Market outlook: is the stock market climbing a wall of worries?

by Troy

The stock market has rallied significantly over the past 6 months. Yet every single day we are bombarded with more things to “worry about”. Macro worries, trade worries, yield curve worries, etc. While there are certain pockets of weakness in the U.S. economy, overall the economy is still growing (but at a slower pace). Moreover, various technical indicators remain bullish on the stock market right now.

In reality, there is almost always something to “worry about”. And when there isn’t something to worry about, people worry about “this is as good as it gets”. So instead of worrying, let’s look at the data.

1. Fundamentals (long term): no significant U.S. macro deterioration, but the long term risk:reward doesn’t favor bulls.
2. Technicals (medium term): mostly bullish
3. Technicals (short term): mixed

Let’s begin with technicals because most traders prefer technical analysis over fundamental analysis.

Technicals: Medium Term

*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

Although the bull market is certainly late-cycle, the stock market’s medium term (next 6-9 months) leans bullish.

Good half year

It’s been a good half year for the financial markets. Stocks are up, commodities are up, bonds are up. This stands in stark contrast with 2018, a year in which most assets fell. CNBC captured this theme in a headline:

Here’s the S&P 500’s % change over the past 6 months.

Here’s what happened next to the S&P 500 when it rallied more than 15% over the past 6 months.

The rally tends to continue over the next half year, although the rally’s pace does slow down. This is to be expected. It’s hard for the market to rally 17% every 6 months.

Trend following

The 2 most common and simple trend following strategies are:

1. Buy when the S&P 500 is above its 200 dma.
2. Buy when the S&P’s 50 dma is above its 200 dma (golden cross).

Traders who use these simple trend following strategies are probably long right now, because both of these criteria are fulfilled.

As we’ve illustrated in the past, these 2 simple strategies on their own do not beat buy and hold (although drawdowns are smaller than buy and hold).

But if you combine them, performance becomes a little better. Most underperformance comes from underinvestment. In this simple trend following strategy, you buy and hold unless the S&P is below its 200 dma AND the 50 dma is below the 200 dma.

60/40 portfolio

As we stated on Wednesday, a classic 60/40 portfolio (60% long stocks, 40% long bonds) has done well over the past 40+ years. Its return has been similar to the S&P’s (slightly less if you include dividends reinvested), but with much smaller drawdowns during major bear markets such as 2000-2002 and 2007-2009. Of course, this is partially due to a 40 year bull market in bonds.

A 60/40 portfolio has done very well over the past 6 months because bond prices went up along with stock prices. Here’s what happened next to a 60/40 portfolio when it gained more than 10% in the past 6 months.

This diversified portfolio typically saw more gains in the year ahead.

Bonds

Speaking of bonds, bonds are extremely overbought and yields are very low right now. The 10 year Treasury yield’s 14 week RSI is below 23.

Such low RSI eventually led to a bounce in Treasury yields (although not always immediately)….

…and is more often than not a good sign for stocks over the next year.

Sentiment

Sentiment remains quite pessimistic, which is rare considering that stocks are near all-time highs. A lot of investors are concerned about the trade war and pockets of economic weakness.

According to AAII sentiment data, there have been more bears than bulls for the 7th week in a row.

7 week streaks are quite bullish for the S&P 3 months later. The only 2 bearish cases occurred in July and October 2008, when the economy was ALREADY deep in a recession and the stock market had already collapsed. That’s clearly a very different environment from today.

Small caps remain weak

A lot of traders are watching small caps, which have been consistently weak. While large caps (the S&P 500) have managed to make new gains since the January 2018 high, small caps have been stuck in a rut.

While small caps’ underperformance may be a short term bearish factor for the stock market, it is not a consistently long term bearish factor.

Here’s what happened next to the S&P when the Russell falls over the past 17 months while the S&P gains more than 4%.

Here’s what happened next to the Russell 2000.

If you look at the dates more closely, this tends to happen around a lot of 15%+ declines (usually AFTER a 15%+ decline).

1. August 2015: happened after a 15% decline
2. May 2012: happened after a 20% decline in 2011
3. January 2008: happened at the start of a bear market
4. August 1998: happened after a 20% decline
5. August 1990: happened after a 20% decline
6. December 1987: happened after a 30%+ decline

Here are 2 recent examples:

Breadth

The Dow McClellan Summation Index is a long term version of the McClellan Oscillator. This breadth indicator has been above zero for 111 consecutive days, which is a long period of decent breadth.

Here’s what happened next to the Dow when the Dow McClellan Summation Index was above 0 for 111 consecutive days.

Mostly bullish 6-12 months later.

Meanwhile, more than half of NASDAQ stocks are above their 50 day moving average for the first time in over 30 days.

This kind of breadth improvement tends to be bullish for the NASDAQ over the next 2 months.

Fundamentals: Long Term

The stock market and the economy move in the same direction in the long run, which is why we focus on macro.

U.S. leading economic indicators are decent right now, which suggests that a recession is not imminent. Let’s recap some of the leading macro indicators we covered:

Housing is a slight negative factor, but could improve

Housing – a key leading sector for the economy – remains weak. Housing Starts and Building Permits are trending downwards while New Home Sales is trending sideways. In the past, these 3 indicators trended downwards before recessions and bear markets began.

Labor market is still a positive factor 

The labor market is still a positive factor for macro. Initial Claims and Continued Claims are trending sideways. In the past, these 2 leading indicators trended higher before bear markets and recessions began.

Financial conditions

Financial conditions remain very loose. In the past, financial conditions tightened before recessions and bear markets began.

Here’s the Chicago Fed’s Financial Conditions Credit Subindex

Meanwhile, banks’ lending standards are still very loose. Lending standards trended upwards (tightened) significantly prior to previous economic recessions and bear markets. This is important because the U.S. is a credit-driven economy.

Heavy Truck Sales

Heavy Truck Sales is still trending upwards. In the past, Heavy Truck Sales trended downwards before recessions and bear markets began.

Corporate Profits

The latest reading for inflation-adjusted corporate profits fell. In the past, corporate profits fell before recessions and bear markets began. Since corporate profits leads the S&P by 5-6 quarters, this will be a long term bearish factor for the stock market beginning in Q1 2020 if corporate profits continue to fall.

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. Long term: risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
2. Medium term (next 6-9 months): most market studies are bullish.
3. Short term (next 1-3 months) market studies are mixed.
4. We focus on the medium-long term.

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