Does the bull market have 1 more year left, or is the end already here?
After a terrible Q4 2018, the stock market is rallying nonstop. The old saying “stocks take the staircase up and elevator down” seems to have become inverted. Now, the stock market is “taking the staircase down and elevator up”.
The economy’s fundamentals determine the stock market’s medium-long term outlook. Technicals determine the stock market’s short-medium term outlook. Here’s why:
- The stock market’s long term risk:reward is no longer bullish.
- The stock market’s medium term is mostly neutral (i.e. next 3-6 months)
- The stock market’s short term has a slight bearish lean.
We focus on the long term and the medium term. Let’s go from the long term, to the medium term, to the short term.
While the bull market could keep going on, the long term risk:reward no longer favors bulls. Past a certain point, risk:reward is more important than the stock market’s most probable long term direction.
*”Bear markets” = 33%+ declines that last >1 year. E.g. 2007-2009, 2000-2002, 1973-1974, 1968-1970.
Some leading indicators are showing signs of deterioration. The usual chain of events looks like this:
- Housing – the earliest leading indicators – starts to deteriorate. This has occurred already
- The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long term topping process. We are in the early stages of this process, but the deterioration is not significant.
- The labor market deteriorates some more, while other economic indicators start to deteriorate. The bull market is definitely over, and a recession has started. A recession is not imminent right now
Let’s look at the data besides our Macro Index
As of January 2019, the S&P 500’s net earnings revisions is solidly negative. This is a “necessary but not sufficient condition” for bear markets and economic recessions.
The labor markets have deteriorated a little, but this deterioration is not significantly. For example, Initial Claims and Continued Claims are mostly trending sideways from a very low level.
The 3 month moving average for Initial Claims is higher than where it was 4 months ago, while Initial Claims is under 250,000. This happens in a lot of late-cycle cases.
This is not yet a clear, long term bearish factor for the stock market. But should these 2 leading indicators start to trend significantly higher over the next few months, then long term bulls should watch out.
Heavy Truck Sales are starting to trend downwards from a very high level. Over the past half year, Heavy Truck Sales have fallen more than -50k from a high of more than 500k
Historically, this happened near major bull market tops:
- January 2007 (10 months before the bull market ended)
- April 2000 (5 months before the bull market ended)
- June 1973 (6 months after the previous bull market’s top was already in).
Several readers have pointed out that 500k Heavy Truck Sales decades ago is very different from 500k Heavy Truck Sales today. This is true. That’s why we treat this as a long term warning sign instead of a long term bearish sign. What matters isn’t the absolute level of Heavy Truck Sales – what matters is the TREND in the data.
Heavy Truck Sales have fallen a little. Should this trend continue and Heavy Truck Sales fall much more, then long term bulls should watch out.
Financial conditions for Americans have improved significantly over the past year.
Source: University of Michigan
Here are months when the “Current Financial Conditions Compared With a Year Ago” exceeded 130, overlapped onto a chart of the S&P 500
As you can see, this is a late-cycle sign for the stock market and economy.
It isn’t an immediately long term bearish sign, because sometimes this situation can persistent for years.
Earnings growth is falling. Expectations for Q1 2019 earnings growth are negative, after being above 20% in 2018.
From 1990 – present, there has only been 1 other case in which earnings growth fell from more than 20% to less than 0% within 1 year.
This is a long term warning sign, but not a long term bearish sign. N=1, so take this with a grain of salt (the decline in earnings growth is also impacted by Trump’s tax cut).
Conclusion: The stock market’s biggest long term problem is that as the economy reaches “as good as it gets” and stops improving, the long term risk is to the downside.
Economic deterioration is not significant yet, so the “bull market top is in” case is not that clear right now. We’re in a “wait and see the new economic data” mode. This doesn’t mean that the bull market can’t last 1 more year.
As of Wednesday, VIX has fallen 6 days in a row, while under its 200 dma.
