Market Report: looking back on 2020, and looking ahead

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by Troy

What a year it’s been. I hope you’re doing well, both health-wise and wealth-wise. This is the first time I’ve written my market thoughts on this blog since August 2019, so thank you if you’ve been following me since I stopped writing here a year ago. Now let’s dive into the markets.

It doesn’t matter if it’s a white cat or a black cat. If it’s a cat that catches mice, it’s a good cat.

There is a battle raging between bulls and bears right now.

  1. Most bears are arguing their outlook by pointing at high sentiment, rich valuations, record-shattering options buying, and a lack of insider buying. Moreover, many bears think that a “real” correction is long overdue.
  2. Most bulls are arguing their outlook by pointing out that the market’s trend, momentum, and breadth are incredibly strong. Moreover, the global economy will improve as vaccines rollout while central banks continue to be supportive.

There is no clear right and wrong in the markets, there is no black and white. It’s better to take a step back and first consider your trading strategy and time frame before deciding on whether to be bullish or bearish. There are many ways to skin a cat, and there are many seemingly-opposite but equally successful trading strategies if implemented correctly. E.g. implementation: trend following works better when applied to growth stocks than value stocks due to stronger animal spirits driving stronger trends.

  1. If you are a short-medium term contrarian trader, you should be bearish right now.
  2. If you are a short-medium term trend follower, you should be bullish right now. Many short term trend followers doubled or tripled their portfolio this year by riding the market’s massive waves.
  3. If you are a long term buy and hold investor, your portfolio’s long term future returns will likely be below expectations. Now is not the right time to be a buy and hold investor.

Let’s look at the markets from bears’ and bulls’ perspectives to better understand what is happening right now.

No corporate insider buying (bearish)

Corporate insiders are incredibly good at trading their own stocks. They know their companies’ situation better than outsiders do, and thus can profit from this information-advantage. Corporate insiders have a consistent track record of buying their stocks near market bottoms and selling their stocks near market tops.

We created a free website that lists all U.S. corporate insider trading data, and then aggregated that data into an Insider Buy/Sell ratio. From 2003-present, the Insider Buy/Sell ratio’s 1 month average (for all U.S. stocks) spiked every time stocks bottomed. The last spike in insider buying came in March 2020, after which global stock markets soared.

Right now, the Insider Buy/Sell ratio for all U.S. stocks is extremely low. Insiders buy low, sell high.

We also calculated an Insider Buy/Sell ratio for only S&P 500 stocks. Once again, the ratio spikes at market bottoms, and is extremely low right now. Insiders are not chasing the rally.

There were only 8 other historical cases in which the S&P 500 Insider Buy/Sell ratio was this low. The S&P 500’s forward returns over the next 2-6 months were poor and usually faced pullbacks/corrections:

Insider trading data is incredibly useful. Next week I will explain in detail how to use this data.

Elevated sentiment (bearish)

A powerful 9 month rally has mostly pushed stock market sentiment in only 1 direction – up.  As you’ve probably heard of by now, traders are buying call options like there’s no tomorrow. The CBOE Equity Put/Call ratio is near its lowest level in 17 years:

The Equity Put/Call ratio’s long term average has changed over time. We can look at the Equity Put/Call ratio’s 10 dma vs. its 200 dma to account for this generational shift:

Such extreme sentiment over the last 15+ years only occurred in 2010 and this year (both after a recession & bear market). The 2010 historical case was immediately followed by a major correction. But record call buying this year has not significantly dented the stock market’s rally thusfar (i.e. it was not a timely SELL signal if you paid attention to this indicator too early):

I calculated a 10-factor Medium Term Sentiment indicator to better gauge sentiment in the U.S. stock market. Sentiment is elevated right now, but not as elevated as it was before stocks pulled back in September-October:

A closer look at the past few years reveals that stocks can continue to rally a little more despite such extreme sentiment, but a pullback/correction usually was not far off in the distance.

One can make the argument that sentiment is not as useful as it used to be. From 2017 – present sentiment has consistently stayed at extreme levels for a long time before the market reversed.

  1. Sentiment was extremely high throughout 2017, but the market rallied nonstop for a year
  2. The market fell in mostly a vertical line in Q4 2018. Traders who bought because “sentiment is too pessimistic!” mostly bought too early
  3. The market rallied in a vertical line in 2019, barely taking a breather despite “extremely high sentiment”
  4. The market crashed in a vertical line in February – March 2020. Many traders bought stocks that fell -10%, only to watch their stocks fall another -25% before bottoming.
  5. The market has rallied in mostly a vertical line from April – present.

In the day and age of mass communication and social media, trends are becoming increasingly powerful. EVERYONE jumps from trend to trend, bandwagon to bandwagon. Hence why trends are more extended than they used to be and sentiment is consistently more extreme than it used to be. As a result, I put less emphasis on the importance of sentiment. Moreover, when using sentiment it is important to wait for true extremes. E.g. if before you turned bearish when sentiment reached 70, now you should only turn bearish when sentiment reaches 80.

Now that we’ve looked at medium term bearish factors for U.S. stocks, let’s look at medium term bullish factors.

Strong trend & momentum (bullish)

The stock market’s uptrend and strong momentum are reason enough for short term trend followers to remain bullish right now. The “everything rally” (and particularly the tech rally) will “eventually” come to a screeching halt. But until it does, short term trend followers will continue to profit handsomely and be protected by their stop losses. Excellent traders like Puru Saxena made a killing this year using this strategy (over 400%!)

As I noted on Monday, ALL major risk assets are rallying: stocks, commodities, real estate, ex-U.S. currencies, etc.

