Market outlook: the next 1-3 months are starting to turn bullish
Outlook summary: the stock market’s chart “looks terrible”, because it looks like the April high was a false breakout. In reality, it’s perfectly normal for the stock market to make a pullack/correction after making a new high.
The data suggests that the medium term is still bullish.
Up until this week, our market studies for the next 1-3 months were mixed. Now, they are starting to turn bullish. This doesn’t mean that the stock market cannot selloff for another week or two. The trade war is the biggest risk, but we are not in the business of guessing the news.
- Fundamentals (long term): no significant U.S. macro deterioration, but the long term risk:reward doesn’t favor bulls.
- Technicals (medium term): mostly bullish
- Technicals (short term): bullish, with trade war news being the biggest short term risk
Let’s begin with technicals because most traders prefer technical analysis over fundamental analysis.
Technicals: Medium Term
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
Although the bull market is certainly late-cycle, the stock market’s medium term (next 6-9 months) leans bullish.
The S&P’s failed breakout in April “looks” terrible on a chart.
On Friday we covered why this is not a “bull trap”. It is completely normal for the S&P to fall -15% to -20%, make a marginal new high of less than +4%, and then immediately fall more than 4%. This has happened multiple times over the past 50+ years.
“Bull traps” aren’t reliable. In real-time, the probability that a bull trap will be the bull market’s top is a 50/50 coin toss. This doesn’t mean that bull traps don’t work – they work 50% of the time. In other words, they are only successful at predicting tops with 20/20 hindsight.
There are other ways of looking at this “awful” chart pattern on a monthly basis.
The S&P fell more than -10% from October-December, rallied more than +10% from January-April, and then fell in May. Similar historical patterns were rare, but not consistently bearish.
Such a small sample size isn’t actionable on the bullish side, but does illustrate the point that these “topping patterns” aren’t consistently reliable.
So why is the stock market making a pullback now? You can blame it on the trade war, but a pullback was to be expected. Trade war news was merely the trigger.
The recent rally had NO pullback at all. This is extremely rare, because most rallies that occur after a -15% to -20% correction have a retest or correction before they make a new all time high.
Chart patterns aside, let’s look at some indicators.
With the S&P breaking below popular moving averages such as the 200 day moving average, trend followers are starting to turn bearish.
Using the 200 day moving average as a buy/sell signal does decrease one’s drawdowns because by definition, most of the major crashes occur under the 200 dma.
Meanwhile, the S&P’s 14 weekly RSI has fallen below 50. While RSI is often used as a contrarian indicator, it can also be used as a trend following indicator. Here are the S&P’s returns from 1950-present when its RSI was > 50 vs. when its RSI was < 50. Clearly returns are higher when RSI is > 50, from a trend following perspective.
While these trend following indicators are not great SELL signals, they do demonstrate that downside risk is higher than normal right now as the trend reverses downwards.
The NASDAQ 100’s MACD histogram has turned negative very quickly from a high positive value.
This is a very quick decline in the MACD histogram. Historically, similar MACD drops often led to a rally 1 month later.
In terms of momentum, May saw the first monthly decline after a 4 month rally.
Here’s what happens next to the S&P when it rallies 4 months in a row, and then falls during the 5th month.
Mostly bullish 6-9 months later.
And is it normal for the S&P to drop -6% in one month, immediately after making a 1 year high?
Rare, but not consistently bearish 6-12 months later.
Collapsing Treasury yields and stocks
The media and social media have paid a lot of attention to the bond market recently, and for good reason
- The yield curve is pushing deeper into inversion. The 10 year – 3 month yield curve is now at -0.21%
- Yields and stocks are falling together (strong correlation).
For starters, the 10 year – 3 month yield curve is now below -0.2%
Here’s what happens next to the S&P when the 10 year – 3 month yield curve falls below -0.2%, for the first time in each economic expansion.
While this didn’t always mark the exact bull market top, it is a long term warning sign. Long term risk:reward does not favor bulls.
Let’s assume a worst case scenario. Let’s assume that the bull market’s top is already in. Will the stock market soon make a rally?
To answer that question, we’ll need to once again look at interest rates because the stock market and interest rates are moving together. All of the S&P’s gains over the past 5 months have occurred when the 10 year yield went up, and all of the S&P’s losses have occurred when the 10 year yield went down.
The yield curve is collapsing because long term interest rates (e.g. 10 year, 30 year Treasury yields) have tanked. For example, the 10 year Treasury yield is now more than -23% below its 200 day moving average.
Historically, this is consistently bullish for the S&P 1-3 months later because the 10 year yield also tends to bounce.
Let’s look at some of these historical cases which saw the S&P and 10 year yield falling together. Here’s the present case.
