Stock market on December 22, 2017: thoughts & outlook


*These are my discretionary thoughts on the market. My Medium-Long Term model determines my trades.
Go to the homepage for my latest market outlook. I update this webpage throughout the day.

Stock index & news

  1. This is the longest rally in history without a 6%+ “small correction”.
  2. Massive outflows from equity funds. A sign of “selling the tax cut news”, but not a bearish indicator.
  3. Bitcoin’s crash will not hurt the stock market.
  4. Sentiment is excessively optimistic. This is not a bearish sign.
  5. The impact of share buybacks on the U.S. stock market in 2018.

3 pm: Massive outflows from equity funds.
The last 2 weeks saw the largest outflows from equity funds (ETFs & mutual funds) in history.

This sounds very bearish right?
No.
Over the long run, absolute value of inflows and outflows will go up because the U.S. stock market goes up over the long run. $10 billion 50 years ago is much more than $10 billion today. A better indicator would be to divide inflows and outflows by the value of the S&P 500. In short, create a percentage that fluctuates from 0% to 100%.
But more importantly, outflow data has not been a consistent indicator for corrections and bear markets. Here’s why.

  1. There have been massive outflows over the past 2 weeks. However, the S&P’s price action has not confirmed this potentially bearish sign. The S&P has gone up despite this massive selling! Why?
  2. The answer is obvious. With the Republican tax cut guaranteed, investors are shifting from index ETF’s into individual stocks. Certain stocks will benefit much more than other stocks from the tax cut. E.g. companies with a lot of cash can afford more share buybacks.
  3. Historically, a lot of big outflows happened at the bottom of corrections. Hence, this is not a consistently accurate indicator that can predict corrections. 

Here are some examples.

  1. December 21, 2016. The S&P has not made a 6%+ “small correction” since.
  2. December 17, 2014. The S&P began a correction 5 months later on May 20, 2015.
  3. February 5, 2014. This marked the BOTTOM of a 6% “small correction”. The next S&P rally lasted 7 months.
  4. August 17, 2011. This marked the BOTTOM of a 20% “significant correction”.

3 pm: Bitcoin’s crash will not hurt the stock market
Based on contagion theory, some analysts are concerned that Bitcoin’s crash will hurt the stock market in a meaningful way. I disagree.

The market cap for cryptocurrencies is $500-600 billion. In comparison, the S&P 500’s market cap is $22 trillion. Crypto is tiny when compared to the stock market
You also need to look at crypto’s market players. Crypto is primarily traded by non-U.S. speculators (i.e. China, Japan, South Korea). So if crypto crashes, U.S. investors won’t lose $500 billion. The loss will be shared with foreigners. In addition, crypto is primarily traded by small speculators, college kids who want to make a fast buck, and “the world is ending” doomsayers. Few institutional investors have significant investments in Bitcoin. This is not a systematic risk

Look at the price action. Bitcoin has CRASHED approximately 40% in the past 4 days.

The S&P 500 has not moved at all.

If a 40% crash in Bitcoin doesn’t impact the stock market, I don’t think the stock market cares about Bitcoin at all.
You can see this in the derision that many of the best hedge fund managers and institutional investors have for crypto. Charlie Munger just said “stay away from Bitcoin like the plague”. They’re neither long nor short crypto because bubbles kill both longs and shorts. These investors are heavily long the U.S. stock market, and most of them couldn’t care less about what crypto does. It’s like watching gamblers in Vegas – fun to watch, but I wouldn’t gamble myself.
*Shorts lose money because it’s impossible to predict the top of a bubble. Longs lose their shirts when the bubble pops.
4 am: Sentiment is extremely optimistic. This is NOT an effective contrarian indicator.
AAII is arguably the best sentiment indicator because it is widely used. AAII bulls just jumped past 50, which is seen by many traders as an “excessively optimistic” level.

