Market outlook: the rally will get choppier over the next half year


Here’s our long term, medium term, and short term outlook for the U.S. stock market. We focus on the long term and medium term. As U.S. stock market investors and traders, our job is to separate the signal from the noise.
As always, 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 is bullish.
  2. The stock market’s medium term is bullish.
  3. The stock market’s short term leans bearish.

Let’s go from the long term, to the medium term, to the short term.

Long Term

The Medium-Long Term Model will probably predict a “bear market is coming” sometime in mid-2019. Hence, our Long Term Outlook is:

  1. This is still a bull market.
  2. The bull market doesn’t have a lot of room left. Probably 1 more year.

Leading economic indicators continue to improve, which is long term bullish for the stock market & economy.
The labor market continues to improve. Initial Claims, Jobless Claims, and the Unemployment Rate are all still trending downwards.



Historically, these 3 leading indicators trended upwards before bear markets and recessions began.



At the same time, you can see that all 3 of these labor market indicators are historically low, which suggests that the bull market and economic expansion don’t have a lot more room left to go. We can use the Unemployment Rate – Inflation to gauge how much room there is left in the economic expansion. When this figure reaches zero, we are close to the top of the economic expansion. It’s almost at zero, but not quite there.

Meanwhile, high yield spreads continue to narrow, which is long term bullish for the stock. High yield spreads widened before the 2000 and 2007 bull market tops.


Inflation-adjusted corporate profits are still trending higher. Historically, this leading indicator trended lower for several quarters before bear markets and economic recessions began.

Consumer Confidence has now exceeded 138 for the first time in this economic expansion. Historically, this is close to “as good as it gets”. When Consumer Confidence exceeds 138 for the first time in an economic expansion, the bull market has less than 2 years left.

  1. This occurred in April 1967 (bull market top in December 1968)
  2. This occurred in June 1998 (bull market top in mid-2000).
  3. This has now occurred in September 2018.


Inflation-adjusted Retail Sales are still trending upwards. This trended sideways before the previous 2 bull market tops.

Heavy Truck Sales are still trending upwards. Historically, Heavy Truck Sales trended downwards before bear markets and recessions began.

Medium Term

This week we looked at the U.S. stock market’s supposedly “very weak breadth”, and explained why breadth isn’t as weak as you think it is.

  1. On the NYSE, most of the issues that are “making 52 week lows” are bond funds (thanks to rising interest rates) and foreign, non-U.S. stocks (thanks to Trump’s trade war)
  2. The NYSE Index (unlike the S&P 500) is being increasingly weighed down by foreign (non-U.S.) stocks. Almost 20% of its stocks are non-U.S., and this problem has increased over the years as more and more foreign (e.g. Chinese) stocks like Alibaba are listed in the U.S.
  3. Looking at an all-American stock index like the S&P 500 demonstrates that breadth is normal.

That is why we focus our market studies and technical analysis on the S&P 500’s OWN price action. The S&P 500 is the best representative index of the “U.S. stock market”.
For starters, Q3 2018 has been exceptionally strong.
The S&P 500 has gone up 6 months in a row.

Moreover, the stock market has completely ignored “sell in May and go away”

And lastly, the S&P 500 has gone up more than 7% in Q3. Historically, this almost always led to gains 9 months later.

Should you be worried about the divergence between large caps (Dow & S&P) and small caps (Russell 2000)?
Not really. These kind of divergences are a normal part of bull markets. Neither consistently bullish nor consistently bearish. Some of these divergence studies are bullish, others are bearish.
For example, as of this Wednesday, the S&P was within 0.4% of all-time highs, while the Russell was more than 4.5% below its all-time high. Historically, this was long term bullish for the stock market (see 1 year later returns).

Meanwhile, the Dow had gone up 4 days in a row as of this Wednesday while the Russell fell 3 out of the past 4 days. 6 months later (historically), all the cases were bullish.

Last Tuesday, the Russell fell more than 1.3% while the Dow went up more than 0.7%. The first time this happened during an economic expansion (October 1989 and October 1999), the U.S. stock market had 9 months before the next “bear market” or “big correction” started.

So as you can see, the divergence between indexes demonstrates that the stock market should be bullish over the next 6-12 months, after which a long term bearish case can emerge.
This week, VIX spiked from a very low price. Historically, this was a long term bullish sign for the S&P 500. VIX usually trends higher (i.e. is much higher) BEFORE bear markets begin because volatility tends to increase during the last rally of a bull market.
On Thursday, VIX spiked more than 20% in 1 day, while being under 15. 1 year later, the stock market was always positive.

On Friday, VIX had spiked >29% within 2 days, while being under 20. 1 year later, the historical cases were almost all bullish. The only bearish cases saw only small losses (all within -3%).

Should you be afraid of rising interest rates? Not really. Historically, the stock market went up more often than it went down when interest rates increased.

Short Term

Let me be clear. The short term is usually a 50-50 bet. Nobody can consistently and accurately predict the stock market’s short term direction. With that being said, the S&P 500’s short term does have a slight bearish lean right now.
After a steady multi-month rally, the U.S. stock market is finally experiencing some short term weakness. Historically, this was usually followed by even more short term weakness.
For example, the NASDAQ 100 closed below its 50 dma for the first time in 5 months. Historically, the NASDAQ 100 was always lower 1 week later.

Meanwhile, the Russell 2000 has made a sharp downwards reversal. It has now fallen more than 2.6 standard deviations below its 50 dma, even though it’s still above its 200 dma (i.e. in an uptrend!)
Historically, this led to more short term weakness (next 1-2 weeks) for both the Russell 2000 and the S&P 500. However, the long term (2 years later) outlook was bullish.

Conclusion

  1. The stock market’s long term is bullish (even though this bull market probably has only 1 year left).
  2. The stock market’s medium term is bullish.
  3. The stock market’s short term leans bearish.

Can the stock market make a 6%+ “small correction” in the near future? Perhaps. But the short term is rarely more than a 50-50 bet, which is why we focus on the medium-long term. With that being said, there are no signs of an imminent “big correction” or bear market right now.
The stock market’s volatility tends to increase during the last year of a bull market. As a result, both the S&P 500 and VIX tend to trend higher together. Also remember that being short just because the stock market is “overvalued” is not rational. Historically, valuations tell you where the stock market will go in the next 3-5 years. Valuations have very little impact on the stock market’s direction over the next 6 months.
*R squared = 0.05

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