The nonstop stock market rally continues

by Troy

The S&P 500 is now up 8 days in a row, for the first time since October 2017. As you may recall, the stock market rallied nonstop in 2017.

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.

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

Momentum

The S&P is now up 8 days in a row, for the first time in more than 1 year.

Historically, this has been more bullish than normal for the S&P 9 months later. Why? Because strength begets strength. This is the basis behind the momentum factor in investing.

What’s behind the nonstop rally in stocks?

An easy target to blame at is “algos”. I generally don’t like to blame things on the algos.

  1. People blamed the December 2018 selloff on algos.
  2. People are now blaming the rally on algos.

Long bull market ahead?

With the S&P rallying almost 20% year-to-date, some bullish investors have gotten a little ahead of themselves in proclaiming that the bull market may last another 10-20 years.

For example, this is the Barron’s cover

In investing and trading, it’s best to be a cautious optimist.

  1. Pessimists (even people who are optimistic 50% of the time and pessimistic 50% of the time) underperform because they miss out on too many rallies
  2. Overly optimistic investors/traders underperform because they get hurt by too many market crashes.

I don’t think the next 10 years will be as good for the stock market as the past 10 years. Here’s the S&P 500’s 10 year rate-of-change, after factoring in dividends and inflation.

As you can see, this has been a remarkable 10 years.

Here’s what happens next to the S&P when the 10 year rate-of-change exceeds 280%.

USD yearly pressure on earnings?

The USD dollar index has been going up over the past year. Its 12 month rate-of-change as of the end of March 2019 was +7.5%

Since many of the S&P 500 companies generate revenues and profits from overseas, a superficial analysis would automatically assume that a rising USD = bearish for U.S. corporate earnings growth.

In Ed Yardeni’s book “Predicting the Markets” (a terrific book), he explains why it’s not as simple as:

  1. Year-over-year rising USD = bearish for stocks & earnings
  2. Year-over-year falling USD = bullish for stocks & earnings

I won’t bore you with the details, but the jist of his argument is that while the S&P 500 companies do derive a lot of their revenues and earnings from overseas, they also derive a lot of their costs from overseas. So while a rising USD hurts American companies’ overseas revenues, it also brings down their overseas costs in USD terms.

This is why a rising USD has more of an adverse impact on the S&P 500’s revenues than earnings.

Regardless, here’s what happens next to the S&P 500 when the USD Index’s year-over-year change exceeds 7.5%.

*3/1/2019 = the month of March 2019.

Here’s what happens next to the USD Index itself.

Sectors

FAANG and tech stocks have surged recently while banks stocks have lagged. For example, XLK (tech sector ETF) has surged over the past 5 weeks while XLF (finance sector ETF) has stalled.

Seasoned traders will recall that this is not a good sign for the stock market. Finance consistently underperformed during 1999 and 2007, among other less ominous historical cases.

Here’s what happens next to the S&P when XLF rallies less than 0.3% over the past 5 weeks while XLK rallies more than 7%.

There are a lot of overlapping dates, but the simple conclusion is that at the very least, this is not a bullish sign for stocks.

Oil

Oil has rallied significantly along with the stock market in recent months. It has almost recovered its entire Q4 2018 decline.

You can see that oil’s momentum (RSI) is now overbought for the first time in a long time.

Here’s what happens next to the S&P when oil’s 14 day RSI exceeds 75 for the first time in half a year.

As you can see, this is a potential short term headwind for stocks over the next month, but not after that.

Traders often automatically assume that rising oil = bearish for U.S. stocks. It’s not as simple as that:

  1. Rising oil $’s = good for countries that are net exporters of oil (for example, rising oil = a boon of Saudi Arabia)
  2. Rising oil $’s = bad for countries that are net importers of oil

As the shale boom continues, the will export more and more oil while importing less and less oil. So while rising oil $’s may have been bad for the U.S. in the past, rising oil $’s won’t be a problem in the future.

Here’s what happens next to oil itself.

Stocks vs Gold

For one reason or another, a lot of market watchers love gold and hate the U.S. stock market. How many times have we heard the phrase “buy gold, sell stocks” over the past 5 years?

These market watchers propagate charts such as the following. “The stock market is most expensive relative to gold since the dot-com bubble! Gold is cheap! Buy stocks, sell gold!”

Here’s the thing. These charts are optical illusions, and goldbugs use them to trigger your recency bias. (“Today is just like 2000” is an example of n=1 sample size).

Here’s a long term chart of the S&P 500 vs. gold ratio, on a log scale.

As you can see, the S&P ALWAYS goes higher and higher in the long run relative to gold. Hence, comparing the stock market to gold doesn’t make a lot of sense.

Why?

Because stocks are a productive asset while gold is an unproductive asset. Stocks generate earnings, and their earnings grow in the long run. But one ounce of gold will always = one ounce of gold. Gold can’t grow “earnings” because it is an unproductive asset.

A more useful ratio is the gold:silver ratio, which is extreme high right now (compare apples with apples, don’t compare apples with oranges). Silver is much more volatile than gold, which is why the gold:silver ratio is very high when gold and silver are in bear markets.

Read Recession probabilities are increasing. Beware of a stock market crash?

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 6-9 months) is mostly mixed, although there is a bullish lean.
  3. We don’t predict the short term because the short term is always extremely random. At the moment, the short term does seem to have a slight bearish lean.
  4. In summary, 12-24 months = bearish, 12 months = neutral, 6-9 months = slightly bullish.

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