Why I'm medium-long term bullish on the stock market

The Medium-Long Term Model does not foresee a “significant correction” or a bear market on the horizon right now. Here’s a weekly updated series as to why I’m medium-long term bullish on the stock market right now, from a discretionary point of view. I will stop updating this when I turn medium-long term bearish.
*I am watching out for signs of significant and sustained economic deterioration because I think this bull market only has 1-2 years left.

Sentiment doesn’t need to become extremely pessimistic for this correction to end

Updated April 22, 2018
The stock market and economy move in the same direction over the medium-long term. The economy is still improving at a healthy pace. There are no signs of sustained economic deterioration. This is why the bull market in stocks is not over.
In this week’s update I’m going to look at sentiment indicators for the U.S. stock market. Remember that sentiment indicators are meant to be used as contrarian indicators for the stock market.
Most sentiment indicators are pessimistic right now. However, the level of pessimism at the stock market’s bottom in early-April was not near historic extremes. This is why some traders and investors are waiting before they buy stocks. They want to see sentiment make an even greater washout – i.e. become even more extreme.
Here’s the AAII Bull Ratio as an example. These patient traders want to see the AAII Bull Ratio fall to 20 before they go long. Sentiment was pessimistic in early-April, but it was not extremely pessimistic. These traders are waiting for the stock market to fall even more and for sentiment to become extremely pessimistic.

But here’s the point they fail to realize. Sentiment is not near historic extremes because the stock market only fell 11.8%! So of course sentiment won’t make that great of a washout!
You cannot expect sentiment to be extremely pessimistic  when the stock market makes a “small correction”. Extreme pessimism tends to only happen during “significant corrections” or bear markets. In other words, waiting for “extreme pessimism” before buying is akin to only buying if the stock market falls more than 20%. And the fact is that in most years, the S&P 500 does not fall more than 20%.
In fact, the AAII Bull Ratio can bottom at 40 during 10%+ “small corrections”. See 1996-1997. The S&P made one 10%+ “small correction in 1996 and two 10%+ “small corections” in 1997. Yet AAII never even reached 40!

This is why we typically ignore sentiment indicators. They aren’t consistently accurate for picking tops and bottoms in the stock market. The stock market’s slight pessimism right now is neither a short-medium term bullish factor nor a bearish factor. It just is. It’s mostly an irrelevant factor.

Bullish signs for the stock market’s medium term outlook

Updated April 14, 2018
The stock market and economy move in the same direction over the medium-long term. The economy is still improving at a healthy pace. There are no signs of sustained economic deterioration. This is why the bull market in stocks is not over.
In this week’s update I am going to look at some medium term bullish developments for the stock market that we covered over the past week. These developments suggest that even if the stock market falls a little more in the short term, this downside is very limited. The medium term risk:reward is heavily skewed towards the upside.
Sentiment is becoming bullish
Various sentiment indicators are becoming more and more medium term bullish for the stock market. As we mentioned today:

AAII is one of the best sentiment indicators for the U.S. stock market. AII’s Bull Ratio is sinking right now (currently at 38). A Bull Ratio below 35 is a good medium term bullish sign. The Bull Ratio will reach 35 if the stock market falls even a little more. This suggests that the stock market’s short term downside risk, although present, is limited.

Breadth is making a bullish divergence with the stock market
Breadth is useful as an indicator when it’s making very clear bullish and bearish divergences with the stock market. And right now, breadth is making a clear bullish divergence with the U.S. stock market.
This study demonstrated that in all 8 historical cases when this happened, the stock market rallied over the next few months. This is an important medium-long term bullish indication for the stock market.
The smart money is extremely bearish on VIX
Despite VIX having fallen from its February highs, commercial hedgers “smart money” are still extremely bearish on VIX. VIX usually moves inversely with the S&P 500. This is a medium term bullish sign for the U.S. stock market (see post)

So the bottomline is simple. The stock market might fall a little more in the short term. It might retest its February 9, 2018 lows. But the medium-long term is decisively bullish. We can clearly see this from various angles of the market. Focus on medium term risk:reward.

