by Troy
The S&P 500 experienced a week of nonstop selling.
Source: Investing.com
The economy’s fundamentals determine the stock market’s medium-long term outlook. Technicals determine the stock market’s short-medium term outlook. Here’s why:
- The stock market’s long term risk:reward is no longer bullish.
- The stock market’s medium term leans bullish (i.e. next 6 months).
- The stock market’s short term is mostly a 50-50 bet.
We focus on the long term and the medium term. Let’s go from the long term, to the medium term, to the short term.
Long Term
While the bull market could very well still last until Q2 2019, the long term risk:reward no longer favors bulls. Past a certain point, risk:reward is more important than the stock market’s most probable direction.
*I do not define “bear markets” via the traditional -20% decline. I define “bear markets” as 40%+ declines that last at least 1 year. E.g. 2007-2009, 2000-2002, 1973-1974, 1968-1970.
Some leading indicators are showing signs of deterioration. The usual chain of events looks like this:
- Housing – the earliest leading indicators – starts to deteriorate. Meanwhile, the U.S. stock market is still in a bull market while the rest of the U.S. economy improves. The rally gets choppy, with volatile corrections along the way.
- The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long term topping process. This will likely happen in the start of 2019. We are almost here right now.
- The labor market deteriorates some more, while other economic indicators start to deteriorate. The bull market is definitely over.
Let’s look at the data (aside from our Macro Index).
Housing Starts and Building Permits have been trending sideways/down over the past year. Historically, these economic data series trended downwards before bear markets and recessions began.
Source: FRED
Homebuilder sentiment is trending downwards. In the past, homebuilder sentiment trended downwards before bear markets and recessions began.
Source: TradingEconomics
Meanwhile, the labor market remains healthy. Initial Claims and Continued Claims have not yet trended upwards. These 2 leading indicators trended upwards before prior bear markets and recessions began.
Source: FRED
Of lesser importance are corporate profits and inflation-adjusted Retail Sales (monthly data is more useful than quarterly data). Corporate profits and inflation-adjusted Retail Sales are still trending higher. In the past, these 2 data series trended downwards before bear markets and recessions began.
Source: FRED
The stock market’s internals are sending some long term warning signs, which are not definitively long term bearish signs. As Stan Druckenmiller calls it, the “internals are amber, but not red”.
Cyclical sectors are significantly underperforming while counter-cyclical sectors are outperforming. This is not good.
As of Friday, on a year-over-year basis, XLF is down more than -17% while the S&P is down less than -11%.
Here’s every similar case, from 1998 – present
Similarly, utilities have massively outperformed the broad stock index.
XLU (utilities ETF) is positive over the past year (252 trading days), while the S&P is down more than -10%.
Here’s every time this happened from 1998 – present.
2 long term bearish signs, 1 long term bullish sign.
Medium Term
Our medium term outlook (next 3-6 months) still leans bullish. Even in the context of a 40%+ bear market, it is very rare to not see a vicious bear market rally given how extreme the market’s technicals and sentiment are right now. Of course, there is always a once-in-a-decade exception, but it is not a good idea to consistently bet on low probability events.
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
For starters, let’s assume the worst case scenario. Let’s assume that this is the start of a -40% bear market (as some of the bears believe). As I explained on Tuesday:
If this is just a -15% or -20% decline, then you would obviously want to be a buyer here. Downside risk is approximately -5%, and the upside is much higher. Think risk:reward
But what you are afraid of is “is this the start of a -30% to -50% decline?” If the stock market tanks -30% and you buy here, your long position will get killed.
Let’s take a look at the previous 30%+ declines that lasted at least 1 year.
Here’s the 2007-2009 bear market. The S&P fell 20%, and then made a >50% retracement rally
Here’s the 2000 – 2002 bear market. The S&P fell 16.4%, and then made a 50% retracement rally.
Here’s the 1981 – 1982 decline. The S&P fell 22.3%, and then made a 50% retracement
Here’s the 1973 – 1974 bear market. The S&P fell 18%, and then made a 50% retracement rally.
