Signs that the recent stock market rally is not a bear market rally


If you feel like the market has gone nowhere over the past few weeks, that’s because you’re right. Times like this remind me of the quote “media is the art of saying something when nothing needs to be said”. Headlines over the past few days have been rather episodic:

  1. “Stocks down today because falling rates stoke growth and recession fears.”
  2. “Stocks up today because growth and recession fears ease.”
  3. “Stocks down today because falling rates stoke growth and recession fears.”
  4. “Stocks up today because growth and recession fears ease.”


Go here to understand our fundamentals-driven long term outlook.
Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day.

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are blindly “guessing” the future.

Golden Cross

A few days ago I said that “buy on the golden cross, sell on the death cross” actually underperforms buy and hold.
*A golden cross = when the market’s 50 dma crosses above its 200 dma

However, the golden cross does have some use.
In the S&P 500’s big historical bear markets, golden crosses always happened AFTER bear markets ended (i.e. golden crosses did not happen within bear markets). This is true of the following bear markets:

  1. 2007-2009
  2. 2000-2002
  3. 1973-1974
  4. 1969-1970
  5. 1937-1942
  6. 1929-1932

The S&P 500 will make a golden cross over the next few days. This technical factor suggests that the current rally is not a bear market rally, but a rally within a bull market.

Let’s take a look at the previous bear markets.
Here’s the 2007-2009 bear market. Notice that once the S&P made a “death cross” in December 2007, it did not make a “golden cross” until the bear market was over in 2009.

Here’s the 2000-2002 bear market. Notice that once the S&P made a “death cross” in October 2000, it did not make a “golden cross” until the bear market was over in 2003. However, the S&P came very close to making a golden cross in April 2002.

Here’s the 1973-1974 bear market. Notice that once the S&P made a “death cross” in April 1973, it did not make a “golden cross” until the bear market was over in 1975. However, the S&P did come close to making a golden cross in November 1974

Here’s the 1969-1970 bear market. Once the S&P fell -20%, it did not make a golden cross until the bear market ended.

Here’s the 1937-1942 bear market. A golden cross occurred after the first major bottom in early-1938. While it looks like the S&P made a lower bottom in 1942, that is actually false. The S&P 500 does not include dividends. Dividend yields were extremely high pre-1957. If you factor in dividends reinvested, the 1938 bottom was actually slightly lower than the 1942 bottom. Moreover, this era marked a wartime stock market and economy. As Ray Dalio would tell you, wartime economies and stock markets are very different from peacetime economies and stock markets.

Here’s the 1929-1932 bear market. A golden cross occurred only after the bear market was over.

So is this a 100% guaranteed sign that the current rally is a bull market rally? No. You can see that sometimes the S&P came close to making a golden cross within a bear market (e.g. April 2002). There’s no 100% guarantee that the next bear market won’t have a golden cross within it. Price action changes over the ages.
For reference, here’s every single golden cross from 1927 – present and what the S&P did next.

Volatility

The stock market’s volatility is extremely low right now. We have a Medium Term Volatility Index in the Bull Markets Membership Program which measures the volatility of volatility.

When most traders think “volatility is low”, they automatically think “time to go long volatility and short stocks”.
Yes, volatility will “eventually spike”. Yes, the stock market will “eventually fall”. But “eventually” can happen tomorrow or it can happen months from now. That’s why trading VIX is extremely hard. You know it will spike, but you don’t know when. And “when” is of paramount importance.
Low volatility is often short term bearish, but it is bullish 6-12 months later for stocks. Why? Because:

  1. The final 6-12 months of a bull market are often extremely choppy. In other words, the final rally is usually accompanied by higher volatility.
  2. Bear market rallies are usually also extremely choppy.

Here’s what happens next to the S&P when our Medium Term Volatility Index is under 3 for 16 consecutive days (i.e. is very low)

As you can see, the stock market’s 2-12 month forward returns are more bullish than random. Perhaps the stock market will have 1 last significant rally before this bull market is over. Either way, think risk:reward
Here’s what happens next to VIX

You can see that some of the historical cases see massive VIX spikes over the next 2-6 months (80-90%+). But as I said, these VIX spikes are very hard to time.

No down days

This has been a remarkably strong rally without any meaningful pullbacks. This is unusual, because most strong rallies are also very choppy. (Remember how choppy the rallies coming out of the 2010 and 2011 big corrections were?)

Here’s what happens next to the S&P when it ralles 19%+ over the past 3 months, while there is only 1 day with a -2% loss.

Not consistently bullish or bearish on any time frame

Problems

For one reason or another, it’s a popular game in the finance industry to overlap the S&P ontop of another indicator/market, demonstrate that the S&P is “diverging” with this other indicator/market, and then presume that the S&P will “reconnect” with this other indicator/market. (It’s weird how everyone automatically assumes that the S&P is “dumb money”, a distinction I find to be rather arrogant).
For example, the Baltic Dry Index (a measure of global shipping) has diverged with the S&P recently. Surely this must be bad news right?

Here’s what happens next to the S&P when the Baltic Dry Index falls more than 20% over the past 3 months while the S&P rallies more than 10%.

You can see that this has happened consistently from 2009-present. The current bull market has seen continued weakness in global shipping, which is probably a hallmark of foreign economic weakness (European crisis, China crisis, Turkey crisis, Argentina crisis, emerging markets crisis….). How many times over the past 10 years have we heard “foreign weakness will lead to contagion in the U.S.?” Eventually those headlines will be proven right, but even a broken clock is right twice a day.
*All of these historical cases occurred within a bull market, so perhaps this time will be different.
Likewise, the S&P is also diverging from the 2 year Treasury yield, which continues to make new lows.

Oops, I guess that chart wasn’t scary enough. Let me adjust the scales.

So how bad is this for the stock market?
Here’s what happens next to the S&P when the 2 year yield falls more than -0.3% while the S&P rallies more than 15%.

Mostly bullish 3-12 months later, with the exception of 1987.
Read How the stock market reacts after yield curve inversions

Conclusion

Here is our discretionary market outlook:

  1. 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.
  2. The medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.

Our discretionary outlook does not reflect how we trade the markets right now. We trade based on our quantitative trading models. When our discretionary outlook conflicts with our models, we always follow our models.
Members can see exactly how we’re trading the U.S. stock market right now based on our trading models.
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