February 11, 2016:
August 8, 2011:
August 16, 2010:
March 17, 2008:
October 5, 1998:
In conclusion, the stock market can fall for another 1-2 weeks, but soon there is a 1-3 month rally. This occurred even during the 2007-2009 bear market (March – May 2008 bounce).
The S&P 500 Bullish Percent Index (breadth indicator) has now fallen below 51 after being above it for more than 80 consecutive days.
Historically, the end of a long streak usually led to gains on all time frames.
AAII sentiment has turned bearish very quickly, considering that the stock market is not far away from an all-time high. Usually it takes a bigger decline for sentiment to turn bearish this quickly.
Here’s what happens next to the S&P when AAII Bearish % is above 40%, AAII Bullish % is below 25%, and the S&P is within 10% of a 1 year high.
Margin debt tends to move together with the S&P.
But over the past 4 months, margin debt has lagged the S&P.
Is this normal?
Here’s what happens next to the S&P when it rallies more than 15% in the past 4 months while Margin Debt rises less than 7%.
Yes, this is quite normal and is mostly bullish. This tends to happen during the first rally after a 20%+ decline. Investors and traders remember the recent crash fresh in their minds, so they hesitate to use margin during the subsequent rally.
Technicals: Short Term
There is no clear edge in the short term right now (e.g. next few weeks), although the outlook does become more bullish 1-3 months later.
The short term is always extremely hard to predict, no matter how much conviction you have. Too many unpredictable factors influence the short term (e.g. trade war news). An objective trader would realize that over a 1-2 week time frame, there are always reasons to be bullish and reasons to be bearish.
Short Term Oversold
The Dow is now down 6 weeks in a row. Historically, it went up 77% of the time the next week.
Treasury bonds – one last panic buying?
But at the same time, the 3 month Treasury yield has fallen below its 200 day moving average as the market is anticipating a rate cut from the Fed.
This marks the end of a long streak in which 3 month yields were trending up.
Historically, this was usually bearish for stocks over the next 2 weeks.
Moral of the story: focus on the medium-long term.
Fundamentals: Long 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. leading economic indicators are decent right now, which suggests that a recession is not imminent.
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.
Labor market is still a positive factor
The labor market is still a positive factor for macro. Initial Claims and Continued Claims are trending sideways. In the past, these 2 leading indicators trended higher before bear markets and recessions began.
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
Heavy Truck Sales
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 latest reading for inflation-adjusted corporate profits fell. In the past, corporate profits fell before recessions and bear markets began. Since corporate profits leads the S&P by 5-6 quarters, this is a long term bearish factor for the stock market beginning in Q1 2020.
Trade and manufacturing related indicators
As you can probably guess, the biggest macro risk is the trade war. This trade war is putting increasing pressure on all trade and manufacturing related economic indicators. There’s been a lot of hype recently in the media and social media about the trade war and “global slowdown”. So to put things into perspective, Bloomberg looked at how much the U.S. – China trade war will hurt GDP.
You can see that the trade war hurts 2020 GDP growth more than 2019 GDP growth.
In other words, the U.S.-China trade war hurts GDP growth but is not severe enough to cause a recession. A U.S.-Mexico trade war will hurt more, but it is yet to be seen if Donald Trump will follow through. We’re not in the business of guessing the news.
Most of the negatives in economic data right now (non-leading indicators) are related to trade or manufacturing. Why don’t we use these indicators?
- They aren’t leading indicators, and they have too many false bearish signals. In a real recession, these tend to turn down long AFTER the recession has started.
- In terms of trade, the U.S. economy is a relatively isolated economy. This is because the U.S. economy is much more diverse than most economies, and it is relatively self-sufficient. When comparing decent domestic oriented economic indicators (e.g. labor market) with weak foreign oriented economic indicators (e.g. trade, manufacturing), domestic oriented indicators are more important.
You can see how the U.S. has a lower trade-to-GDP ratio than most major economies.
Focus on the data. Guessing the news is a 50/50 coin toss. Charlie Bilello had a great table, demonstrating that each correction has a “reason”. Each of these reasons felt like the end of the world at the time. If you trade the news, you’ll panic every few months. Focus on the data and focus on your strategy.
Here is our discretionary market outlook:
- The U.S. stock market’s long term risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
- Most of the medium term market studies (e.g. next 6-9 months) are bullish, although a few of trend following studies are starting to become bearish.
- Market studies over the next 1-2 weeks are mixed (some bullish and some bearish). Trade war news only adds to this uncertainty.
- HOWEVER, our market studies for the next 1-3 months are starting to turn more bullish.
- We focus on the medium-long term.
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.