Medium term is bullish, but long term risk:reward is bearish

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Last week’s market outlook was not clearly explained, so I would like to clarify.

Our models have not yet turned long term bearish, although they are getting close to turning long term bearish. But while building new and better models like the Macro Index, I’ve come to realize that at least from a long term risk:reward perspective, it doesn’t favor long term bulls. Market outlook and risk:reward are not the same thing. Here’s an example.

Let’s assume that there’s a 80% probability that the stock market goes up from here, which means there’s a 20% probability the stock market goes down from here. While on the surface this seems bullish, it fails to take into account risk:reward. If the risk:reward is 5:1, then the expected outcome factors neither bulls nor bears. (5x probability of the stock market going up, but 5x the downside risk. These 2 things cancel each other out.)

Goldman Sachs has a very simple Bull/Bear Indicator which illustrates this point.

*This Bull/Bear Indicator is constructed by taking a percentile for the Unemployment Rate, Inflation, Yield curve, ISM manufacturing, and P/E ratio

As you can see, Goldman’s Bull/Bear Indicator is quite high, historically speaking. Is this immediately long term bearish? No. This indicator can remain very high for 1-2 years. This means that while the indicator is not long term bearish (i.e. it is not a timing indicator), it demonstrates that long term risk:reward points to the downside.

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, week, or month.

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are walking into the future blindly.

Russell’s significant underperformance

The small caps Russell 2000 Index has been much weaker than the large caps Dow. The Russell is more than -16% below its 1 year high, while the Dow is less than -10% from its 1 year high.

Some traders think this means that the Dow will “catch down” with the Russell, thereby bringing the broad S&P 500 down. Are they correct?

Here’s what happened next to the S&P when the Russell fell more than -16% from a 1 year high while the Dow fell less than -10% from a 1 year high.

*Data from 1987 – present

As you can see, the S&P tends to face weakness over the next 1 month, after which forward returns start to improve. It’s interesting how our 1 month forward market studies are mixed right now. Some are bullish and some are bearish. This demonstrates how the market can go either way in the short term right now.

MACD

The MACD(12,26,9) monthly made a bearish cross at the end of November. Of course, the bears eyeball the chart and state “this is long term bearish for the stock market”.

The problem with “eyeballing” a chart is that you tend to see what you want to see, while ignoring the historical cases that don’t match your pre-existing market outlook.

Here’s what happened next to the S&P 500 when its MACD(12,26,9) monthly histogram crossed below zero.

As you can see, this isn’t consistently bearish for the stock market on any time frame. Technical analaysis on its own is incapable of catching long term tops without too many false signals.

*This post was written as of the morning on Monday. I will update this post with more market studies after the CLOSE

Conclusion

Here is our discretionary market outlook:

  1. 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.
  2. The medium term direction is still bullish  (i.e. trend for the next 6-9 months)
  3. The short term is a 50/50 bet

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