It looks like the stock market is in a bubble

by Troy

As the stock market approaches all-time highs, a few economic indicators are deteriorating. Meanwhile, the stock market’s uptrend remains strong.

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.

Strong uptrend

The S&P 500 is in a strong uptrend. Its 20 day moving average has gone up 64 days in a row.

Here’s what happens next to the S&P when its 20 dma rises 64 consecutive days.

*Data from 1950 – present

The stock market’s 3-6 month forward returns are mostly bullish.

XLY

Consumer discretionary and tech stocks are on fire. XLY’s (consumer discretionary ETF) 14 weekly RSI is now above 67.

From 1998 – present, XLY’s weekly RSI has exceeded 67 just 17.38% of the time. Here’s what would happen if you only buy XLY when its 14 weekly RSI exceeds 67.

So if you are thinking of buying XLY right now, now is probably not the time to chase the rally. (Short Term)

With that being said, here’s what happens next to XLY when its 14 weekly RSI exceeds 67.

*Data from 1998 – present. This week isn’t over, so keep this in mind.

Here’s what happens next to the S&P

You can see that the 9-12 month forward returns are more bullish than random. Why?

Because consumer discretionary didn’t have such strong momentum in the 2000-2002 and 2007-2009 bear markets.

Economic Surprise Index

The Citigroup Economic Surprise Index continues to fall while the stock market continues to rally.

This divergence confounds many people.

In fact, this degree of a divergence is very rare.

The S&P has rallied more than 23% over the past 77 days (since the December 24, 2018 bottom). Meanwhile, the Citigroup Economic Surprise Index is now at -63.

From 2003 – present, this has never happened before. This is why I caution investors when using indicators with limited historical data.

With that being said, here’s a complete look at the Citigroup Economic Surprise Index.

Here’s what happens next to the S&P when the Citigroup Economic Surprise Index falls below -63

*Data from 2003 – present

You can see that the stock market’s 1 month and 3 month forward returns are mostly bullish. This might not be the case this time, considering that the stock market has already rallied so much while economic data missed expectations.

*For the record, the Citigroup Economic Surprise Index doesn’t measure the actual state of the economy. It merely measures the economic data vs. analysts’ expectations. In fact, economic data has improved a little recently while the Citigroup Economic Surprise Index falls.

Here’s what happens next to the USD

Here’s what happens next to gold.

NAHB

While the NAHB Homebuilder Index went up in its latest reading, it remains under its 12 month moving average (i.e. a downtrend). Housing is a key leading indicator for the economy and stock market.

Here’s what happens next to the S&P when the NAHB Housing Market Index is under its 12 month moving average for 11 consecutive months.

What if we only want to look at late-cycle cases, when Unemployment is under 5%?

Sample size is small, but the picture is clear. At most, the bull market has 2 years left.

Non-confirming economic markets?

Traders frequently use Dr. Copper (copper’s price action) as a gauge of how healthy the economy is. This gauge is flawed – copper is better at reflecting the state of the Chinese economy than the U.S. economy.

Either way, copper has gone sideways since late-February while U.S. and Chinese stocks continue to rally.

In an example of recency bias, it’s clear that “the last time the S&P diverged from copper by this much was September 2018” (insert scary music).

How bearish is this?

Here’s what happens next to the S&P when copper falls more than -1% over the past 7 weeks while the S&P rallies more than +4%.

This happens quite often, and is not consistently bullish or bearish for stocks.

Here’s what happens next to copper.

Mostly random, although there is a slight short term bearish lean for copper.

Industrial Production

Industrial Production Durable Consumer Goods’ 3 month % change is now AS LOW AS IT WAS IN 2008.

However, rational investor/trader would avoid recency bias and look at the data holistically.

Here’s what happens next to the S&P when Industrial Production Durable Consumer Goods’ 3 month % change is less than -3.9%

What if we only look at the late-cycle cases, in which Unemployment is under 5%?

You can see the stock market’s short term forward returns (2-3 months later) were mostly bearish. After that, it was mostly random.

Avoid linear scales

This is what a very popular permabear who frequents CNBC said today

50% of the stock market’s gains have occurred in the last 5 years, whereas the other 50% took 100 years to create. Must be a bubble.

*These permabears shall remain unnamed. They do nothing except hurt investors’ returns. Trigger your fear, then sell you a panacea to soothe that fear.

“50% of the stock market’s gains have occurred in the last 5 years, it’s a bubble” makes no sense at all. That’s how linear scales work.

You could have said the same thing in 1986

Or 1994…

Or 1996…

Or 1998….

Herein lies the problem with linear scales. It always “looks like” a bubble, even if the actual pace of the market’s growth is slowing down. Your eyes tend to see what it wants to see. This is why we always use log scales.

Read Should you chase the stock market’s rally?

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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