Will the Stock Market Make a V-shaped Recovery?

This is a Guest Post by Troy Bombardia of BullMarkets.co

The stock market crashed and has now bounced. V shaped recoveries are rare, but not impossible. Most crashes are followed by a bounce and a retest of the lows.

Will the Stock Market Make a V-shaped Recovery?

Source: Investing.com

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:

  1. The stock market’s long term risk:reward is no longer bullish.
  2. The stock market’s medium term leans bullish (i.e. next 3-6 months).
  3. The stock market’s short term is mostly a 50-50 bet (although there is 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.

Long Term

While the bull market could very well still last until Q2 2019, 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.

*I do not define “bear markets” via the traditional -20% decline. I define “bear markets” as 33%+ declines that last at least 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:

  1. Housing – the earliest leading indicators – starts to deteriorate. Meanwhile, the U.S. stock market is still in a bull market while the rest of the U.S. economy improves. The rally gets choppy, with volatile corrections along the way.
  2. The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long term topping process. This will likely happen in the start of 2019. We are almost here right now.
  3. The labor market deteriorates some more, while other economic indicators start to deteriorate. The bull market is definitely over.

Let’s look at the data (aside from our Macro Index).

The inflation-adjusted net value added of nonfinancial corporate business is trending sideways. This suggests that we are in the late stages of this economic expansion and bull market. This is not a tool for timing the bull market’s top.

Will the Stock Market Make a V-shaped Recovery?

Source: FRED

The Delinquency Rates is still trending downwards. Delinquency Rates tend to trend higher before equity bear markets and economic recessions begin.

Will the Stock Market Make a V-shaped Recovery?

Source: FRED

The ISM manufacturing new orders index is still relatively high, at 62.1. In the past, bear markets and recessions started when the ISM manufacturing new orders index was at 50-55, or lower.

Will the Stock Market Make a V-shaped Recovery?

Initial Claims and Continued Claims are very low right now, and are trending sideways. If this trends upwards in the first half of 2019, then this will be a long term bearish sign for the stock market at the time.

Will the Stock Market Make a V-shaped Recovery?

Will the Stock Market Make a V-shaped Recovery?

Source: FRED

As the U.S. stock market crashed on Christmas Eve, I said that it’s unlikely for the stock market to crash non-stop. By then the S&P had crashed -20%, which I said was the normal target before a big rally.

How much did the S&P fall before the first big rally began (regardless of whether that rally led to new highs or not)?

  1. 19-25%: 10 cases (we are here right now)
  2. 25-30%: 2 cases
  3. 30-35%: 0 cases
  4. 35-40%: 1 case (1987)

As you can see, most cases cluster around 19-25%, with the big exception at 35% (October 1987).

This is the point the permabears don’t understand (as much as they love 1929, it seems few of them have actually studied 1929). Even if this is a bear market, even if this is “just like 1929” (which I don’t think so), the stock market is not going to crash -30%, -40%, or -50% in a straight line.

Here’s every case in which the S&P fell more than -30%, from 1927 – present

This is 2007-2009

The S&P fell 20.2% before making a big retracement that almost reached 50%

The total size of the decline was 57.7%

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

This is 2000-2002

The S&P fell 28% before making a big retracement that almost reached 50%

The total size of the decline was 50.4%

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

1987

The S&P fell 35.9% before making a small retracement that almost reached 38.2%

The total size of the decline was 35.9%

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

This is 1973 – 1974

The S&P fell 18% before making a 50% retracement

The total size of the decline was 49.9%

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

This is 1968 – 1970

The S&P fell 19.5% before making a 50% retracement

The total size of the decline was 37.2%

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

This is 1937-1942

The S&P fell 19% before making a 61.8% retracement.

The total size of the decline was 60%

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

This is 1929 – 1932

The S&P fell -44%, and then made a 50% Fibonacci retracement.

The total size of the decline was 85%.

Will the Stock Market Make a V-shaped Recovery?

As you can see, the S&P always made a big 50%+ fibonacci retracement after the initial crash. Even 1929 saw a massive rally. Bear markets do not go down to hell in 1 straight line.

  1. Sometimes the stock market’s initial decline happens before macro deteriorates
  2. Sometimes the stock market’s initial decline happens after macro deteriorates

But without an exception, the big drop (e.g. September – October 2008) happened after macro deteriorated significantly.

