- Correlations between stock sectors are falling. This is not bearish (unlike 1999).
- Investors are heavily overweight stocks and hold very little cash. This is not a concern right now.
- The S&P 500 has not made a bearish wedge (yet).
- Expect some companies to announce big losses in their earnings reports.
Also read How the 1st day of the trading year impacts the rest of the year.
3 pm: Correlations between stock sectors are falling. This isn’t bearish (unlike 1999)
A falling sector correlation is usually seen as a bearish sign. Here’s conventional thinking:
Investors and traders are exuberant in the last year of a bull market. They just want to chase the hottest bubble sector. So they sell everything else and plunge head first into whatever sector is hot. That’s why sector correlation breaks down.
This is indeed what happened in 1999. Investors sold “old economy” stocks and bought “new economy” tech stocks in the NASDAQ. HOWEVER, this claim is somewhat misleading.
- Correlations fell a little in 1999 when the overall stock market was surging. Tech surged in 1999, and old economy stocks mostly plateaued.
- Correlations tanked in 2000, after the bull market topped. (Some old economy stocks went up in 2000 while tech stocks crashed).
Hence, this is not a leading indicator for bear markets. It’s a lagging indicator!
The breakdown in correlation today is a result of Trump’s tax cut. Investors are rotating into sectors with lots of cash (can do share buybacks like tech) and sectors that will directly benefit the most from the tax cut (e.g. finance sector). There’s nothing sinister about this great rotation.
7 am: Investors are heavily overweight stocks and hold very little cash. This is not a big concern right now.
Households are heavily invested in the U.S. stock market. See the following chart.
As a percent of stocks/bonds/cash, households hold more than 30% in stocks. This is very high, historically speaking. Does this mean that investors are “all in”, and nobody is left to buy stocks over the medium-long run (i.e. a bear market will ensue right now)?
No. This just means that people are holding less bonds and less cash. Yields are near 100 year lows, and will remain historically low even if the Fed hikes interest rates 3 times in 2018.
These extremely low interest rates have made stocks a more attractive long term investment. (People don’t like to hold cash, which depreciates over the long run thanks to inflation). So unless interest rates rise significantly to e.g. 4-5%, there will be no mass exodus from stocks into bonds.
This post explains why QE Unwind will not cause interest rates to surge in the first half of 2018.
This indicator is not an immediate bearish concern. It just means that we are in the final quarter of this bull market, which our Medium-Long Term Model confirms.
Also note that this indicator is very similar to Tobin’s Q (valuation indicator).
This is why Easy financial conditions aren’t an immediate concern, and this is why An overvalued stock market doesn’t have to crash.
In a sense, this indicator is almost a copy of Tobin’s Q (valuation indicator). If valuation isn’t a problem, then this shouldn’t be a problem.
3 am: the S&P 500 has not made a bearish wedge (yet).
Some traders have mentioned “the S&P 500 is making a bearish wedge. It is ready to come down”.
A “bearish wedge” is when the market goes up in smaller and smaller increments, and RSI becomes compressed (i.e. lower highs). Eventually the support and resistance lines converge, and the market breaks down. This is what a “bearish wedge” looks like (aka a rising wedge).
I don’t know if the S&P will make a 6%+ small correction right now. But from a chart pattern perspective, the S&P is not making a bearish wedge.
Here’s the S&P on a weekly log scale. (Log scales are better. On an absolute value scale, the stock market ALWAYS seems like it’s in a bubble over a long enough time frame.)
Notice that the S&P has not broken below its lower trend line (support) yet. It’s actually breaking ABOVE its upper trendline (resistance). In addition, RSI is not being compressed. RSI is making higher highs!
3 am: expect some companies to announce big losses in their earnings reports.
Some companies will announce large losses for their Q4 2017 earnings reports (announced in January 2018). Do not be alarmed.
These losses are part of the one-time repatriation tax under Trump’s tax cut. By bringing their overseas cash back to the U.S., these companies will take a one-time tax hit. It has nothing to do with the state of their businesses.
- Goldman will take a $5 billion hit.
- Citigroup will be hit by as much as $20 billion.
- Bank of America will take a $3 billion hit.
In other words, the more cash a company has stashed overseas, the bigger its “losses”. Over the long term, this tax bill is a massive benefit to corporations (via the corporate tax cut).
Hence, you will see some companies announce big year-over-year earnings declines. This is to be expected. Ignore year-over-year growth and focus on whether these earnings reports “beat” or “missed” analysts’ expectations. (Analysts have included these one-time hits in their estimates).
Here’s what I think will happen based on my discretionary outlook.
- The S&P will make a small 6%+ “small correction” in Q1 2018. This will not become a “significant correction”. The current rally is the longest one in history without a 6%+ “small correction”.
- 2018 will be much chopper than 2017. If you haven’t already, please read Are financial conditions “too easy”.
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.