The S&P 500 has finally started a pullback after a multi-week win streak. Meanwhile, macro data remains without significant deterioration.
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 medium term direction (e.g. next 6-9 months) is more bullish than bearish.
- 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
*All data charts from FRED
The earliest leading indicators – housing – improved a little. However, the key point is that housing remains in a downtrend.
Here is Housing Starts.
Here is Building Permits.
Here is New Home Sales.
In the past, Housing Starts, Building Permits, and New Home Sales trended downwards before bear markets and economic recessions began. The recent downtrend in housing is clear, but not significant.
Meanwhile, the labor market is no longer improving. With a tight labor market, the risk is that labor conditions will deteriorate (i.e. trend upwards). The labor markets have not yet deteriorated significantly, so this isn’t a bearish sign right now. Investors should be on guard.
In the past, Initial Claims and Continued Claims trended higher before bear markets and recessions began.
*Nonfarm Payrolls growth fell -250k from the previous month. While this may seem shockingly bearish, it’s not. Nonfarm Payrolls is a very noisy data series. Such big month-over-month declines happen all the time, in bull markets and bear markets alike.
Heavy Truck Sales made a new high for this economic expansion. In the past, Heavy Truck Sales trended downwards before recessions and bear markets began.
The inflation-adjusted New Orders for Consumer Goods is still trending upwards.
In the past, inflation-adjusted New Orders trended downwards before bear markets and economic recessions began.
Household networth in Q4 2018 fell almost 4%. And of course, the media sensationalized this fact as “the biggest decline in household net worth since the financial crisis” (insert scary music).
Should a rational investor/trader run for the hills because household networth plunged in Q4 2018?
Household networth is a coincident indicator for the stock market. It plunged because asset values fell significantly in Q4 2018.
Here’s what happens next to the S&P when the inflation-adjusted household networth falls more than -3% in one quarter.
Future returns are mostly random.
And lastly, the Citigroup Economic Surprise Index is now quite low, at -43.
Historically, such low readings for the Economic Surprise Index were more bullish than bearish for the S&P 3 months and 9 months later.
Because the Citigroup Economic Surprise Index doesn’t measure the state of the economy. It merely measures the state of economic data versus analysts’ expectations. Reality vs. expectation is a cycle. When reality constantly disappoints expectation, it will likely soon start to beat expectations.
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 clear right now. We’re in a “wait and see the new data” mode. As long as the economic data doesn’t deteriorate significantly, the bull market case is still valid.
This bull market has lasted for a long time: 10 years. As a result, the S&P’s 10 year rate-of-change is extremely high. This suggests that the S&P’s returns over the next decade won’t be as good as the S&P’s returns over the past decade.
However, this isn’t immediately bearish for the stock market.
Here’s a real concern. Earnings growth could potentially turn negative in Q1 2019. If this happens, then it’s not a good sign for the stock market. Negative earnings growth + a flat S&P 500 = a bad recipe for stocks.
Jeremy Grantham conducted a very interesting interview with CNBC recently.
I think that Jeremy’s scenario is a very real possibility.
We humans are influenced by our behavioral biases. For anyone under the age of 45, our entire recollection of “economic recessions” has been -50% bear markets.
- 2001 recession: S&P fell approximately -50%
- 2008 recession: S&P fell approximately -50%
As a result of recency bias (especially with the most recent crisis being 2008), many investors automatically assume the “the next one” will be just as bad as the previous ones. But this is nothing more than a flawed bias. Most recessions don’t result in -50% stock market declines, and most recessions aren’t financial crises.
*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. Absent significant macro deterioration, this is a good sign for stocks in 2019.
The S&P made a very rare bearish engulfing pattern this week.
The S&P’s OPEN this week exceeded the highest HIGH over the previous 2 weeks, and the S&P’s CLOSE this week was lower than the lowest LOW over the previous 2 weeks. Textbook candlesticks called this a “bearish engulfing pattern”.
From 1950 – present, this has only happened 3 other times. It was more bearish than bullish for the stock market going forward, but it’s hard to draw conclusions from a sample size of n=3
Based on pattern and chart analysis, the S&P 500 seems to have made a bearish reversal pattern. The S&P gapped up on Monday, closed down, and then fell 4 days in a row.
Is this really bearish, as the textbooks suggest?
No. Similar historical cases were mostly random for the S&P in the short term, but bullish 6-12 months later.
The Dow Jones Transportation Index is now down 11 days in a row. Historically, the Dow Transportation Index’s forward returns were quite bearish.
Examine these dates more closely and you can see that all of these were late-cycle dates.
- May 1972: 7 months before the bull market top
- 1966-1968: less than 2 years before the bull market top
- September 1930: in the middle of the 1929-1932 crash.
It seems that transports are leading the way down. Late-cycle. Not necessarily immediately bearish for the S&P, but is bearish for transports.
Small caps have significantly underperformed other indices during the recent pullback. The Russell 2000 fell much more than its large cap brethren on Wednesday.
The first Russell 2000 drop after a big rally is more bearish for the Russell than S&P. This suggests that the small caps will underperform large caps going forward.
USD Index and Treasury yields
The USD Index is slowly starting to breakout.
Here’s what happens next to the S&P when the USD Index breaks out to a 80 week new high.
As you can see, the USD isn’t a long term headwind for the stock market, but it is a short term headwind.
We can look at the USD another way.
The USD Index has gone up more than 8% over the past year while the S&P 500 has gone nowhere.
Here’s what happened next to the S&P when the USD Index goes up 8%+ over the past 52 weeks while the S&P falls.
A short term bearish factor.
The 2 year Treasury yield’s 14 month RSI is starting to roll over.
Here’s what happens next to the 2 year Treasury yield when its 14 month RSI falls below 63.
As you can see, this suggests that the top is in for interesting rates in this economic expansion. When the Fed stops hiking rates, it tends to stop for a long time. The Fed almost never hikes, pauses for a little bit, and then hike again.
What not to worry about
The Smart Money Flow Index has “diverged” significantly from the S&P 500.
On the surface, this seems like a bearish sign for the stock market. Upon closer examination it is clear that the Smart Money Flow Index isn’t very “smart”.
“Divergences” between the S&P 500 and Smart Money Flow Index can last a long, long time.
Here is our discretionary market outlook:
- The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic 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 (e.g. next 6-9 months) is more bullish than bearish.
- 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.