Historically, this has been consistently bullish for the stock market 9-12 months later
The NYSE McClellan Summation Index also exceeded 850 on Wednesday. This is a sign of extremely strong breadth, and is quite bullish for stocks 6-12 months later
Another measure of breadth is the % of stocks above their 50 day moving average, which has surged from less than 10% to more than 88% within 3 months.
This kind of breadth surged happened 3 other times over the past 17 years, and all of them occurred within a bull market.
The Baltic Dry Index has collapsed recently, reflecting the global economic slowdown. This global slowdown is much more pronounced outside the U.S. than within the U.S.. This indicator has garnered quite a bit of media attention recently.
Is this a long term bearish sign for the U.S. stock market and economy?
Here’s what happens next to the S&P when the Baltic Dry Index is more than -50% below its 200 dma
This is neither consistently bullish nor bearish for stocks.
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
Our medium term market studies are mostly mixed. Slightly more than 50% of them point to the high probability of a pullback/retest.
As of Monday, the S&P 500’s 27 day rate-of-change has gone from less than -13% to more than +11%.
Historically, this has been more bearish than bullish for stocks over the next 2-3 months. Once again, “crash, rally” patterns are typically followed by a pullback/retest.
As of January 31, the 2 year Treasury yield made a “death cross”, whereby its 50 day moving average fell below its 200 day moving average.
Here’s what happens next to the S&P when the 2 year Treasury yield made a “death cross” while the Unemployment Rate is above its 12 month moving average.
With the exception of 1995, all of these historical cases happened within the context of a bear market or economic recession.
As the stock market surged in January, investors’ allocation to stocks has once again surged. The AAII Equity vs Cash ratio has exceeded 5 again.
While not outright bearish for the stock market, it certainly isn’t consistently bullish either on any time frame.
The S&P has closed higher than the weekly OPEN for 7 weeks in a row. The latest week’s candle is a “doji” (candlestick patterns), which from a traditional technical analysis perspective, is bearish.
Is it bearish?
Here’s what happens next to the S&P 500 when it goes up 7 weeks in a row, while under its 200 dma
Rare, but not consistently bearish.
The sample size is small, so let’s try adding some macro context.
Here’s what happens next to the S&P 500 when the S&P goes up 7 consecutive weeks, while Unemployment is under 5%
Once again, not consistently bullish or bearish on any time frame.
The South Korean Composite is viewed by some traders as a bellweather for the global economy (and hence the global stock market). This is due to South Korea’s nature as an export-driven economy.
South Korean stocks have sunk over the past year.
Is this a bearish sign for the U.S. stock market and economy? Is this a sign of “contagion”?
Here are all the historical cases in which the South Korean Composite fell more than -12% over the past year, while the S&P was down less than -3%
You can see that this is sometimes a long term bearish sign, but there are also several false signals.
Copper is another asset class used by traders to gauge the economy, hence its nickname “Dr. Copper”.
Copper has been much weaker than the stock market over the past 8 months.
Is this a bearish sign for the stock market and economy?
Here are all the cases in which copper fell more than -14% over the past 8 months, while the S&P was down less than -3%
Not consistently bullish nor bearish. This happens all the time.
Generally speaking, it is not a good idea to use other markets as a bullish/bearish signal for the S&P 500. Above all else, the U.S. stock market is driven by the U.S. economy. As we have repeatedly seen in the past, the U.S. economy can consistently ignore “global economic weakness” (ex-U.S.).
The short term is extremely hard to predict, even when you have an edge. Many random and unpredictable factors impact the short term. That’s why we focus on the medium-long term and mostly ignore the short term.
Here is our discretionary market outlook:
- 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. Long term risk:reward is more important than trying to predict exact tops and bottoms.
- The medium term direction (i.e. next 3-6 months) is neutral. Some market studies are medium term bullish while others are medium term bearish
- The stock market’s short term has a slight bearish lean. Focus on the medium-long term (and especially the long term) because the short term is extremely hard to predict.
Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.