It’s been a tough 2018, but so far we’ve been on the right side of the market this year, partially due to the Medium-Long Term Model. Our message throughout this year has been:
- The bull market is not over. At least 1-2 more years.
- The January-February 2018 “small correction” will not turn into a “big correction”.
Both of these predictions have turned out to be correct. The S&P 500 just made a new intraday all-time high. The “small correction” is over.
So what’s next for the stock market going forward? Before I share my forward looking thoughts, I’d like to reflect on my predictions so far throughout 2018. I’ve had a lot of successes (some due to skill, some due to luck), and some failures that I can improve on in the future.
December 2017-January 2018
In December and January I kept on referring to the fact that the S&P’s rally was the longest in history without a 6%+ “small correction” (see study). Hence, I believed that the S&P 500 would make a 6%+ “small correction” sometime in Q1 2018. I thought the most likely date would be in February 2018, after Q4 2017 earnings season ended in January 2018 (it’s hard for stocks to tank on earnings season).
In fact, I wrote a piece titled The upcoming correction in EVERYTHING on January 14, 2018
Turns out I was mostly right. The S&P made a 11.8% “small correction” from late-January to early-February 2018.
However, I also kept on pointing out that “the next correction WILL NOT turn into a ‘big correction’ or bear market”. The stock market was exhibiting EXTREME strength (very high momentum).
- The S&P 500 has been above its 100 dma for a LONG time
- The S&P is insanely far above its 200 daily moving average
- The S&P is insanely overbought on a daily, weekly, and monthly basis (see study and study)
- Far too many days without a >1% decline
- Longest rally in history without a 3% pullback
All of these studies demonstrated the same thing:
- The stock market will make a short term decline. HOWEVER…
- The stock market will go up in the medium-long term. This is not an important market top.
This is inherently logical. Tops occur AFTER the stock market’s momentum has weakened. In other words, there needs to be a bearish divergence BEFORE the market can make a major top. Imagine the market as a person. When a person is extremely healthy (i.e. the market is rallying like crazy), it doesn’t just succumb to the first illness that strikes it (i.e. the first stock market correction). A person will only succumb to illness once his immune system has already been weakened. This is where the phrase “strength begets more strength” comes from.
Reflection: this was the right analysis
So if my analysis was right, why didn’t I get out of the way? Why did I remain long the S&P 500?
Because avoiding “small corrections” is just not worth it. There’s a >50% chance you will turn bearish too early. This means that you will miss out on more of the rally than you will benefit from catching the “small correction”.
Many savvy traders that I know turned bearish on the S&P 500 in November 2017. But by the time the S&P fell, it was no lower than where it was in November 2017!
I told everyone to BUY on February 6, 2018. This was 4 trading days before the exact bottom. Remember, ALWAYS buy on the CLOSE. Don’t buy on the intraday. This was my BUY alert
I used a very simple strategy: BUY when the S&P falls at least 6%, and buy on the close. A 6% decline is the definition of “small correction” based on the Medium-Long Term Model.
My rationale was simple.
Risk:reward is the guiding principle for medium-long term traders and investors. Here’s the essence of risk:reward.
If you go long when the market is falling, do you have a margin of safety on your side? If you WAIT long enough (but not too long), will your loss turn into a profit?
Our studies suggest that the current “small correction” will be closer to 10% than 6%. The S&P has already fallen 8.1% as of Monday’s close! So even if this small correction is 11% or 12% or 13%, your risk is a maximum of 5%!
Turns out this was the right philosophy. Medium and long term traders should always focus on risk reward. Remember Reminisces of a Stock Operator: “the final 1/8th is always the most expensive 1/8th”. Stop trying to catch the market’s exact tops and bottoms. If you keep trying to catch the exact top and bottom, you will MISS out on a lot of very profitable trades.
I did make a mistake though. I didn’t think it would take the S&P 500 this long to make a new all-time high (142 trading days). I thought a new high would be possible in 2-3 months. That’s why I don’t like to predict the short term. No matter how certain you are of the short term, it is rarely more than a 50-50 bet. That’s why I don’t trade the short term.
