Market outlook: price action is bullish for stocks, but macro is weakening
The S&P’s nonstop rally continues. Since the S&P broke out above its 200 day moving average, a lot of standard trend followers are coming off the sidelines. The stock market’s price action is more bullish than bearish for 2019, but macro is weakening a little.
Here’s what this means for the stock market.
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 6 months)
- The stock market’s short term has a slight bearish lean.
We focus on the long term and the medium term.
While the bull market could keep going on, the long term risk:reward no longer favors bulls. Towards the end of a bull market, risk:reward is more important than the stock market’s most probable long term direction.
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.
- Other economic indicators start to deteriorate. The bull market is definitely over, and a recession has started. A U.S. recession is not imminent right now
Let’s look at the data besides our Macro Index
The labor markets are no longer improving. This is probably because they are “as good as it gets”. While the recent deterioration is not yet significant, long term bulls need to watch out if this persists over the next few months.
For example, Initial Claims and Continued Claims are now mostly trending sideways from a very low level.
Here’s what happens next to the S&P when Initial Claims’ 4 week average makes a 1 year highs, while Unemployment is above its 12 month moving average and below 5% (late-cycle).
As you can see, all of these were bear market cases.
Personally, I would wait a little to see if the bearish trend in Initial Claims continues. Not long term bearish now, but something to watch out for over the next few months.
Other leading indicators have not shown significant deterioration yet.
For example, inflation-adjusted Retail Sales are still mostly trending upwards. This is different from prior recessions and bear markets, in which inflation-adjusted Retail Sales trended sideways for many months.
Likewise, inflation-adjusted corporate profits are still trending upwards. This figure will probably flatten in 2019 as corporate earnings growth slows down.
The latest reading for Banks’ Lending Standards tightened significantly. This is important, because credit is the lifeblood of the U.S. economy. In the past, Lending Standards tightened before bear markets and economic recessions began.
One data-point does not make a trend, so this is not yet a long term bearish factor. But if Lending Standards continue to trend higher throughout 2019, long term bulls should watch out.
Inflation-adjusted New Orders for Consumer Goods is still trending sideways/upwards. In the past, inflation-adjusted New Orders trended downwards before bear markets and economic recessions began.
Financial conditions are still very loose, which is different from prior recessions and bear markets.
Q4 2018 could have been a growth scare.
Towards the end of a bull market and economic expansion, there is usually a sharp growth scare that convinces market watchers “this is the start of a mega-crash”. In reality, big bear markets typically start off more slowly.
Inflation has dropped more than -1% over the past 6 months (a rapid decline thanks to oil’s crash), while unemployment is under 5% (i.e. late cycle).
Here are similar cases, and what happened next to the S&P 500
Note the late-cycle cases:
- March 2006: the bull market lasted another 1.5 years
- 1997: the bull market lasted another 3 years
- March 1967: the bull market lasted another 1.5 years
Late-cycle indeed, but not an immediately long term bearish sign for stocks
The New York Fed has a model that predicts the probability of a U.S. recession within the next 12 months. It is based on inverting the 10 year – 3 month Treasury yield curve.
According to this indicator, the probability of a recession is 23% right now.
Is this bad news for the stock market?
Here’s every single month in which the NY Fed’s Recession Probability Indicator exceeded 23%, overlapped onto a chart of the S&P 500
Here’s what happens next to the S&P when the Recession Probability Indicator exceeds 23%, for the first time in 1 year.
As you can see, the stock market’s forward returns deteriorate 1-1.5 years later. This is more of a problem for stocks in 2020 than 2019
Source: all economic data charts from FRED
Conclusion: The stock market’s biggest long term problem right now 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 is over” case is not that clear right now. We’re in a “wait and see the new economic data” mode. As long as the economic data doesn’t deteriorate significantly, the bull market could still last 1 more year.
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
Macro has deteriorated a little, but the deterioration is not significant enough to warrant a full blown recession and bear market.