Medium Term & Short Term

Our medium term outlook (next 3-6 months) still leans bullish. Here’s the most likely medium term path.

Will the Stock Market Make a V-shaped Recovery?

Source: Investing.com

After such crashes, the stock market typically makes a quick bounce, a retest, and then a medium term rally. What follows the medium term rally depends on macro (the economy).

  1. If the economy continues to improve, then the stock market will push on to new highs, even if the rally is very choppy. (This was the case in 1987-1988. Macro improved after the crash, pushing the stock market higher).
  2. If the economy deteriorates, then the stock market will go on to make new lows.

We are watching macro carefully in 2019 through our Macro Index.

Let’s get into the quantitative market studies.

*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

Will the Stock Market Make a V-shaped Recovery?

As the U.S. stock market is bouncing, it is backing off from many extreme readings.

For example, the S&P was more than -4.9 standard deviations below its 200 dma during the crash. As of this bounce, the S&P is less than -3.5 standard deviations below the 200 dma.

Historically, this led to a short term AND a medium term decline in the stock market.

Will the Stock Market Make a V-shaped Recovery?

Likewise, the S&P’s 30 day RSI is bouncing off an extremely low reading.

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

Here’s what happens next to the S&P when its 30 day RSI goes from under 30 to above 39

Will the Stock Market Make a V-shaped Recovery?

Once again, there’s a tendency for the stock market to fall in the next few weeks.

One of the weirdest things about the recent -20% decline is how the Chicago Fed’s Financial Conditions Credit Subindex has not tightened (increased) at all. Credit tends to tighten (increase) when the stock market tanks and the economy deteriorates.

Will the Stock Market Make a V-shaped Recovery?

Source: FRED

Here’s what happened next to the S&P 500 when the S&P fell more than -15% over the past 3 months, while Credit Conditions did not tighten at all.

Will the Stock Market Make a V-shaped Recovery?

As you can see, the stock market tends to make a multi-month rally. -15% declines that occur within a recession are bearish, while -15% declines that occur without a recession are bullish.

As of Friday, the stock market has made a sharp reversal, falling more than -15% over 4 weeks and then reversing upwards more than 5% in 1 week.

Will the Stock Market Make a V-shaped Recovery?

Source: Investing.com

Historically, such sharp reversals were often followed by a retest.

Will the Stock Market Make a V-shaped Recovery?

Breadth also surged from a very low level as the stock market bounced. The NYSE McClellan Oscillator went from under -100 to above -10 within 2 weeks.

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

Historically, such sharp reversals in breadth led to a retest in the short term of the lows.

Will the Stock Market Make a V-shaped Recovery?

The NYSE New Lows Index went from more than 800% above its 3 year moving average to less than 100% above its 3 year moving average. In other words, the % of issues on the NYSE making new lows has fallen because the stock market has rallied.

Will the Stock Market Make a V-shaped Recovery?

Source: StockCharts

Historically, the stock market had a slight tendency to fall in the short term.

Will the Stock Market Make a V-shaped Recovery?

The financial sector’s underperformance throughout the stock market’s Q4 2018 decline is worrisome. When the financial sector underperforms this much, it suggests that there is weakness in the economy.

Here’s what happened next to the S&P 500 when XLF (finance sector ETF) fell more than -18% over the past year while the S&P fell less than -13%

*Data from 1999 – present

Will the Stock Market Make a V-shaped Recovery?

Will the Stock Market Make a V-shaped Recovery?

While this was a long term warning sign, it’s worth noting that even in the long term bearish cases (2000 and 2007), the stock market experienced a multi-month medium term rally.

Short Term

Based on these market studies, it would make sense for my short term market outlook to be bearish (short term retest, then medium term rally).

However, this -20% decline was so extreme, there is a possibility that the stock market will go straight up without a short term retest.

Anyways, the short term is always very hard to predict, which is why I focus on the medium-long term.

Conclusion

Here is our discretionary market outlook:

  1. 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.
  2. The medium term direction is still bullish (i.e. trend for the next 6 months). However, if this is the start of a bear market, bear market rallies typically last 3 months. They are shorter in duration.
  3. The stock market’s short term is mostly a 50-50 bet (although there is a slight bearish lean)

Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.

Will the Stock Market Make a V-shaped Recovery?

This is a Guest Post by: Troy Bombardia you can follow him on Twitter at @bullmarketsco and his website is BullMarkets.co.