In reality, this is not a bearish sign for the U.S. stock market.
Sentiment extremes cannot consistently and accurately pick market tops (before corrections). Sentiment can be extremely bullish for a long time before a correction begins. We don’t use sentiment indicators in our Medium-Long Term Model because they aren’t consistently accurate.

  1. AAII bulls reached 50 on November 23, 2016. It’s been more than a year, and the S&P still has not made a correction.
  2. AAII bulls reached 50 on August 27, 2014. The next correction began 3 weeks later on September 19, 2014.
  3. AAII bulls reached 50 on January 23, 2013. The next correction began 4 months later on May 22, 2013.
  4. AAII bulls reached 50 on February 8, 2012. The next correction began 2 months later on April 4, 2012.
  5. AAII bulls reached 50 on September 15, 2010. The next correction began 5 months later February 18, 2011.

4 am: The impact of share buybacks on the S&P 500 in 2018.
Long term stock market bears like to say “corporations are manipulating their stock prices via share buybacks. Share buybacks is the only thing that’s propping this market up.”
This statement is false. You can see in the following chart that share buybacks have fallen a little since 2015 and 2016!

This argument was true during the 2003-2007 bull market, when stocks went up because share buybacks soared.

As you can see, share buybacks have been flat since 2014, meaning that the S&P’s gains have come from A) earnings increases & B) P/E expansion (valuation expansion).
With the Republican tax cut guaranteed, U.S. corporations will increase their share buybacks in 2018 and 2019. This is a long term bullish factor for the U.S. stock market.

Conclusion

Here’s what I think will happen based on my short term discretionary outlook.

  1. The S&P will make a small 6-10% “small correction” in Q1 2018.
  2. Then the S&P will make a new high, before making a multi-month consolidation or multi-month “small correction” in the 2nd half of 2018.
  3. 2018 will be much chopper than 2017. As of October 2017, this is the longest rally in history without a 6%+ “small correction”. If you haven’t already, please read What will the S&P do after rising 8 consecutive months.

I do not use my discretionary outlook to trade. I remain 100% long UPRO because my Medium-Long Term model does not foresee a significant correction at this point in time. I ignore small corrections. I only sidestep significant corrections and bear markets.
I have been 100% long UPRO since September 7, when the S&P was at 2465 and UPRO was at $109.3
*I also have a small Day Trading portfolio. Click here to view my day trades.

10 comments add yours

  1. Hi Troy, For your medium-long term model portfolio how long do you hold the UPRO on average ? And do you ever worry about the reset of options/derivatives as an issue ? I know very little about them but what I have read the reset of options erodes the ETF over time. The 2x and 3x leveraged ETF have always intrigued me but I have never bought any as I don’t trust myself when to buy or sell. Your portfolio performance has done extremely well, and I always enjoy your daily update. Cheers Steve.

  2. I just continue my dollar cost average strategy but on small corrections I buy more. I like reading your forecasts! 🙂 Keep up the good work!

  3. Hi Troy,
    Your model had predicted a correction for Oct/Nov, right? Was it wrong about that correction? Also, what is your confidence level about the correction in Q1 2018? If someone is all cash, should they wait?
    Thank you so much! 🙂

    • The Medium-Long Term Model has never predicted a significant correction since early-2016. This model is not in the business of predicting small corrections
      Back when I ran the hedge fund, we employed a more short term model to understand the PROBABILITY of a small correction happening right now. The probability of a small correction has been very high since October/November, and continues to be extremely high. https://bullmarkets.co/longest-stock-market-rally-in-history-without-a-6-small-correction/
      That being said, I think the probability of a “small correction” in Q1 2018 is very high. There is no certainty in the markets. Only probability.

      • If you were to speculate, how far away do you thin we are from a bear market? Does your model offer any predictions (I know you mentioned it does not see one in the near future).
        Thank you for all your help! 🙂

        • Based on the current data, a most likely top date for this bull market is 2020-2021.
          The date used to be 2019, but the data has now pushed that out to at least 2020.

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