Is this rally all JUNK? Examining the short term bearish case

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by Troy

The U.S. stock market has rallied significantly over the past 3.5 months. But do you know what’s rallied even more?

JNK, or more colloquially known as JUNK. (JNK = junk bond ETF). Junk bonds often move in the same direction as the stock market, something that Michael Milken discovered in the 1980s.

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.

Zahorchak Method

I’ve been looking at breadth indicators more closely recently, and I stumbled across the Zahorchak Method. It’s an interesting indicator that combines trend following techniques with breadth/participation indicators (market’s 5, 15, 40 weekly moving averages + weekly Advance/Decline Line).

Here’s the Zahorchak Method. The general idea is that you sell when the Zahorchak indicator is breaking down (e.g. falls below -6), and buy when the indicator is breaking up (e.g. rallies above 0)

Here’s what happens next to the S&P 500 when the Zahorchak Method goes from -10 to +6 within the past 6 months.

As you can see, the stock market can face short term resistance, but 6-12 months later is still quite bullish.

Small caps vs large caps

The Russell 2000 (small caps) significantly outperformed the Dow (large caps) today.

  1. The Russell rallied 1.4%
  2. The Dow rallied less than 0.2%

Here’s what happens next to the S&P when the Russell rises more than 1.4% in a day while the Dow rises less than 0.2%

Let’s examine the cases in which both the Russell and Dow were above their 200 day moving averages.

Interestingly enough, the stock market has a slight bearish lean over the next 1 month.

Breadth

The S&P 500 Bullish Percent Index (breadth indicator) continues to push higher. As you can see, breadth was usually weaker in the 2000-2002 and 2007-2009 bear market rallies.

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Here’s what happens next to the S&P when the Bullish Percent Index reaches 76.

Short term bearish over the next 1 week, mostly bullish 6-12 months later.

SKEW

SKEW is often viewed as a black swan indicator. As it rises, the potential risk in financial markets rises. However, I’ve noticed that SKEW mostly just tracks the S&P. This is logical:

  1. As the market rises, risk of a correction/decline rises
  2. As the market falls, risk of a correction/decline falls because the market has already gone down.

You can see that SKEW tracked the S&P quite closely from April 2018 – January 2019.

SKEW has diverged from the S&P since January 2019. Is this bearish for stocks?

Here’s what happens next to the S&P when SKEW falls more than -3% over the past 57 days while the S&P rallies more than +10%.

This does appear to be a short term bearish sign over the next few weeks.

2 year Treasury yield

I said on February 9:

As of January 31, the 2 year Treasury yield made a “death cross”, whereby its 50 day moving average fell below its 200 day moving average.

Here’s what happens next to the S&P when the 2 year Treasury yield made a “death cross” while the Unemployment Rate is above its 12 month moving average.

Lucky guess or not, the 2 year Treasury yield has indeed fallen since then.

And of course, this means that the 2 year yield has diverged from the S&P 500.

Here’s what happens next to the S&P when it rallies more than +9% over the past 50 days while the 2 year Treasury yield falls more than -9%.

(Calculation: if the 2 year yield falls from 2% to 1.8%, it’s a 10% decline. We’re not looking at absolute value % changes)

*Data from 1976 – present

Not bearish for stocks, especially 6-12 months later

Is this rally is all junk?

The junk bond ETF’s 14 day RSI is extremely high.

In its limited history, this is JNK’s 2nd highest RSI.

Here’s what happens next to JNK when its 14 day RSI exceeds 80.

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Here’s what happens next to the S&P 500.

Short term bearish? Perhaps.

I can see the short term bearish case for stocks over the next few weeks, However, I don’t like predicting the market’s short term because it’s extremely random. Even when you think there’s a high probability that the market will fall/rise over the next few weeks, there’s an equally high probability that you’re wrong. Too many random and unpredictable factors move the market in the short term.

Moreover, I find short term predictions to be a little dishonest. I’ve seen far too many financial gurus predict that the market will fall -5%. Then the market rallies +20%, it falls -5%, and they say “see, I saw it coming!” To avoid this dishonesty, I usually resort to not commenting on the short term.

The key point when trading the S&P is “when you sell, can you guarantee that the market will at least fall back to where you sold”?

More often than not, selling for short term dips does not accomplish this task. E.g. if you sell because you think that the market will fall -3%, there’s a >50% probability that it will first rally +5% before falling -3%. Hence, you would need to buy back your stocks at an even higher price, thereby underperforming buy and hold.

Read While the stock market rally pause under its all-time highs?

Conclusion

Here is our discretionary market outlook:

  1. 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.
  2. The medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.
  3. We don’t predict the short term because the short term is always extremely random. At the moment, the short term does seem to have a slight bearish lean.
  4. In summary, 12-24 months = bearish, 12 months = neutral, 6-9 months = slightly bullish.

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

 

 

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