Is the stock market trending downwards again?

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by Troy

The S&P fell today, and the 10 year – 3 month yield curve pushed further into negative territory. Meanwhile, the S&P’s 200 day moving average is once again sloping downwards. Today’s headlines:

  1. S&P’s 200 day moving average is trending downwards
  2. Yield curve even more inverted
  3. Margin debt is lagging the S&P
  4. Small caps vs. large caps ratio is falling
  5. NASDAQ’s breadth is weakening
  6. VIX is making lower highs while the S&P is making lower lows

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.

S&P’s 200 day moving average is trending downwards

The S&P’s 200 day moving average is going down again.

From a trend following perspective, here’s what happens when you

Buy and hold the S&P only when its 200 day moving average is going up

Otherwise, sell & shift into cash.

Performance is almost the same as the S&P in the long run. The outperformance mainly comes from massive bear markets, and this tends to underperform during a bull market. Of course, the drawdowns are much lower than buy and hold.

Yield curve

The 10 year – 3 month Treasury yield has fallen below -0.08 today (at the time of this writing, it is at -0.11). People love bad news, so of course this made headlines everywhere today.

From Bloomberg

Here’s what happens next to the S&P when the 10 year – 3 month yield curve falls below -0.08%, for the first time in each economic expansion.

An inverted yield curve “eventually” leads to a recession and bear market. But this typically has a lead time of 1 year.

Here are all the historical cases, with their returns over the next year.

Here is each of the historical cases, in detail:

Margin Debt

While financial pundits love to criticize rising debt, the reality is that margin debt in the stock market tends to move inline with the S&P. The problem arises when margin debt growth OUTSTRIPS the S&P’s growth.

The opposite “problem” is occurring right now. Margin debt growth over the past 4 months is lagging the S&P’s growth.

Is this normal?

Here’s what happens next to the S&P when it rallies more than 15% in the past 4 months while Margin Debt rises less than 7%.

Yes, this is quite normal and is mostly bullish. This tends to happen during the first rally after a 20%+ decline. Investors and traders remember the recent crash fresh in their minds, so they hesitate to use margin during the subsequent rally.

Small caps vs. large caps ratio

The Russell 2000 vs. S&P ratio has been falling over the past year. Small caps have underperformed large caps.

The Russel:S&P ratio’s 1 year rate-of-change has fallen below -0.1, which is quite low.

Historically, this is not consistently bullish or bearish for the S&P…

…but it does imply that the Russell:S&P ratio will improve over the next year. This means that the Russell 2000 will outperform the S&P.

NASDAQ 100 Bullish Percent Index

The NASDAQ 100 Bullish Percent Index (breadth indicator) has fallen below 50. Breadth is weakening as the stock market declines.

This marks the end of a long streak in which the NASDAQ 100 Bullish Percent Index was above 50.

Here’s what happens next to the NASDAQ 100 and S&P when the Bullish Percent Index falls below 50 for the first time in at least 90 days.

Slightly bearish over the next 1 week. Mostly bullish 1 month later and 9-12 months later.

VIX lower highs, S&P lower lows

The S&P has fallen over the past 10 days while VIX has made lower highs. The S&P and VIX mostly move in the opposite direction. So when the S&P makes lower lows, VIX usually makes higher highs.

Some traders think this “anomally” means that VIX is broken. It’s not. This is normal.

Here’s what happens next to the S&P when the S&P falls over the past 10 days, while VIX falls more than -14%

Mostly bullish over the next 2 weeks.

Here’s what happens next to VIX

Allow me to explain why this is normal and does not mean that VIX is “broken”.

The stock market tends to fall in 2 waves. VIX tends to spike higher in the first wave than the 2nd wave. Hence why stocks will often make lower lows, but VIX will make lower highs. Here’s an example from 2010.

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. We focus on the medium-long term.

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

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