The bottom line for Trump’s trade war

Updated April 8, 2018
The stock market and economy move in the same direction over the medium-long term. The economy is still improving at a healthy pace. There are no signs of sustained economic deterioration. This is why the bull market in stocks is not over.
In this week’s update I am going to look at Trump’s new tariff threats.
I did not expect Trump to escalate the tariff threats. Clearly I was wrong. Let’s examine the worst case scenario and then work from there. Then let’s look at the most likely scenario. We cannot base all of our trading decisions on the worst case scenario because the worst case scenario rarely happens. Trading according to the worst case scenario = missed opportunities. Missed opportunities = opportunity costs, which is akin to losing money.
The worst case scenario
The worst case scenario is obvious – a full blown trade war. This is the one that everyone “fears” and rightfully so. A full-blown trade war prolonged the Great Depression.
However, there are several reasons why this is extremely unlikely today:

  1. The 1930s trade war was ACROSS THE WORLD. Every country instituted across-the-board tariffs on exports from other countries. Today, we are talking about tariffs between the U.S. and China. 2 countries. The scale is vastly different.
  2. There has been no trade war yet. There’s merely been the THREAT of tariffs. Words. As you might recall, Trump threatened total nuclear war against North Korea in 2017. Nothing came of that. Typical Trump.
  3. The U.S. and China will negotiate over the next 3 months with regards to a better trade deal for the U.S.. This doesn’t seem like a trade war. Both sides are merely throwing threats at each other, which is standard procedure before the bargaining begins. A real trade war would not wait 3 months to begin.
  4. Remember, China has more to lose than the U.S. from a real trade war. This is not a war of equals. China doesn’t “own” the U.S.. China merely owns 6% of U.S. federal debt. China exports far more to the U.S. than the U.S. exports to China.
  5. Trump needs to at least reduce the U.S.’ trade deficit with China. That was a campaign promise. But he can’t reduce it by too much. An across-the-board retaliation from China would sink the U.S. economy and trash the Republicans’ midterm election chances. The U.S. primarily exports agricultural products to China. Agricultural states helped the Republicans and Trump win the 2016 election.
  6. Trump’s ultimate goal is to help the U.S. economy. If the trade war starts to hurt the economy in a meaningful way, he will stop. Congress will not sit idly and watch the President single-handidly destroy the economy.

Some facts about Trump’s current tariff threats
Here’s what will happen if Trump actually does carry out his threats.
Trump threatened to increase tariffs on an additional $100 billion worth of Chinese exports to the U.S.. If he follows through with this threat, Trump will have placed tariffs on $150 billion worth of Chinese exports to the U.S.
Here’s the interesting part. China CAN’T reciprocate on tariffs on $150 billion worth of goods. The U.S. only exports $130 billion worth of goods to China! In a way, you have to admire how Trump played this.
China has a few options, NONE of which are options that China really wants to take:

  1. Sell U.S. Treasury bonds. The problem is that China owns a mere 6% of the U.S. Treasury debt. This means that China’s influence on U.S. interest rates is limited. And with Treasury auctions witnessing strong private sector demand recently, China’s selling will mostly be absorbed by the private sector.
  2. China can depreciate its currency to offset the loss in exports. This is the last thing China wants to do. China spent $1 trillion from 2015-2016 to defend its currency. China wants its currency to appreciate because it wants to replace the Petrodollar with the Petroyuan.
  3. Make it harder for U.S. companies selling services in China. This is smaller than U.S. exports to China (around $50 billion).

What hasn’t been mentioned is the TARIFF RATE on these exports. That’s what matters. If this rate turns out to be 25%, it will likely reduce U.S. exports to China by 30% and Chinese exports to the U.S. by 30%.

  1. This will hit Chinese GDP growth by 0.6%. Hardly a “disaster”.
  2. This will hit U.S. GDP growth by 0.2%. Hardly a “disaster” for an economy that’s growing at 2-3% each year.