Over the next half year (February – August), my focus was on explaining why all the “XYZ will crash the stock market” fears were wrong. I focused on saying “these fears will caused increased short term volatility in the stock market, but will not have a meaningful impact on the stock market in the medium term or long term”. And I’ve been right.
Here’s the reality. Financial media loves to play the “I’m worried that XYZ will crash the stock market” game. These fears/worries drive clicks, which drives ad revenue. In reality, there is no point in “worrying” or “guessing” what will bring the stock market down. Just do the historical studies. Traders who “guess” and “worry” should do their homework.
“Climbing the wall of worry” is NOT bearish for the stock market, contrary to what financial dogma would tell you. Here’s the reality. There will ALWAYS be bad news, even in the best of times. The market ALWAYS “climbs the wall of worry”.
Let’s go through these “fears” and “worries”, shall we?
The big fears in February were:
- The soaring VIX (and demise of VIX’s etf XIV) would cause the stock market to crash.
- Interest rates would surge/rise and crush the stock market/economy.
I said that both of these “worries” were silly.
VIX study: For starters, VIX is merely an inverse of the S&P 500. Hence, the spike in VIX was actually a chance to SHORT VIX and bet on a decline in volatility.
I said that:
- Interest rates will rise, but not by a lot. There is no such thing as “if the 10 year yield rises above 3%, it’s all over”. The economy doesn’t care about support/resistances. The economy is the stock market’s long term driver. The economy is made up of ordinary people doing ordinary business. They don’t spend all day drawing lines on charts. No company says “shit, the 10 year yield went from 2.9% to 3%? Better stop borrowing money”. This turned out to be sound logic and the right analysis
- The kicker is that the stock market usually goes UP when interest rates rise. (see study, study, study). While this may sound like financial heresy, it’s the fact. And it makes sense. Interest rates rise when the economy is improving. An improving economy is bullish for BOTH stocks and interest rates. This turned out to be sound logic and the right analysis
In March I started to focus on the extremely high earnings growth rate. This is partially due to the strong U.S. economy and partially due to Trump’s tax cut.
I demonstrated that when earnings growth is extremely high (i.e. right now), the stock market almost always goes up in the medium-long term (see study). Whoever says that “strong earnings growth is not bullish for stocks” has no idea what he’s talking about. The stock market moves in the same direction as the economy & corporate earnings in the medium-long term.
I demonstrated in another study that when the economy improves but the stock market falls, the stock market almost ALWAYS moves higher and reconnects with the economy. The dog wags the tail. The economy wags the stock market. See study
March/April is when you started to hear about “the trade war will kill the U.S. stock market and economy”. I repeatedly disagreed with this belief. I stated:
- Trump’s goal is to WIN. If the trade war does tank the economy, Trump will stop.
- Even in the worst case scenario, this trade war will not hurt the U.S. significantly. The U.S. is a net importer and China is a net exporter. The U.S. has the upper hand and China has the weaker hand. China CAN’T retaliate simply because the U.S. doesn’t export enough to China.
- Economists have done the study. This trade war will shave -0.2% off of U.S. GDP in 2018. For an economy that’s growing at >4%, this is small potatoes.
And so far I’ve been right. The S&P 500 is at all-time highs while Chinese stocks have cratered in 2018. Even China knows that it cannot win this fight.
A mistake I made
I switched from UPRO (3x leveraged S&P 500 ETF) to SSO (2x leveraged S&P 500 ETF) on March 14.
I should have switched sooner, all the way back in December 2017. I knew in December 2017 that:
- The U.S. stock market would be choppier in 2018 than 2017. Hence, leveraged ETFs won’t benefit as much from ETF compounding as they did in 2017.
- The bull market only has 1-2 years left. The stock market’s volatility always increases in the final 1-2 years of a bull market. Hence, it is prudent to reduce your leverage from UPRO to SSO.
