January 10, 2019: fundamental outlook for stocks


*Go to the blog for my latest market outlook. Members can go here to see our trading model’s latest updates and how we’re trading the U.S. stock market right now based on these models.
The economy and stock market move in the same direction in the long term. Hence, leading economic indicators are also leading indicators for the stock market.

Thoughts

*We’re seeing mixed readings in the leading economic indicators right now. Some are still bullish while others are turning bearish. This is typically what happens towards the end of bull markets, when leading indicators start to deteriorate one at a time.

  1. Ed Yardeni: expect valuations to remain high, interest rates to remain low, and inflation to remain low over the next decade.
  2. The KC Fed’s Labor Market Conditions Index is still relatively high. Suggests that the bull market is not over.
  3. Initial Claims are trending sideways/upwards. Not long term bearish for U.S. stocks yet, but will be bearish in Q1 2019 if Initial Claims starts to trend upwards significantly.
  4. Continued Claims are trending sideways. Not long term bearish for U.S. stocks yet, but watch out if this starts to trend upwards.

*Note: labor market indicators will deteriorate a little as the government shutdown progresses.
Ed Yardeni: expect valuations to remain high, interest rates to remain low, and inflation to remain low over the next decade.
Ed Yardeni is one of the few economists and macro watchers I follow. (Unfortunately, most macro “analysis” these days merely comprises of surface-level analysis such as “VALUATIONS ARE HIGHHHHH!!! EVILLL FED!!!).
Here are a few lines from his latest blog post:

Demographic trends around the world will hurt population growth. Families are having fewer babies, which means that without immigration, developed nations would have shrinking populations. Even developing nations like China face demographic problems.
The economic consequences of these demographic trends will be slower growth and subdued inflation, if not outright deflation. That means that interest rates most likely will remain historically low for a very long time. That could be positive for the valuation multiples that investors are willing to pay for the stocks of companies that are able to grow their earnings at an above-average rate. It should also be very positive for the stocks of companies that are able to grow their dividends in this demographically challenged environment.

I agree with Yardeni on the point about inflation. There is a strong correlation between population growth and inflation rates, with an 18 year lead time. (This lead time is logical. A baby becomes an adult 18 years after he/she is born. As an adult, his demand for loans and expenditure increases.)
Moreover, I agree with Ed Yardeni’s point on valuations. Valuations will fall in the next bear market, but they will not fall to levels seen in the 1970s or 1950s unless interest rates go significantly higher.

The above chart is Tobin’s Q, a popular valuation indicator. What you can see is that the ENTIRE RANGE for Tobin’s Q from 1995 – present has been higher than from 1900 – 1995.
What changed?
Inflation and interest rates were lower than they used to be. There is a strong correlation between interest rates and valuations. Lower rates support higher valuations. So while there will be 30%, 40%, and 50%+ declines in the stock market in the coming decades (as there always are), I don’t think valuations will revisit their lows seen in previous decades.


The KC Fed’s Labor Market Conditions Index is still relatively high. Suggests that the bull market is not over.
Despite the recent increase in the unemployment rate, the labor markets remain healthy. (The unemployment rate’s increase was more due to an increase in people actively searching for work rather than an increase in the newly unemployed.)
The KC Fed’s Labor Market Conditions Index is still relatively high. This indicator was much weaker before prior bear markets and recessions began. Granted, there are only 2 prior economic cycles for this indicator, so it isn’t as useful as other labor market indicators.

Initial Claims are trending sideways/upwards. Not long term bearish for U.S. stocks yet, but will be bearish in Q1 2019 if Initial Claims starts to trend upwards significantly.
Yesterday’s reading for Initial Claims went down from its previous reading (from 233k to 216k). While Initial Claims have mostly been trending lower throughout 2018, they are trending sideways now. Perhaps Initial Claims will start to significantly trend upwards in Q1 2019.

*Initial Claims leads the economy and stock market. Historically, it trends higher before a bear market in stocks started (see study).

We are watching out for any SUSTAINED increase in this data series because Initial Claims are very low right now (historically speaking).
This chart demonstrates the relationship between Initial Claims & the S&P 500

Continued Claims are trending sideways. Not long term bearish for U.S. stocks yet, but watch out if this starts to trend upwards.
Yesterday’s reading for Continued Claims went down (from 1.755 million to 1.722 million). However, the key point is that Continued Claims are trending sideways.

Like Initial Claims, Continued Claims lead the stock market and economy.

We are watching out for any SUSTAINED increase in this data series because Continued Claims are very low right now (historically speaking).
Read Stocks on January 7, 2019: fundamental outlook

Conclusion

Here is our discretionary market outlook:

  1. 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. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction is still bullish  (i.e. trend for the next 6 months). However, if this is the start of a bear market, bear market rallies typically last 3 months. They are shorter in duration.
  3. The stock market’s short term has a slight bearish lean. Focus on the medium-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.

Our discretionary outlook is not a reflection of how we’re trading the markets right now. We trade based on our quantitative trading 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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