Recession probabilities increase as breadth weakens. What’s next for stocks

by Troy

Amidst the never-ending sea of things to worry about, more economic indicators are flashing warning signs. Meanwhile, breadth is weakening a little. Today’s headlines:

  1. NY Fed’s Recession Probability
  2. OECD’s Leading Indicator
  3. Dow Theory
  4. Sentiment divergence
  5. Breadth divergence

Go here to understand our fundamentals-driven long term outlook. For reference, here’s the random probability of the U.S. stock market going up on any given day.

NY Fed’s Recession Probability

The New York Fed has a popular Recession Probability Model that basically just flips the yield curve on its head.

As you can see, recession probabilities are increasing because the yield curve is pushing deeper into inverted territory.

Here’s what happened next to the S&P when the probability of a recession exceeded 32%.

All of these historical cases occurred when a recession/bear market had already begun, or within 1+ year of one.

OECD

OECD produces a Composite Leading Indicator that looks at the state of the global economy. This indicator is falling right now.

Based on this indicator, the global economy is the weakest since 2008!

Here’s what happens next to the S&P when the OECD Composite Leading Indicator fell to 99

With the exception of 1992, this occurred within a recession/bear market.

Dow Theory

The Dow Theory states that the 2 Dow indices (Dow Jones Industrial Average & Dow Jones Transportation Average) should “confirm eachother”. If 1 index is making new highs but another is not, then this is a bearish sign.

And right now, the Dow Transportation Average is significantly lagging the Dow Jones Industrial Average.

Is this actually bearish?

Here’s what happens next to the Dow when the Dow Industrial Average makes a 1 year high, while the Dow Transportation Average is more than -9% below its 1 year high.

Not consistently bullish or bearish for stocks.

NAAIM

As the stock market made new highs since late-2017, the NAAIM Exposure Index has made lower highs.

*NAAIM Exposure Index measures the exposure to U.S. equities of active managers. In other words, active managers are more and more worried about the stock market.

Is this divergence in sentiment something to be worried about. Do active managers “know something” that we don’t know?

Here’s every week in which the S&P rallied more than 10% over the past 81 weeks, but NAAIM fell more than -30%.

Neither consistently bullish nor bearish, but it does tend to happen around a lot of 15%+ corrections (see 2011, 2015-2016, 2018).

Breadth divergence

And lastly, there has been a small breadth divergence as the stock market pushes to new highs. While the S&P rallied over the past few weeks, the % of issues making new highs has fallen.

This divergence on its own isn’t consistently bearish for stocks….

But if you only look at the cases that occurred at an all-time high (i.e. right now), the stock market’s forward returns up to 3 months are more bearish than random.

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.