With the S&P down a 2nd week, it’s important to remember that this decline comes on the heels of a very strong 4 month rally. This is to be expected, because no rally can go up forever without making a pullback/correction along the way.
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 6-12 months) has a bullish lean.
- The stock market’s short term is neutral, with trade war news being the biggest short term risk.
We focus on the long term and the medium term.
The stock market and the economy move in the same direction in the long run, which is why we pay attention to macro.
U.S. macro is decent right now, which suggests that:
- A recession is not imminent.
- The risk of a big bear market decline like 2007-2009 or 2000-2002 is low right now.
However, the U.S. economy is also in the vicinity of “as good as it gets”. This means that while the stock market can keep going up for another year, the long term risk on the downside is much greater than the long term reward on the upside.
Let’s recap some of the leading macro indicators we covered:
Housing is a slight negative factor, but could improve
Housing – a key leading sector for the economy – remains weak. Housing Starts and Building Permits are trending downwards while New Home Sales is trending sideways. In the past, these 3 indicators trended downwards before recessions and bear markets began.
You can see that the deterioration right now in housing is not as severe as it was before historical recessions. Hence why this is a slight negative factor for macro.
Labor market is still a positive factor
The labor market is still a positive factor for macro. Initial Claims and Continued Claims are still trending sideways. In the past, these 2 leading indicators trended higher before bear markets and recessions began.
Here’s Initial Claims.
And here’s Continued Claims
Inflation-adjusted corporate profits are still trending higher. Corporate profits leads the stock market by approximately 5-6 quarters. This remains bullish for stocks in 2019.
Financial conditions remain very loose and banks have not significantly tightened their lending standards. In the past, financial conditions tightened along with banks’ lending standards (i.e. trended higher) before recessions and bear markets began.
Here’s the Chicago Fed’s Financial Conditions Credit Subindex
Here’s banks’ lending standards.
Industrial Production Manufacturing has been extremely weak recently. Year-over-year % growth is now negative.
This is one of the few negatives in macro.
Here’s what happens next to the S&P when Industrial Production Manufacturing’s year-over-year % growth falls below 0%
OECD Leading Ecomic Index
The OECD’s U.S. Composite Leading Indicator is now the lowest since 2008!
Historically, this is more bearish than bullish for the S&P 500.
However, our issue with the OECD’s Leading Indicator comes down to its components. This indicator uses many obscure indicators that often aren’t “leading” at all. For example, the OECD’s Leading Indicator indicated “strong economic growth” in January 2008, when our own Macro Index and many other leading economic indicators were already falling off a cliff.
Conference Board LEI
The Conference Board’s Leading Economic Index is better constructed than the OECD’s Leading Indicator. And the Conference Board’s LEI points to continued expansion right now. In the past, this figure trended downwards before recessions began.
From the Conference Board:
Baltic Dry Index
The Baltic Dry Index – a measure of global shipping – is improving.
This is mostly bullish for stocks.
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
The stock market’s medium term (next 6-12 months) leans bullish. There is a theme that’s common among most of these market studies: the first pullback/correction after a very strong rally is usually not the start of a major bear market. Bull markets peak on weakened rallies that are more volatile.
The first decline
While trade war fears are heightened, it’s important to remember that this is the first 2 week decline after a very strong 19 week rally. This is to be expected. The stock market cannot keep going up forever nonstop, and “eventually” it always makes a pullback/correction.
While these sort of “first pullbacks” could see more selling in the short term, after that the S&P usually pushed towards new all-time highs.
U.S. vs rest of the world
Some traders are concerned that while the U.S. stock market was recently at all-time highs, the MSCI World Index ex-U.S. (rest of the world’s stocks) were much lower than all-time highs.
The last time this happened was September 2018.
Is this bearish for stocks, just like “Q4 2018 all over again”? To avoid recency bias, let’s look at the data holistically.
Here’s what happens next to the S&P when it is at a 2 year high, while MSCI World is more than -10% below its 2 year high.
This is a slight bearish factor for the S&P over the next 3 months, but not a bearish factor after that.
Here’s what happens next to the MSCI World Index
Treasury yields are falling. Contrary to popular belief, this does not mean that the bond market is not “confirming the stock market’s rally”.
Here’s what happens next to the S&P when the 2 year Treasury yield falls more than a quarter over the past 6 months.
Here’s what happens next to the 2 year Treasury yield
Sentiment (AAII) saw a rather large drop this week considering that the S&P only fell modestly. This is probably due to a spike in trade war fears.
Here’s what happens next to the S&P when it falls less than -1% over the past week, but AAII Bulls % falls more than -13%
Here’s what happens next to the S&P when it falls less than -1% over the past week, but AAII Bears % rises more than 16%
And here’s what happens next to the S&P when the AAII Bull-Bear spread falls more than -25% over the past week while the S&P falls less than -1%.
All 3 of these studies demonstrate a slight bearish lean over the next 2-4 weeks.
This is not a breadth divergence
Other traders are concerned that while the U.S. stock market was recently at all-time highs, fewer NYSE issues made new highs. On a chart, it looks like a breadth “divergence” between now and January 2018.
Here’s the thing. These “divergences” can last a very long time, to the point that they are not valid timing indicators.
Here’s what happens next to the S&P when it is at a 15 month high, but the % of NYSE Issues at New Highs has fallen more than -5% over the past 15 months.
Except from a slight bearish lean over the next 2 months, this is not consistently bearish for stocks.
Long term breadth indicators like the NYSE, Dow, and NASDAQ Summation Indices are weakening right now.
Historically, weakening breadth after a sustained breadth surge is not consistently bearish for stocks in the medium term (although it may be a short term bearish factor for stocks).
A quick and shallow decline
The Dow has fallen 4 weeks in a row, while still within -5% of a 2 year high. This demonstrates controlled yet persistent selling.
Similar historical cases were more bearish than bullish 9 months later. This is one of our few medium term bearish market studies.
The short term is mixed right now, offering no clear risk:reward advantage in either direction. Trade war news adds extra uncertainty. The short term is always extremely hard to predict, no matter how much conviction you think you have. Too many exogenous factors impact the short term.
Day vs Night
Over the past 10 days, the S&P has consistently gapped down (fallen in overnight trading) and rallied during the day. It is down more than -4% over the past 10 nights and up more than +2% over the past 10 days. This is the biggest night vs. day difference from 1962 – present.
Similar (but less extreme) night vs. day differences were slightly short term bullish over the next week. Personally, I wouldn’t read too much into this. The night vs. day difference is probably related to trade war news and foreign selling.
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 6-12 months) leans bullish
- The short term is very noisy right now. There is no clear risk:reward edge in either direction (bullish or bearish). Some short term market studies are bullish, and others are bearish. And with trade war news flying left and right, we have even less conviction for the short term than usual.
Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.
***All content, opinions, and commentary is by Troy Bombardia and is intended for general information and educational purposes only, NOT INVESTMENT ADVICE.