Market outlook: the stock market isn’t as bullish or bearish as you think

by Troy

With the S&P at new highs this week, traders are generally divided into 2 camps:

  1. Those who think that December 2018 was a major bottom and the bull market still has years left (FOMO).
  2. Those who think that this rally is fake and another stock market crash is imminent.

The most likely outcome is somewhere inbetween. The stock market probably will not keep rallying throughout 2019 at the current pace (otherwise it will go up 60% in 2019!), and it probably won’t crash even further than its December 2018 lows right now.

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:

  1. The stock market’s long term risk:reward is no longer bullish.
  2. The medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.
  3. The stock market’s short term leans bearish

We focus on the long term and the medium term.

Long Term

While the bull market could keep going on, the long term risk:reward no longer favors bulls. Towards the end of a bull market, risk:reward is more important than the stock market’s most probable direction over the next 12+ months

A few leading indicators are showing signs of deterioration. The usual chain of events looks like this:

  1. Housing – the earliest leading indicators – starts to deteriorate. This has occurred already, but is not significant
  2. The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long term topping process. The labor markets have not deteriorated significantly yet.
  3. Other economic indicators start to deteriorate. The bull market is definitely over, and a recession has started. A U.S. recession is not imminent right now

Valuations

The stock market’s valuations are high, as they have been for years.  But valuations alone do not cause bear markets. Recessions cause bear markets. A recession is like jumping out of the building, and valuations are like the floor from which you jump out. Jumping out of the building causes the damage, the floor from which you jump out determines how much damage.

  1. High valuations + recession = big bear market
  2. Low valuations + recession = big correction

Housing

There is some deterioration in the housing market, with 2 of the 3 key indicators trending downwards. However, the deterioration is still not significant.

Building Permits is trending downwards.

Housing Starts is trending downwards.

New Home Sales is trending sideways.

In the past, these 3 key leading indicators trended downwards before recessions and bear markets began.

Labor market

Initial Claims is trending sideways/downwards while Continued Claims is trending sideways.

In the past, these 2 figures trended higher before bear markets and recessions began.

Corporate Profits

Corporate Profits are still trending higher, after adjusting for inflation. In the past, corporate profits trended lower before bear markets and recessions began.

Personal Consumption Expenditures

Personal Consumption Expenditures’ year-over-year % growth remains flat. In the past, Personal Consumption Expenditures growth trended downwards before recessions began.

Freight

Truck Tonnage continues to trend higher. In the past, Truck Tonnage trended sideways before bear markets and recessions began.

Delinquency

The Delinquency Rate on All Loans is trending downwards. In the past, delinquency rates trended upwards before bear markets and recessions began.

GDP growth

Real GDP growth is trending upwards.

In the past, GDP growth usually trended sideways or downwards before recessions and bear markets began.

GDP growth has been steady for 11 consecutive quarters, which is a long time. The last time this happened was Q4 1998 (late-cycle, but bull market wasn’t over).

Such long periods of sustained economic growth don’t usually suddenly tip over into a recession/bear market.

Global Trade

Global trade volumes are slowing down primarily due to ex-U.S. weakness.

While it’s tempting to look at this 1 indicator and think “it’s 2008 all over again!!!!”, it’s better to use U.S. economic data to trade the U.S. stock market than to use foreign economic data to trade the U.S. stock market.

Financial Conditions

Financial conditions are still extremely loose and making new lows for this economic expansion. In the past, financial conditions tightened before bear markets and recessions began.

Conclusion: The stock market’s biggest long term problem right now is that as the economy reaches “as good as it gets”, the long term risk on the downside is much greater than the long term reward on the upside.

The end of a bull market is always very tricky to trade. The stock market can go up a lot in its final year, even if the macro economy is deteriorating (e.g. 2006-2007). That’s why it’s better to focus on long term risk:reward instead of trying to time exact tops and bottoms. Even when you think the top is in, the stock market could very well surge for 1 more year. (Just ask the people who thought that the dot-com bubble would end in 1998. It lasted another 1.5 years).

Medium Term

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

The stock market’s price action demonstrates a bullish lean over the next 6-12 months.

New highs

Both the S&P and NASDAQ made new all-time highs (daily CLOSE $) on Tuesday. This is the first new high in a long time, which is bullish from both a TIME and MAGNITUDE perspective.