As you can see, things aren’t as bad once you put them into perspective. You can also see that Trump wants to avoid a trade war. Trump wants to negotiate, and China has the weaker hand. If Trump didn’t want to negotiate, he would not be conceding on certain issues in the NAFTA renegotiation process.
Remember, Trump continuously threatened to “rip up NAFTA” if he didn’t get what he wanted. In the end, he wants to concede so that he can get an easier deal. Trump, Canada, and Mexico might agree to a deal in principle next Sunday.
So the bottomline is simple:

  1. The worst case scenario is a disaster (full blown trade war). This is very unlikely.
  2. The bad scenario is possible ($150 billion in tariffs), with less than 50% odds. Even if this does happen, it is hardly a “disaster” that can cause a recession or bear market.
  3. The best case scenario is most likely: ongoing negotiations over the next 3 months that increases market volatility but does not cause a bear market.

I am not going to guess how much of an impact this will have on the economy. “Guessing” is not we should do as traders. Remember, the stock market and economy move in sync over the medium-long term. I’m just going to monitor the economic indicators and know FOR A FACT whether or not this has had any meaningful impact on the economy. So far these threats have not.
Focus on actions and facts. Don’t focus on words.

The stock market’s highs in January wasn’t the peak for this bull market

Updated March 31, 2018
The stock market and economy move in the same direction over the medium-long term. The economy is still improving at a healthy pace. There are no signs of sustained economic deterioration. This is why the bull market in stocks is not over.
People attribute the correction from January-present to multiple factors: rising interest rates, fear of the Fed, new Fed chairman, steel and aluminium tariffs, fear of a potential trade war with China, etc.
The reality is that none of these factors caused the correction. These were all just excuses/triggers.
The real reason for this correction is that the stock market was insanely overbought by January 2018. Here’s the S&P 500’s weekly RSI.

In other words, the current correction is a normal technical correction. This is just standard mean reversion, and the news is just an excuse.
It doesn’t matter what measure you use: the stock market by December 2017 and January 2018 had set record after record.
When the stock market’s rally is extremely overbought and investors are exuberant, that usually isn’t the stock market’s stop. Bull market tops feature bearish divergences. The correction after an insane rally is supposed to help create that bearish divergence.
This is a study we did in January on extremely overbought momentum. The conclusion was simple: a “significant correction” or bear market was at least months away.
Financial Conditions were also extremely easy in December 2017 and January 2018. Historically, this has meant that the start of a bear market is AT LEAST half a year away (see study we did).
Investor sentiment was also extremely high in January. Historically, this has ALWAYS resulted in the S&P closing higher 6 months later, even if the stock market experienced short-medium term weakness (see study we did).
The stock market is in the process of making a long term bearish divergence right now. That’s why we think the bull market has 1-2 years left from a discretionary stand point. The stock market will make new highs, but momentum and sentiment will not return to their January 2018 highs.
Remember: the stock market is always very volatile in the final 1-2 years of a bull market because some traders and investors jump on the long term bearish bandwagon too early. The tug-of-war between long term bears and long term bulls creates this increase in volatility. That’s why VIX tends to trend higher in the final few years of a bull market, BEFORE a bear market begins.

It’s important to note that the economy tends to deteriorate BEFORE a bear market and recession begins. The U.S. economy is healthy right now. We are on the lookout for sustained and significant economic deterioration to help us predict the bull market’s top.

Bullish on stocks as of March 25, 2018

The stock market and economy move in the same direction over the medium-long term.
As I’ve mentioned countless times here on the blog, the economy is still improving at a healthy pace. There are no signs of sustained economic deterioration. This is why the bull market in stocks is not over.
Trump’s tariffs and potential trade war: medium term stock market outlook
I’d like to focus on Trump’s tariffs on $50-$60 billion worth of Chinese goods today. These tariffs have clearly caught the attention of the media. I think fears of a trade war are overblown.

  1. For starters, China has “retaliated” in a very small way: with tariffs on $3 billion worth of goods. China is a net exporter vs. the U.S.. China is even more afraid of a tariff escalation leading to a trade war than the U.S.. China has far more to lose from a real trade war.
  2. Yes, there is the potential that China will increase the size of these tariffs over the next few weeks to tens of billions of dollars. Chinese President Xi Jinping has just been named emperor for life. He needs to show some backbone back home and stand up against “the evil Americans” in order to gain support in China.
  3. In the worst case scenario, China places equal tariffs on $50-$60 billion worth of U.S. exports.
  4. People seem to misunderstand these tariffs. These aren’t “tariffs WORTH $50-$60 billion”. These are tariffs on “trade that is WORTH $50-$60 billion”. So these tariffs aren’t going to cause a sudden $50-$60 billion decrease in exports and GDP.
  5. The annual U.S. GDP is $18.6 trillion. A $60 billion reduction in GDP is a -0.3% decline in GDP. Hardly a “recession inducing disaster”. And like we’ve said, these tariffs will reduce GDP by far less than $50-$60 billion.