As we approach the end of a bull market, there’s always the possibility that the bull market will have 1 more leg higher, like in 1999. (Everyone thought 1998 would be the top, but it wasn’t).
This is what the market’s price action suggests.
The S&P has closed higher than its weekly OPEN for 8 consecutive weeks.
1 year later, this is slightly more bullish than random.
Meanwhile, the VIX has collapsed.
As of Friday, VIX closed below 15 today for the first time in more than 4 months. This is important, because VIX is typically more elevated in bear market rallies.
Here’s what happens next to the S&P when VIX closes under 15, for the first time in 4 months
This is a short term bearish factor for the stock market (especially 2 months later), but is bullish for stocks over the next 1 year.
Here’s what happens next to VIX
Breadth is still quite strong, with the S&P 500 Bullish Percent Index’s 14 day RSI now at 86.
This isn’t consistently bearish for stocks on any time frame, although there is a slight bullish lean 9-12 months later. Breadth usually isn’t this strong in a bear market.
Similarly, the NYSE McClellan Summation Index is extremely high right now, above 960. Bear market rallies typically do not see such strong breadth.
Here’s what happens next to the S&P 500 when the NYSE McClellan Summation Index exceeds 960
The S&P’s 6-12 month forward returns are quite bullish.
The NASDAQ’s breadth is very strong, just like the S&P 500’s breadth. As of Monday, more than 90% of NASDAQ 100 stocks were above their 50 dma.
Historically, this is consistently bullish for the NASDAQ 9-12 months later.
Seasonality (not as important as other market factors)
If the S&P 500 hangs on to its gains for February, then this will be a good sign for the rest of the year. The S&P is already up 10% this year. If the S&P remains up 8% by the end of February, then that bodes well for the rest of the year.
As of Wednesday, the S&P has now been above its 10 day moving average for 28 consecutive days. (As of Friday, this streak is now at 30 consecutive days).
This is a slight bullish factor for the S&P 1 year later
As of Tuesday, the S&P had rallied more than 15% over the past 33 days, while experiencing only two -1% daily losses.
Similar no-pullback rallies happened in:
- August 2009
- November 1998 (after the -20% decline)
- June 1997
- February 1987
- December 1962
- July 1955
The stock market’s 6 month forward returns were quite bullish
And as of Tuesday, the S&P 500 had broken out above its 200 day moving average, after being deeply oversold in December 2018.
Here’s what happens next to the S&P when it closes above its 200 dma, after being more than -14% below its 200 dma sometime in the past 3 months.
As you can see, this is consistently bullish for the stock market 3-12 months later.
Should stock market investors be worried about the rising U.S. Dollar?
As of Monday, the USD was up 8 days in a row. This is not consistently bearish for the S&P 500
The short term is extremely hard to predict, even when you think 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.
With that being said, the elusive pullback/retest is still a high probability. (We’ve been saying this for weeks. If anything, this non-stop rally illustrates why you should trade the medium-long term instead of trying to “guess” the short term.)
A long time
As of Thursday, the S&P had gone 100 days without making a new all time high, while unemployment is under 5% (late-cycle).
This is a short term bearish sign for the stock market, especially over the next 1 month.
Meanwhile, industrials have outperformed financials, which isn’t a good sign for the S&P over the next 1 month.
*XLI = industrial sector ETF, XLF = financial sector ETF
Many market watchers attribute the recent stock market surge to Fed chairman Powell’s dovish shift.
Here’s what happens next to the S&P when it goes up more than 15% over the past 35 days, while the 3 month Treasury yield does not go up (i.e. dovish Fed).
As you can see, there is a short term bearish sign for stocks
Here is our discretionary market outlook:
- The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimstic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
- The medium term direction (i.e. next 6 months) is mostly neutral. There are a few more medium term bullish studies than medium term bearish studies
- The stock market’s short term has a bearish lean due to the large probability of a pullback/retest. 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.
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