Stock market on July 25, 2017: thoughts and outlook


*These are our short term discretionary thoughts on the market.  We’re looking at how the market reacts to news, earnings, and other fundamental themes. Our models determine our trades.
Go to our homepage for our latest market outlook. We update this webpage throughout the day.

Stock index & news

  1. Another sign that there is no significant correction ahead: credit spreads
  2. We’re really tempted to long VIX
  3. The tech sector’s bullish momentum is very strong.

4 pm: credit spreads are shrinking
It’s true that bond market players generally tend to be smarter (and earlier) than stock market players. There is just too much mom-and-pop “keep buying forever” money in the stock market.
Historically, credit spreads always flatten or widen a few weeks before a significant correction begins.
A significant correction (as defined by our medium-long term model) began on May 20, 2015. Notice how credit spreads had been widening long before then.

A significant correction began on May 2, 2011. Credit spreads had been flat for more than 2 months by then.

A significant correction began on April 26, 2010. Credit spreads had been flat for 2 weeks by then.

A significant correction began on July 20, 1998. Credit spreads had been widening for months by then.

Today, credit spreads are falling. They are low (compared to prior lows during this economic expansion), but not extremely low historically (compared to 1990s and 2000s).

This confirms out our medium-long term model: there is no significant correction in the foreseeable future.
4 pm: We’re really tempted to long VIX
By various measures, VIX and volatility are at historic lows. As we demonstrated in our volatility study,

  1. When volatility is extremely low, the stock market will eventually fall and volatility will eventually explode. A relatively small decline in the S&P (e.g. 3-4%) can yield a massive VIX spike.
  2. But that “eventually” could be next month, 3 months from now, 6 months from now, or 1 year from now! Historically, extremely low volatility doesn’t necessarily mean that volatility will skyrocket immediately. Volatility is not a good timing indicator.

If we could outright long VIX without worrying about timing, this would be the greatest risk:reward trade of the century. VIX doesn’t get much lower than this.
Here’s a monthly chart for VIX.

Here’s a daily chart for VIX.

Unfortunately, there is no good investment vehicle that will let us buy and hold VIX until we are right. Here’s VIX’s etf VXX. Notice how VXX erodes like crazy – it’s gotten crushed while VIX remains relatively flat. So if you long VIX and VIX remains flat for a few months, your VXX position will be annihilated.

Being long VIX call options isn’t a good idea either. Your timing has to be perfect when it comes to options. If your VIX options expire in 3 months, and VIX spikes 4 months down the road, your options still expire worthless.
So as tempting as it is to be long VIX, we’re sticking to what we know – trading UPRO (3x S&P 500 ETF).
6 am: tech sector’s upwards momentum is very strong.
A market rarely bottoms when downwards momentum is very strong. Likewise, a market rarely tops when upwards momentum is very strong.
The NASDAQ 100 (dominated by FANG) has gone up 12 days in a row. This is a rare event that has only happened 6 times in the NASDAQ 100’s short history.

  1. July 11, 2013: the next 6%+ “small correction” began in January 2014.
  2. March 11, 2010: the next correction began 1.5 months later on April 26, 2010.
  3. July 23, 2009: this was a bear market case, so we can ignore it. Our medium-long term model does not foresee a bear market today.
  4. January 8, 1992: the S&P 500 began a 6.8% correction 1 week later on January 15.
  5. May 15, 1990: the S&P began a “significant correction” 2 months later in July.
  6. February 18, 1986: the S&P began a “small correction” 4.5 months later.

Notice that there are 5 short term bullish cases and 1 bearish historical case (January 8, 1992). Could the bearish case be repeating itself today? Yes.
As we expected, Q2 earnings season has been strong thusfar. However, stocks’ reactions to their earnings reports have been weak.
JPMorgan released strong earnings on July 14. Its stock has not gone up.

Bank of America released strong earnings on July 18. Its stock has been flat since then.

Goldman released strong earnings on July 18 despite weaker revenue. Its stock has been falling.

Microsoft released strong earnings on July 20. Microsoft stock has not gone up since then.

Google announced strong earnings yesterday afternoon. Its stock is down 2.5% in pre-market hours trading.
In other words, many stocks’ price action vs their earnings reports are weak. Perhaps these stocks have front-run most of their earnings-related gains. This isn’t always a bearish sign. Sometimes the market flattens on a strong earnings season but goes up after earnings season. But at the very least, this is certainly not a bullish sign.
*FANG companies will announce their earnings reports this week.
It’s still impossible to know when the next 6%+ “small correction” will begin. It could begin in August, September, or October. Who knows. Guessing is pointless.

Bottom line

Nothing has changed since our our July 24 bottom line.

  1. Our medium-long term model says that the U.S. stock market is still in a “big rally within a bull market”. There is no significant correction or bear market on the horizon. The optimal investment decision is to follow our medium-long term model and be 100% long stocks.
  2. We have been sitting on 100% cash since May 13. Prior to that we were 100% long UPRO. Based on our Easy Trading model, the most risk-free and guaranteed part of the current “small rally” is over.
  3. We’re waiting for the next 6%+ small correction. Then we’ll shift into 100% long UPRO (3x S&P 500 ETF).
  4. Our portfolio is up 17% year-to-date.

Sectors

Sector rotation is very obvious in the stock market.
Energy
The energy sector outperformed the S&P today because oil surged on OPEC news.
Here’s XLE. Notice how it’s slowly breaking out from its downtrend.

Here’s WTI oil.

Finance
Finance outperformed the S&P too because interest rates soared. Interest rates soared because oil soared. (Oil impacts inflation, which impacts interest rates).
Here’s XLF (finance ETF).

Here’s the 2 year Treasury yield. (The 2 year yield’s correlation with XLF is stronger than the 10 year yield’s correlation with XLF).

Tech
The tech sector lagged the S&P today after outperforming the S&P over the past few days. This is sector rotation.
Here’s XLK (tech ETF)

1 comment add yours

  1. Why are you 100% cash if your “medium-long term model” does not foresee a bear market over the next two years? If you expect the market to continue to grow for the next 2 years, why be out of the market? Even with a 6% correction you would still be up?

Leave a Comment