Study: the case for a medium term bounce, but why the long term risk:reward favors bears in 2019

by Troy

Pay special attention to this post. While our technical market studies are more popular, fundamental (macro economic) analysis is far more valuable when it comes to predicting the U.S. stock market. We trade based on macro. We don’t trade based on technical analysis.

I have now completed the initial version of the Macro Investing Model, which is based on the Macro Investing Index. If you haven’t read the explanation already, click here.

*The Macro Investing Model does not try to pick exact bull market tops. It determines long term risk:reward.

The Macro Investing Index is released once a month, at the end of the month. The latest data (which goes into the Index) was made available on November 30, 2018, right before the recent selloff. Unfortunately, we were working on this Index throughout late-November, and have only completed the final edition of the initial version today.

So where is the Macro Investing Index today? (as of November 30)

The Macro Investing Index is at 0.54 right now

You can clearly see that this is unprecedented throughout the entire 2009 – present bull market. It is even worse than the January 2016 “big correction”.

As I mentioned yesterday, 0.5 = the line in the sand.

So what does the stock market do when macro deteriorates for the last time in a bull market until it reaches 0.5? (assuming the worst case scenario, that this is the last time?)

  1. Sometimes the stock market goes down
  2. Sometimes the stock market swings sideways
  3. Sometimes the stock market goes up (in a very choppy manner) before going down.

The important thing to note is that the mega-crashes all happened AFTER the Macro Investing Index fell to 0.5. So until the Macro Investing Index reaches 0.5, your downside risk is limited.

With the Macro Investing Index now at 0.54, it is very close to 0.5 (but not quite there yet). Here are the cases in which the Macro Investing Index fell to 0.54, and what the S&P 500 did next.

September 30, 2018

September 30, 2000

August 31, 1989

August 31, 1987

August 31, 1985

June 30, 1979 and August 31, 1981

August 30, 1973

September 30, 1969

From this we can take away 3 key points:

  1. Macro falling below 0.6 is a WARNING SIGN that the long term trends are changing. Macro reaching 0.5 is the LONG TERM BEARISH SIGN
  2. Sometimes, Macro takes quite a bit of time (i.e. up to 1 year) to go from 0.54 to 0.5 (this was the case from September 2006 all the way to December 2007)
  3. Tops are a process. They come in all shapes and sizes. Sometimes the stock market makes a marginal new high. Sometimes the stock market goes down, bounces, and makes a marginal new low. But the big drops all happened after the Macro Investing Index reached 0.5

So what does this mean?

The bull market is in a topping process, and the long term risk:reward favors the bears

As you can see, the stock market can go on to make new all-time highs, swing sideways, or go downwards some more because the Macro Investing Index has fallen below 0.6 but is not yet at 0.

But the key point is that risk:reward no longer favors long term bulls. It now favors long term bears. As of November 30, 2018, long term risk:reward is assymetric to the downside.

This means that while there still is the possibility the stock market will go up another e.g. 10-20% (see 2006-2007 case), the long term downside risk is much greater. Do not underestimate how big bear markets can be once they start.

If you think the current -10% decline is big, you need to ignore the trees and focus on the forest. Year-to-date, the S&P 500 is practically flat. Realize that in bear markets, the stock market can go down 30%, 40%, 50%, etc. That will make the current decline look like chicken scratch.

Here’s a simple way to think about risk reward. If the stock market goes up, will it at least fall to where it is today after the next bear market?

Let’s be conservative, and assume that the next bear market falls -30%. Even if the stock market rises another 40% from where it is today, it’ll still be below where it is today once the stock market falls -30%

That’s risk:reward. If you’re a long term bear, can you in a worst case scenario buy back your stocks where you sold them?

When will the Macro Investing Index reach 0.5?

This is the big question, because the Macro Investing Index is already so close, at 0.54 right now.

*0.5 = the real long term bearish sign, while 0.54 is the warning sign

The data won’t be available until the end of December 2018.

I ran a bunch of numbers through the Macro Investing Index to test for different possibilities (i.e. what happens to the Macro Investing Index when economic indicator XYZ prints out ABC).

If I had to assign probabilities, it would look like this:

  1. 70% chance the Macro Investing Index will not reach 0.5 on December 31, 2018
  2. 30% chance the Macro Investing Index will reach 0.5 on December 31, 2018

In other words, this month is critical.

Here is the most probable outcome (Macro Investing Index rises to 0.59 at the end of December 2018):

Interestingly enough, this means that the Macro Investing Model and the Medium-Long Term Model will turn bearish at approximately the same time in the first half of 2019, give or take a few months. If the Macro Investing Model doesn’t reach 0.5 at the end of December 2018, then we’ll see where the Index is in Q1 2019

I will release the model going forward in the Membership Program. But just know this. Long term risk:reward now favors the bears, even if there’s a >50% chance of a medium term rally. This has NOTHING to do with technical analysis. It is pure fundamental analysis. I’m not a fan of technical analysis, because the chart always “looks bullish” after the stock market has gone up, and “looks bearish” after the stock market has gone down.

If you are still long stocks, use the rallies to sell your positions. No one can consistently and accurately know where the exact top is (whether the top is in or not), so focus on long term risk:reward.

While I’ve been long term bullish throughout this entire bull market, I finally now think that the long term risk:reward no longer favors the bulls. Long term upside is limited, but long term downside is much bigger.

You’ll notice that the Macro Investing Model will turn long term bearish a few months sooner than the Medium-Long Term Model. Either way, they’ll turn long term bearish very close to each other. For a 9 year bull market, a few months apart is good enough.

What to do if you are long

Here are some hypothetical trading plans to use if you are long:

I think there’s a >50% chance (e.g. a 70% chance) of a medium term rally, even if the stock market goes down in the short term.

Now here’s the thing about probability. For you to come out ahead in the long term, you need to repeatedly flip the coin and bet on the side with a higher probability of success. E.g. if you flip a coin that has a 70% chance of landing on heads and you bet on heads:

  1. With one flip (n = 1), your outcome is bimodal. You either win 100% of the time, or you lose 100% of the time
  2. With e.g. 10 flips (n = 10), your outcome will center around the true mean, which in this case is 70% (which means you will win if you are long)

Now of course, this is just one trade, hence your outcome is bimodal. At bull/bear turning points, risk management becomes slightly more important than probability.

So if I was 100% long right now, my decision would be to:

  1. Cut my position to 60% long, and have the rest in cash.
  2. If the market bounces straight up from here, cut the rest of the longs on the rally. Tops are a process. If the market keeps going up, don’t chase it. Remember where the long term risk:reward is
  3. If the market goes straight down from here, add some more longs, then cut on the bounce. Bear markets don’t go down in 1 straight line.

*This is not how I’m trading. It’s just a hypothetical scenario that several people have asked me to consider.

This is our new stock market outlook

  1. The stock market’s long term risk:reward favors the bears. The bull market is in a topping process.
  2. The stock market’s medium term outlook leans bullish
  3. The short term is a 50/50 bet



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