So these tariffs (and China’s potential counter tariffs) have little impact on the economy. Some investors are more afraid of ESCALATION. They’re afraid of a tit-for-tat trade war. I think this is an unlikely scenario.
Trump doesn’t want a trade war. Trump wanted to work with China to reduce the U.S.’ trade deficit by $100 billion before he announced these tariffs. This sounds like a lot, but keep in mind that the U.S.’ trade deficit with China is $375 billion.
With this perspective in mind, Trump’s tariffs on $60 billion worth of Chinese exports are mild. He won’t even be able to reduce Chinese exports by anywhere close to $100 billion.
Hence it’s likely that Trump just wants to create a fervor and a lot of fear, thereby bringing the Chinese back to the bargaining table. You’d know that this is how Trump negotiates if you’ve read his “The Art of the Deal”, .

  1. Start with a very shocking and outrageous ask. Get the other side riled up.
  2. Slowly work your way to a more reasonable middle ground that both parties can accept.

This is exactly what Trump did with his steel and aluminium tariffs. He announced those “across the board” tariffs and ended up exempting most U.S. allies. Trump’s bark is loud but is bite is much softer.
*Trump is just using the “IP theft” as an excuse for his real goal: to reduce the trade deficit with China.
Trump isn’t an idiot. He knows that a real trade war will hurt the U.S. economy in a meaningful way. And for a president who’s constantly tweeting about the economy and stock market, Trump would be shooting himself in the foot by starting a full-blown trade war.
Short term outlook
The stock market’s medium-long term outlook is bullish. The short term outlook is also starting to favor the bulls from a risk:reward perspective.
Sentiment is extremely low and suggests that a capitulation low is either at hand or very close. Here’s CNNMoney’s Fear and Greed Index.

You can also see this in the S&P 500’s momentum, which is very oversold. Here’s RSI (14 days).

There is nothing abnormal about the stock market’s decline over the past few days. The stock market crashed in February 2018. These sort of stock market crashes are usually followed by a retest of the lows (and usually a marginal new low). This is a standard technical pattern. (See historical study).
The reality is that nobody knows where the market’s exact short term bottom will be. The most likely short term scenario is that the stock market makes a new intraday low on Monday and then rises from Tuesday – Thursday. (See historical study).
Focus on the medium-long term, which is bullish.

14 comments add yours

  1. Ever since your interview on 52 traders I have been following your musings on the markets. As always you are sharing valuable information which is refreshingly different from the normal news which we are constantly bombarded with. Keep up the good work and thanks for keeping the alternative market perspective news coming.

  2. What would you rate as the likelihood of a bearing market starting by January 2019?

    • Can’t say for 2019. I’m taking this one step at a time. But for 2018, I think the odds are very low.

  3. I don’t think China is care about whether $150bn or $1500 tariffs.
    A good example wad Japan in late1980s, who “lost 20 years” since then.
    In any case, China will fight back, for the peace of next 10 years.

  4. China can also use higher tariffs to compensate inequality, so if Trump impose 25% on $100 billion worth goods China can impose 50% on $50 billion worth of goods to match Trump’s threat… and that will be worse for the US (steel and agricultural producers, than us buying cheap T-shirts from China)…

  5. This is one of the few blogs with consistently good posts! It is refreshing to see a data-driven approach and the emphasis on facts or historical evidence rather than trying to push forth an opinion. Its nice to see your frequent updates and your strategy to take it one step at a time rather than try and predict what you don’t know. In a time where living an echo chamber of mainstream news and constant news posts that try to link every short term event to a random news article, it is great to have a more rational blog that gives you a better perspective of what actually matters! Keep up the good work!!

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