Market outlook: another week, another failed rally. What's next for stocks


After a solid start to the week, the S&P 500 once again sits at the bottom end of this correction.

Source: Investing.com
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:

  1. The stock market’s long term risk:reward is no longer bullish.
  2. The stock market’s medium term leans bullish (i.e. next 6 months).
  3. The stock market’s short term is mostly a 50-50 bet.

We focus on the long term and the medium term. Let’s go from the long term, to the medium term, to the short term.

Long Term

While the bull market could very well still last until Q2 2019, the long term risk:reward no longer favors bulls. Past a certain point, risk:reward is more important than the stock market’s most probable direction.
Some leading indicators are showing signs of deterioration. The usual chain of events looks like this:

  1. Housing – the earliest leading indicators – starts to deteriorate. Meanwhile, the U.S. stock market is still in a bull market while the rest of the U.S. economy improves. The rally gets choppy, with volatile corrections along the way.
  2. The labor market starts to deteriorate. Meanwhile, the U.S. stock market is still in a bull market but getting close to a long term top. This will likely happen in the start of 2019. We are almost here right now.
  3. The labor market deteriorates some more, while other economic indicators start to deteriorate. The bull market is definitely over.

Let’s look at the data (aside from our Macro Index).
The labor markets remain healthy. The KC Fed’s Labor Market Conditions Index is still relatively high. This indicator was much weaker before prior bear markets and recessions began.

Source: FRED
Meanwhile, Initial Claims and Continued Claims have not yet trended upwards. These 2 leading indicators trended upwards before prior bear markets and recessions began.


Source: FRED
The year-over-year change in nonfarm payrolls is flat. Historically, this figure trended downwards before bear markets and recessions began.

Source: FRED
The unemployment rate is very low and trending sideways.

Source: FRED
In conclusion, the labor market indicators suggest a very late-cycle bull market, but not long term bearish yet.
It’s also worth noting that in the past, lending standards tightened before bear markets and recessions began. Lending standards are still very loose today.

Source: FRED
Meanwhile, Heavy Truck Sales just made a new high for this economic expansion. In the past, Heavy Truck Sales trended downwards before bear markets and recessions began.

Source: FRED
And lastly, the widely 10 year – 2 year yield curve has almost inverted. While this is a late-cycle sign, it is not a timing indicator for bull market tops. The yield curve can invert long before a bear market or recession begins.

Source: FRED

Medium Term

Our medium term outlook (next 6 months) still leans bullish, although the market studies are no longer as bullish as they used to be. There are some medium term bearish studies mixed in with the bullish studies.
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

This week’s S&P 500 decline has been interesting. The S&P fell more than -1% while VIX also fell more than -5%. This is unusual, because the S&P and VIX (volatility) usually move in opposite directions.

Source: StockCharts
Here’s what happened next to the S&P when the S&P fell more than -1% in the past week, while VIX fell more than -5%.
*Data from 1990 – present

As you can, the stock market tends to go up 6-12 months later, even if it does face short term weakness over the next 1 week.
Meanwhile, VIX tends to fall.

A really interesting CNBC article caught my eye:

Source: CNBC
I wanted to see if CNBC is right. Is the divergence between earnings & stocks a bullish sign for stocks?
Here’s what happened next to the S&P 500 when the P/E ratio fell more than -17% in the past year while the S&P was down less than -3% (i.e. valuations depressed despite high earnings growth).
*Data from 1950 – present

As you can see, CNBC is mostly correct. This is mostly a bullish factor 1 year later, but it also does happen at the end of bull markets (see 1973 and 2000).
The S&P 500 : Russell 2000 ratio has surged during this correction because small caps have fallen much more than large caps.

Source: StockCharts
Here’s what happened next to the S&P when the S&P:Russell ratio is more than 7% above its 200 dma.
*Data from 1988 – present

As you can see, the stock market tends to face short term weakness over the next 1-2 weeks, but is mostly bullish 6-12 months later.
Meanwhile, the stock market’s DOWN volume has been quite heavy over the past week.
As of Thursday, the 5 day moving average of the NYSE Up/Dow Volume Ratio fell below 0.4

Here’s what the S&P 500 did next (historically) when this happened.
*Data from 2003 – present

Once again, this is a bullish sign for stocks 6-12 months later.
One of the few things that worries me is the defensive sectors’ massive outperformance during this correction. This usually doesn’t happen during a bull market corrections.
For example, XLU (utilities sector) has gone up more than 5% over the past 3 months while XLK (tech stocks) has gone down more than -12%.

From 1998 – present, this happened when:

  1. The stock market was within 1 year of a bull market top, or…
  2. A bear market had already begun.


As you can see, the stock market’s returns started to deteriorate at the 6-9 month forward point.
As of Monday, XLU had risen more than 3.2% in the past 6 days, while the S&P falls more than -3.6% in the past 6 days.
From 1998 – present, this has only happened 4 other times.


Similarly, XLU has massively outperformed XLF (finance stocks).

The financial sector has been hammered this year, possibly due to the flatness of the yield curve. Here’s the KBW Bank Index ($BKX)

Source: Investing.com
Here’s what happened next to the S&P 500 when BKX fell more than -20% to a 1 year low, while the S&P was within 10% of a 1 year high.
*Data from 1993 – present

As you can see, this happened in 2000 and 2007-2008
Hence, there is an interesting dichotomy in our market studies:

  1. The technical indicator studies (e.g. mean reversion) are bullish 6-12 months later
  2. The stock market’s internals studies (sector-specific) are bearish 6-12 months later.

This dichotomy has not occurred until the past few weeks.
So what’s more important?

  1. The economy (macro)?
  2. Technical indicators?
  3. Stock market’s internals?

In my opinion, macro is the most important. Macro gives fewer false signals than technical indicators and the stock market’s internals.
When the stock market’s short term outlook is confusing, jump to the higher time frame (i.e. medium term). When the medium term is confusing, jump to the higher time frame (i.e. long term). And when the long term is confusing, focus on long term risk:reward. In other words, focus on the forest + risk:reward
For example, Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.

Short Term

The stock market’s short term is mostly a 50-50 bet right now, as it is most of the time. The market studies do seem to point to a slight bearish lean. I wouldn’t act on this because the short term is extremely unpredictable.

Conclusion

Here is our discretionary market outlook:

  1. For the first time since 2009, the U.S. stock market’s long term risk:reward is no longer bullish. This doesn’t necessarily mean that the bull market is over. We’re merely talking about long term risk:reward.
  2. The medium term direction is still bullish  (i.e. trend for the next 6-9 months)
  3. The short term is a 50/50 bet

Our discretionary outlook is not a reflection of how we’re trading the markets right now. We trade based on our clear, quantitative trading models, such as the Medium-Long Term Model.
Members can see exactly how we’re trading the U.S. stock market right now based on our trading models.
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