I made the change in March. I should have made the switch in December 2017. Going forward, here’s how I’m going to use the Medium-Long Term Model:
- Use $SPY during the first 1-2 years of a bull market. The Medium-Long Term Model is pretty accurate at predicting bear market bottoms. But in case it BUYs too early, $SPY reduces your short term downside risk compared to $UPRO or $SSO
- Use $UPRO in the middle of the bull market. The middle of the bull market is the safest part of the bull market. It is also most conducive to $UPRO’s ETF compounding.
- Switch to $SSO during the final 2 years of the bull market, when the stock market becomes more volatile.
*Note: day trading strategies (long AND short) are extremely profitable during the final 2 years of a bull market when the stock market’s volatility increases. Long and short strategies work poorly in years like 2017, when the market moves in one direction and short positions get monkey-hammered.
I first started to note the Advance-Decline line’s bullish divergence in March (see study).
The Advance-Decline line made a new all-time high in April, even though the S&P was below its all-time high. I said that this was bullish (see study). The Advance-Decline line always made a bearish divergence before previous bull market tops.
Year-to-date, the Advance-Decline line continues to lead the S&P 500 higher.
In June we started to see some extreme strength in small caps (Russell 2000 Index) and tech (NASDAQ).
- The Russell 2000 is up 6 weeks in a row (later 7 weeks in a row, then 8 weeks) See study, study, study
- NASDAQ is leading the S&P 500 higher. See study
- Russell is leading the S&P higher. See study
- Dow fell 6 days in a row, while being above its 200 dma.
- Russell is up 4 months in a row. See study
All of these studies pointed to the same thing: extreme strength in Russell or NASDAQ is medium-long term bullish for the S&P 500.
By July it was clear that the S&P 500 had ignored “sell in May and go away” this year. I demonstrated that when this happens (i.e. the stock market is bullish when seasonality leans bearish), it usually keeps going up. See study
How have I been able to remain on the right side of the market (for the most part)?
For starters, I mostly ignore the short term. I make some short term predictions, but I know that these are usually no better than a 50-50 guess. I have yet to see anyone who can consistently and accurately predict the stock market’s short term direction (i.e. next few weeks). There is a high degree of randomness to the short term.
Instead, I focus on the medium-long term. This strategy is sound and logical.
- The stock market’s long term direction is determined by the economy. The stock market and economy move in the same direction in the long term. Hence, leading economic indicators are also long term leading stock market indicators. Valuations do not predict turning points in the market. Valuations are only useful if you’re extremely long term investor.
- The stock market’s medium term direction is determined by a mixture of fundamental anlaysis (i.e. the economy) and technical analysis.
However, my brand of technical analysis is very different than traditional technical analysis. Instead of guessing “indicator XYZ is bullish/bearish for the market right now”, I actually quantify this and do the statistical/historical analysis. I don’t “guess”. These are my market studies.
These market studies show you a lot of really interesting things that you wouldn’t have thought of before. It challenges a lot of conventional thinking.
What’s next for the stock market?
Now that the S&P has made a new all time high, here’s what I think will happen next.
- The Medium-Long Term Model remains bullish. This is still a “big rally” in a bull market. It doesn’t look like the Medium-Long Term Model will issue a “big correction” or “bear market” warning this year. Next year? Who knows. We’ll worry about that at the end of 2018. Take things one step at a time.
- I don’t think this bull market will last past 2019. Early 2020 at the latest. But then again, this is just an estimate. As new data comes in, the Medium-Long Term Model will adjust its SELL date.
- I think the stock market will trend higher throughout the rest of 2018, although it will do so in a choppy manner. Such choppy trends are conducive to day trading (traders who go long AND short at the same time).
- I think it is a better idea to be long $SSO instead of $UPRO. Reduce your risk, because the stock market’s volatility increases in the final year of a bull market. But remember, the stock market can go up a lot (e.g. 20%) in the final year of its bull market. That’s why I’m long $SSO instead of $SPY.