Here’s the 1969-1970 bear market. The S&P fell 18.3%, and then made a 50% retracement rally.
So what do you see?
If this is indeed the start of a 30-50% decline, then the stock market tends to make a big 50% retracement rally after the S&P falls -15% to -22%
The S&P is currently down -18%, almost in the middle of this -15% to -22% range.
Right now, the stock market is demonstrating extreme fear in sentiment, breadth, and mean-reversion indicators. Think about this as an elastic band: when you stretch an elastic band to an extreme, it “eventually” snaps back very strongly. This “eventually” can happen immediately, or it can happen after more short term selling. That is why if you go long here, it is better to scale in with very wide ranges. E.g. don’t scale in at -18%, -19%, -20%. It’s better to scale in at -15, -25%, -30%. The mean-reversion rally “eventually” happens, but no one can consistently and accurately know where. That is why our market studies are consistently medium term bearish, but they are a 50-50 bet on the short term.
*I’m not saying that this is the start of a -40% bear market. I’m just saying that even in a worst case scenario, there is eventually a vicious bear market rally.
Let’s look at the stock market’s technicals and sentiment
The S&P 500 Bullish Percent Index is a point-and-figure breadth indicator for the stock market’s internals. It is extremely low right now at 17%.
Here’s what happened next to the S&P 500 when the Bullish Percentage Index fell below 18% (first case in 1 month).
*Data from 1996 – present
As you can see, this usually led to a medium term rally in the stock market, with the exception of October 2008.
Similarly, the % of stocks above their 50 day moving average has fallen to 6.2%. This is one of the most extreme readings over the past 16 years.
Here’s what happened next to the S&P when the % of stocks above their 50 dma fell below 7%.
In this case, the stock market often went lower, before rallying 6 months later.
As of Wednesday, the Put/Call Ratio spiked more than 65% above its 50 day moving average. Historically, the stock market could go lower in the short term, but it rallied 3 months later.
And lastly, small caps have been absolutely hammered.
The Russell 2000’s weekly RSI is extremely low – almost equivalent to the 2009 bottom.
Here’s what happened next to the Russell 2000 when its 14 weekly RSI was below 25
Here’s what happened next to the S&P 500 when the Russell 2000’s 14 weekly RSI was below 25
If anything, this illustrates how extreme the stock market’s current selloff is, and how such extremes “eventually” lead to a vicious rally.
On an interesting note, this is officially the third worst December for the stock market since 1900. The only other 2 times the S&P fell more than -12% in December were 1930 and 1931
*I’m not saying that we’re in a Depression. Far from it. By the time this occurred in December 1930, the S&P was already down -60% while the economy saw 20%+ unemployment. That stands in stark contrast to today. This stat merely exemplifies how extreme the current selloff is. Moreover, seasonality factors are always of secondary importance. Seasonality changes over the ages.
Short term
You’ll notice that while our medium term studies have been consistently bullish (e.g. rally 3-9 months later, depending on if it’s a bull or bear market rally), the short term outlook is not consistently bullish.
Why?
Because in the short term, extreme can always get more extreme. Once the selling and fear is on autopilot (e.g. right now), there is always the possibility of one final big crash. That rarely does happen (low probability), but low probability ≠ non-existent. In such times, your trading strategy needs to be prepared for every scenario (including low probability scenarios) while simultaneously betting on the most likely scenario. For example, this means that you should not be long futures right now. If the stock market falls more than you expect in the short term, you will be wiped out with a margin call.
*For the record, I have always advised against trading futures for this precise reason. ETFs don’t have margin call problems. You can hold your position until you are right, but you can’t do the same with futures.
Conclusion
Here is our discretionary market outlook:
- For the first time since 2009, the U.S. stock market’s long term risk:reward is no longer bullish. This doesn’t necessarily mean that the bull market is over. We’re merely talking about long term risk:reward.
- The medium term direction is still bullish (i.e. trend for the next 6 months). However, if this is the start of a bear market, bear market rallies typically last 3 months. They are shorter in duration.
- The short term is a 50/50 bet
Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.