The following chart illustrates the average 180 day % change of 10 stock markets and 4 commodities markets.

  1. Stock indices from the world’s 10 biggest stock markets: U.S., Japan, Germany, Canada, Australia, UK, China, India, South Korea, France
  2. Commodity prices: crude oil, natural gas, copper, sugar

Such strong across-the-board momentum is how multiple bull markets in the past were started. For example, this occurred at the start of the 1990s bull market, at the start of the 2003-2007 bull market, and at the start of the 2009-2020 bull market. It also happened in 1999 after a major scare in 1998. Back then, stocks roared for another year before topping.

When this happened in the past, the S&P usually rallied over the next year:

Looking at tech & growth stocks specifically, the NASDAQ 100 managed to rally 10 days in a row this week:

In the past, such strong momentum almost always led to more gains for the NASDAQ 100 over the next 9 months:

The stock market is a tug-of-war between momentum (trend following) vs. sentiment (contrarian). Thusfar momentum is winning.

Strong breadth (bullish)

Many analysts were worried a few months ago because “breadth is weak”. Now that previous laggards such as value stocks, energy stocks, and ex-U.S. stocks are catching up, such worries are dissipating. Breadth is improving, and the % of S&P 500 stocks above their 200 dma (in a long term uptrend) is at its highest level in years:

Such strong breadth, like such strong momentum, can lead to a short term pullback. However, in the long term it led to more gains for the broad S&P 500:

NASDAQ data paints a similar story: the % of NASDAQ Composite stocks above their 200 dma is at one of the highest levels ever:

Data source: StockCharts

This was consistently bullish for NASDAQ stocks going forward:

Looking at breadth from a different angle, the NASDAQ McClellan Summation Index is at one of its highest readings ever:

*This breadth indicator is based on stock advances & declines.

Such powerful breadth occurred 3 other times in the past 20+ years, and consistently pushed the NASDAQ Composite higher over the next year:

Improving economy (bullish)

A major tailwind for stocks in 2021-2022 will be the global economy. The global economy will most likely improve as vaccines rollout and government stimulus mutes the worst of the pandemic’s fallout.

To illustrate the point that the improving economy is a long term tailwind for stocks, the following chart demonstrates that earnings estimates are being revised upwards:

Such strong upwards revisions are common at the start of major bull markets as economic conditions improve and analysts chase the news. (The 2017/2018 earnings boost was unique in that it was mostly caused by Trump’s tax cuts). The following chart maps the S&P 500 against global earnings revisions:

*earnings revision charts from Yardeni

While an improving economy is a long term bullish factor for stocks, it is not very important in the medium term. Post-recession economic expansions are usually followed by massive stock market rallies, and then a multi-month consolidation period. That is my base case going into 2021: the best of the rally is behind us, and 2021 will not see the gains we’ve seen in 2020.

News-related sentiment is improving as the world anxiously awaits coronavirus vaccines. The San Francisco Fed’s Daily News Sentiment Index has rallied back to zero (neutral sentiment) after plunging during the global lockdowns in March. Description for this indicator:

The Daily News Sentiment Index is a high frequency measure of economic sentiment based on lexical analysis of economics-related news articles.

Improving news sentiment was usually a good sign for stocks over the next 3 months. Perhaps this is due to more optimistic media coverage influencing readers’ biases, making readers more optimistic towards the macro landscape as well. The one major historical exception was in March 2002, when the recession was already over yet stocks continued to fall:

Now that we’ve looked at the medium term bullish and medium term bearish cases, I’d like to touch on the biggest problem for stock market returns over the next 5-10 years: valuations.

Valuations (long term problem)

We are in a very unique situation today: a new economic expansion has begun while the stock market is at high valuations.

The previous 2 economic expansions and bull markets began while the S&P 500 was at lower valuations (Forward Price/Earnings ratio of 18 and 15). Today, forward Price/Earnings ratio is at a hefty 22. The higher valuations are when a bull markets begin, the weaker long term future returns are. E.g.

  1. The 2004-2007 bull market began at a higher valuation (P/E of 18), so the 2004-2007 bull market was weaker. Stocks needed to grind higher slowly and allow earnings to increase fast enough to work off these high valuations
  2. The 2010-2020 bull market began at a lower valuation (P/E of 15), so the 2010-2020 bull market was stronger. Stocks could rally further on earnings increases and multiples expansion.

So while we could be at the start of a multi-year bull market, and stocks could pullback in the short term, I do not think this bull market will be anywhere similar to the previous 2010-2020 bull market. Valuations do not provide as much room for stocks to rally. Thinking that “the next one” will be “just like the last one” is a prime example of recency bias.


To reiterate:

  1. If you are a short-medium term contrarian trader, you should be bearish. Avoid stocks and let the market’s short term optimism wash out.
  2. If you are a short-medium term trend follower, there is no reason at all for you to be bearish. Be long and have protective stops! The market can turn downwards any day now.
  3. If you are a long term buy and hold investor, your portfolio’s long term future returns will likely be below expectations. Perhaps it’s better to look at value pockets such as energy stocks.

There are other trading strategies which require you to be neither outright bullish nor bearish right now, and I’ll explain my thinking on those next week.

The beauty of trading is that 2 different traders can have entirely different opinions at a point in time, and both can outperform in the long run if they stay true to their own strategy and are open-minded to others’ strategies.

Personally, I use a basket of different strategies so that my portfolio’s returns smooth out. It’s easy for any single trading strategy to go through a rough patch. It’s harder for a group of diversified strategies to all fail at the same time.


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