TIME:

MAGNITUDE:

Other indices aren’t doing so well

While the S&P is at an all-time high, the Russell is still far below its all-time high.

While it’s tempting to think “this is just like the dot-com bubble all over again”, we need to look at the data holistically. Not consistently bullish or bearish for stocks.

Momentum

The NASDAQ’s momentum is strong. A little too strong. It has gone up 16 of the past 18 weeks.

This is extremely rare, and typically happened 1 year before a bear market or recession.

  1. February 2000: bull market top
  2. July 1989: recession and big correction 1 year later
  3. August 1980: recession and big correction 1 year later
  4. March 1972: bull market top 9 months later

Sample size is small, but this does demonstrate somewhat of a blowoff top.

The S&P has gone up 14 of the past 18 weeks. Bull markets don’t usually die on such strong momentum, which is why this is mostly bullish for the S&P 6-12 months later.

In terms of RSI, the S&P and NASDAQ are both quite overbought.

The S&P’s weekly RSI is at 64 and the NASDAQ’s weekly RSI is at 66. While such strong momentum may not be a bullish factor for stocks in the short term, it is usually a bullish factor 9-12 months later.

Patterns

Some traders think that the S&P is making a flat top. The S&P has rallied a mere 4.11% over the past 15 months. Is this bearish?

Here’s what happens next to the S&P when it goes up less than 5% over the past 15 months, while at a 2 year high.

Rare, but not consistently bearish.

But what about the S&P’s megaphone pattern, which are rare patterns that occur mostly at major tops and bottoms (or so the technical analysis books say)?

Here’s what happens next to the S&P when its 6 month high-low range is more than 25% today, more than 10% a year ago (expanding range), with higher highs and lower lows.

Rare. But it seems that these megaphone patterns aren’t consistently bearish.

No pullbacks

Since the December bottom, the S&P has rallied on almost 2/3 of days. This is unusual because the random probability of the S&P going up on any given day is 56%.

This is mostly bullish for the S&P 9-12 months later.

Moreover, there have been only 4 days in which the S&P fell more than -1% in the past 4 months while the stock market has soared. And while this is rare, it isn’t long term bearish.

Yield curve

The 10 year – 2 year yield curve has closed above its 200 dma for the first time in 2 years.

The first steepening of the yield curve isn’t long term bearish for the stock market.

Breadth

The stock market’s breadth is weakening as the rally slows down.

The NASDAQ and NYSE McClellan Oscillators have made “death crosses” (50 dma falls below 200 dma)

Sample size is small, but overall this isn’t a bullish sign for the stock market over the next few weeks and months.

Some traders have noted that while more than 70% of S&P stocks are above their 200 dma, less than 50% of NASDAQ stocks are above their 200 dma. Considering that both indices are at all-time highs, this is often considered to be a “bearish breakout”.

Except that it’s not. While such weak breadth during a breakout is rare, it’s not unprecedented.

While the S&P made a new high this week, relatively few stocks in index made new highs. The last time this happened was (insert scary music) October 2018. Here’s a 10 day average of the number of S&P stocks making new highs.

So how bearish is this? Let’s look at the data holistically to avoid recency bias. Here’s what happens next to the S&P when it breaks out to a 2 year high when less than 50 S&P stocks are making new highs.

So yes, the “last time this happened” was August 2018. But more often than not, this is not bearish.

Sentiment

Sentiment remains in disbelief of the current stock market rally. For example, AAII Neutral % remains extremely high at 46%. (Sentiment tends to move inline with price. Price goes up, sentiment goes up. Price goes down, sentiment goes down.)

Here’s what happens next to the S&P when it rallies more than 10% over the past 4 months while AAII Neutral % exceeds 40%.

Short Term

With the stock market up so much over the past 4 months, it’s easy to say that the stock market has a short term bearish lean. But over the years I’ve noted that it’s extremely hard to predict the short term, no matter how much conviction you have. Too many factors have a big impact on the stock market’s short term.

With that being said, I’ll leave you with this headline from Bloomberg…

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 6-12 months) has a bullish lean.
  3. We don’t predict the short term because the short term is always extremely random, no matter how much conviction you think you have. Focus on the medium-long term.

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

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