The U.S. stock market has been been gapping up on the open and selling off later in the day recently.
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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 blindly into the future.
Failed gap ups
The S&P has gapped up each morning on the OPEN, only to close lower.
Is this a bearish sign for the stock market? Is this a sign of “distribution selling”? (The permabears would have you believe that some “evil force” is purposely pushing the market higher before the open, only to unload stock to “dumb mom and pop” during the day.)
Here’s what happened next to the S&P 500 when it gapped up 3 days in a row, while each day’s CLOSE was below the OPEN.
*Data from 1962 – present
As you can see, the stock market does quite well 3-9 months later.
Remember: for every 100 conspiracy theories, 99 turn out to be false.
Defensive sector outperformance
One of the things that continues to worry me about the stock market’s current decline is XLU’s massive outperformance. It’s generally not a good idea to use 1 stock or 1 sector to predict the whole stock market, but this one is worth watching. XLU’s outperformance is quite extreme, which tends to happen towards the end of a bull market.
Over the past 7 days, XLU has gone up more than 1% while the S&P 500 has tanked more than -5%.
It’s common for XLU to outperform when the S&P goes down (i.e. XLU falls less than the S&P). However, it’s uncommon for XLU to go in a completely different direction from the S&P when the S&P goes down. That’s a long term warning sign.
Here’s what happened next to the S&P 500 when XLU went up more than 1% over the past 7 days while the S&P fell more than -5%.
*Data from 1998 – present
As you can see, the first time this happened was February 2001 and January 2008. The data is limited from 1998 – present, so take this long term bearish sign with a grain of salt.
Investors have turned quite bearish on the stock market recently, prompting AAII Bears to exceed 48% (AAII is a sentiment survey).
Is this a bullish contrarian sign?
Here’s what happened next to the S&P 500 when AAII Bears Exceeds 48%.
As you can see, forward returns are no different from random on any time frame.
Here’s another way to look at the AAII sentiment survey.
Here’s what happened next to the S&P 500 when AAII Bear – Bull exceeded 27%.
In this case, there is a bullish lean 6 months later.
I generally don’t like sentiment surveys. They have just as many accurate signals as false signals. Sentiment will mark the bottom in a bull market, but sentiment is useless in a bear market. Extremely oversold becomes even more extremely oversold. And of course, you only know with 100% certainty that it’s a bull/bear market with 20/20 hindsight.
VIX has been going down over the past 4 days while the S&P has been mostly flat. Going into this study, I had the belief that this was a bullish sign for the stock market.
But our eyes are deceiving, and we see what we want to see when staring at charts (that’s how the human brain works).
Here’s what happened next to the S&P 500 when VIX went down 4 days in a row (while above 20), while the S&P went down more than half of those 4 days.
*Data from 1990 – present
Once again, this is not consistently bullish nor bearish on any time frame.
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Here is our discretionary market outlook:
- 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.
- The medium term direction is still bullish (i.e. trend for the next 6-9 months)
- The short term is a 50/50 bet
Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.