and hold the market only if it is above its 200 dma. Otherwise, sell & switch to 100% cash.

You can see that on its own, the 200 day moving average as a buy/sell signal doesn’t significantly beat buy and hold. Any outperformance comes from the massive bear markets (e.g. 1929-1932 and 2007-2009). Using this indicator as a buy/sell signal results in underperformance during a bull market. The main benefit of course, is that drawdowns are smaller than buy and hold.

The relationship between stocks and yields

CNBC published an interesting article today:

We plotted this on a chart, demonstrating the S&P’s returns from December 24 – present when the 10 year Treasury yield went up vs. the S&P’s returns when the 10 year yield went down. Starting value $1.

Is this bullish or bearish for stocks?

Mostly bullish over the next week.

Here’s what happens next to the 10 year Treasury yield.

Slightly more bearish than bullish over the next few months. (Also keep in mind that interest rates have been falling for the past 40 years).

Anyways, here are all the signal dates plotted on a chart of the S&P.

It’s interesting to note that this has only happened over the past 20 years. I think this is just correlation and not causation. Interesting, but not actionable.

Put/Call ratio

The Put/Call ratio spiked today to the highest level since December 24.

While it’s tempting to think “this is just like the December 24 bottom”, that would be an example of recency bias. We need to look at the data holistically.

We cannot use the Put/Call ratio’s absolute value because this value changes over the decades. Hence, it’s better to calculate the Put/Call ratio against its 200 day moving average.

Here’s what happens next to the S&P 500 when the Put/Call ratio is more than 40% above its 200 dma, while the S&P is still above its 200 dma.

Mostly bullish 1 month later.

Breadth

The % of S&P stocks above their 200 dma (breadth indicator) has fallen below its 200 dma for the first time since February.

This marks the end of a long streak.

Here’s what happens next to the S&P when such a streak ends.

Mostly bullish 1 month later. But since the sample size is small, we can look at the NYSE Bullish Percent Index (another breadth indicator).

The NYSE Bullish Percent Index fell below 50 today.

From a trend following perspective, it’s better to buy the S&P when the Bullish Percent Index is above 50 than to buy the S&P when the Bullish Percent Index is below 50.

Anyways, this is also the end of a long streak in which the Bullish Percent Index is above 50.

Historically, this leans bullish for the S&P 1 month later.

Seasonality

And finally, a quick word on seasonality. You’ve probably heard of the phrase “sell in May and go away”. This has been a weak May. Here’s what happens next to the S&P when it falls more than -5% at any point in May (not just from April’s CLOSE to May’s CLOSE).

Seems to be slightly bearish for June (1 month later), mostly bullish for July (2 months later), and mostly bullish 1 year later, doesn’t it?

Here’s the problem with seasonality: it changes on a dime. If you include the pre-1950 data, the results are different.

Seasonality works until it doesn’t, which is why we don’t use it in our trading.

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 mostly mixed right now. We focus on the medium-long term.
  4. Specifically, we can see that the 1-2 week forward market studies are slightly bearish, and the 1-3 month forward market studies are slightly bullish.

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

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