When this happens, the stock market goes up 100% of the time

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by Troy

The market expects a Fed rate cut soon as the stock market pushes to new highs. Today’s headlines:

  1. Fed rate cut
  2. AAII sentiment
  3. Volatility of volatility
  4. Using copper to trade stocks
  5. Are bonds and interest rates reversing?

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.

Fed rate cut

The Fed will probably cut interest rates this month, even though the stock market is at all-time highs and the economy is not in a recession. This prompted an article from CNBC and Fundstrat:

I decided to look at the data myself because this stat is a little flawed. The article only points out the cases that were followed by economic expansions that lasted at least another year. It ignores the historical cases in which a recession followed within the next few months.

The flaw is simple

You cannot know if a Fed rate cut will be followed by an economic expansion without 20/20 hindsight. This is like saying “if the economy is good after a rate cut, stocks will go up 100% of the time!”

Instead, I decided to look at every single rate cut that occurred when the economy was not in a recession at the time of the rate cut.

The S&P’s forward returns were not “100% bullish”. Sometimes the Fed would cut rates, and a recession would start a few months later.

There’s another problem with using “recession” or “no recession” to filter rate cuts. A “recession” is officially defined by the NBER a long time after which it has already occurred. For example, the NBER officially declared in December 2008 that a recession had started in December 2007, 1 year after the recession had started. Clearly, waiting for an official “recession” is useless in real-time.

A better way to filter rate cuts is to use a more real-time indicator, like the Unemployment rate. Here’s every single case in which the Fed cut rates, while the economy is strong (i.e. unemployment is under 5%).

The S&P’s forward returns are more bearish than random. Examining the cases more carefully, the stock market today (in terms of macro) is more similar to 1998 than 1973, 2001, or 2007.

AAII sentiment

As the stock market rallies, bearish sentiment is coming down. AAII Bears % is finally below 30% for the first time in 8 weeks

Historically, this was slightly more bullish than random for stocks 2-3 months later.

Volatility of volatility

The volatility of volatility (VVIX) has been rising recently, even though the stock market has gone up. VVIX usually moves in the opposite direction as the stock market.

Is this something to be worried about? Here’s what happens next to when the S&P rallies more than 0.5% over the past 2 days, while VVIX rises more than 7%.

Not consistently bullish or bearish for the S&P or VIX.

Using copper to trade stocks

Copper continues to perform poorly.

A lot of traders believe that copper is a “tell” for the economy, which moves in the same direction as stocks in the long run.

This isn’t entirely true or false. Copper is a better indicator for emerging markets than the U.S. stock market. Why?

Because emerging market economies are driven by construction and infrastructure development, whereas the U.S. economy (as a developed economy) is not. Copper is used in many aspects of infrastructure development.

The following chart illustrates what happens when you buy EEM (emerging markets ETF) when copper is above its 200 dma, vs. what happens when you buy EEM when copper is below its 200 dma.

Clearly, copper is somewhat useful for understanding emerging markets.

But the same cannot be said about using copper to trade the S&P. The following chart illustrates what happens when you buy the S&P when copper is above its 200 dma, vs. what happens when you buy the S&P when copper is below its 200 dma. There is no difference.

Bonds

And lastly, many contrarian traders have been calling a bottom for interest rates over the past few weeks. And right now, it looks like interest rates may be reversing upwards. Here’s the 30 year Treasury yield.

The 30 year Treasury yield has seen a sizable surge over the past week.

Is this bearish for bonds (bullish for rates)?

Here’s what happens next to the 30 year Treasury yield when it is more than -10% below its 200 dma (i.e. in a downtrend), and surges more than 15 basis points in the past 5 days (reversal?)

Not consistently bullish in the short term, but there is a slight bullish lean for rates over the next year. (While 68% may not seem like a lot, keep in mind that rates have been trending downwards in the past 40+ years).

Here’s what happened next to the S&P.

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.

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