This week’s market summary and outlook is going to be a little different than usual. I’m going to explain what my main bearish worries are for the U.S. stock market and how I’m going to deal with these worries.
*This post isn’t just for you guys. It’s a personal reflection for me as well.
As you know, the U.S. economy and U.S. stock market move in the same direction for the medium-long term. Hence, leading economic indicators are also leading stock market indicators.
Based on the Medium-Long Term Model, I define:
- “Long term” = whether the S&P 500 is still in a bull market or bear market.
- “Medium term” = whether the S&P is still in a “big rally” or a “big correction”.
Based on where the data is right now, the bull market in stocks probably has 1 year left. This is an approximate TIME target, and will be updated as we get new data.
This is where things get interesting. Since the bull market doesn’t have many years left, the “long term” and “medium term” start to mold into 1 single time frame. I.e. the next “big correction” probably won’t be a “big correction” – it’ll be the start of the new bear market.
And that is where my primary “concern” lies. This bull market doesn’t have a lot of years left (1 year is most likely, 2 years at maximum). Risk:reward doesn’t support being heavily long stocks towards the end of a bull market. Moreover, consistently and accurately predicting the bull market’s exact top is extremely hard.
In this post, we’re going to cover:
- Why the bull market doesn’t have a lot of room left.
- Why the bull market should be fine going into 2019, but then long term risks will start to increase as 2019 goes on.
- What to do with your portfolio right now.
My main long term worry: this is about as good as it gets
The economy & the stock market move in the same direction in the medium-long term. Key economic indicators tend to deteriorate BEFORE bull markets end.
But here’s the tricky part. Sometimes leading economic indicators deteriorate JUST before bull markets end (i.e. only a few months before). Sometimes leading economic indicators deteriorate 2 years before bull markets end. This makes it hard to estimate the bull market’s exact top.
The best way to deal with this is:
- Accept that it’s IMPOSSIBLE to consistently and accurately catch the bull market’s exact top.
- Use position size to scale-out, thereby reducing risk incrementally as time goes on.
Key U.S. economic indicators have not deteriorated so far. HOWEVER, I believe they will start to deteriorate in 2019, if not 2020 at the latest (2019 is far more likely than 2020).
Here are some signs that this is about as good as it gets for leading U.S. economic indicators.
Initial Claims are extremely low. This key leading indicator was last this low during the 1960s, when the U.S. population was much lower than it is today. Perhaps Initial Claims will fall lower, but it’s hard to believe that Initial Claims will go much lower than where it is today.
Like Initial Claims, the Unemployment Rate is still historically low and has not gone lower over the past 3 months. Perhaps the Unemployment Rate will fall for another few months, but it’s hard to see how Unemployment can fall for another year or two.
Meanwhile, the S&P 500 itself has spent 30 consecutive months above its 12 monthly moving average. Here are the other historical cases in which the S&P spent this many consecutive months above its 12 monthly moving average. These historical cases usually ended with a “bear market” or “big correction” within the next 6 months.
- 2015 (43 months).
- 2007 (56 months).
- 1998 (43 months).
- 1994 (38 months).
- 1987 (38 months)
- 1965 (30 months)
- 1956 (33 months)
So the next time the S&P breaks below its 12 monthly moving average, be very careful. With valuations this high, I don’t think the next breakdown will be a “big correction”. It’ll be a bear market.
The S&P’s 12 monthly moving average is currently at 2728.
And lastly, Citigroup’s Panic/Euphoria model is starting to show “Euphoria”. This model has a history of turning bearish too early. Hence, a bearish signal now in 2018 is more likely a bearish signal for 2019.
*The U.S. housing sector is the only part of the U.S. economy that is still a long way from recovery (i.e. has a lot of room left for growth). However, it’s entirely possible for housing to increase during a recession (e.g. 2001 recession).
Why the stock market should be fine going into 2019
The majority of our recent market studies are still bullish for the stock market on a 6-9 month forward basis. Momentum has returned to the U.S. stock market. This momentum usually carries the stock market higher over the next half year.
The S&P is up 5 months in a row. Historically bullish.
The S&P has become overbought for the first time in 7 months. Historically bullish.
The 10 – 2 year yield curve will most likely invert within the next few months. Historically, the stock market goes up another 1-2 years after the yield curve inverts.
ISM manufacturing made a new high for this economic expansion. The stock market can also go up for 1-2 years after ISM manufacturing peaks.
And lastly, the S&P has experienced some “sector rotation”, which is a slightly bullish factor for the stock market.
With that being said, the stock market is starting to exhibit some long term warning signs. These warning signs were notably absent during the first half of 2018, even though the stock market made a correction from January-February 2018.
In short, while the majority of medium-long term studies are bullish, there are now a few bearish studies thrown into the mix. The stock market’s long term outlook is no longer as bullish as it was at the start of this year.
Some warning signs
*These warning signs were notably absent during the first half of this year.
The stock market was strong in August – a little too strong. At the very least this isn’t bullish for the stock market.
Following an extremely strong August, the stock market’s start to September has been exceptionally rare: down 5 days in a row with lower highs and lower lows. This isn’t bullish either
As you can see, both of these studies include the 1987 crash as a historical case. Is a 1987 crash likely to happen right now?
I think it’s unlikely. The S&P 500’s rally prior to the 1987 crash was exceptionally powerful (much more powerful than the S&P’s rally from 2017-today). The S&P is 6.2% above its 200 daily moving average today. In August 1987, the S&P was 18% above its 200 daily moving average! The need for mean reversion was much stronger back then than it is today.
The NASDAQ experienced some distribution selling in July 2018 that has only been seen in 1999.
Lastly, corporate buybacks have been putting a floor under U.S. equities in 2018. This will start to wear off in 2019 as the effects of the tax cut start to wear off.
What to do
So here’s the case that I’m advocating: the stock market should do fine for the remainder of 2018, even if there is some short term volatility/weakness. However, medium-long term risk increases as 2019 goes on.
What you should do right now depends on:
- What your position size is.
- What your average BUY price is.
*These 2 factors are very important because trader psychology is important. It’s a very different feeling when you go from a gain to being flat vs. from being flat to a loss. Giving back some of your paper profits is a very different psychology vs. starting a position immediately with a loss.
If you have spare cash
I don’t think buying into SSO or UPRO from the current price is a good idea. If the S&P goes up for another year and yields 10-15%, SSO will yield 20-30%. But if the S&P goes down earlier than you expected, it’s easy for your small profit to turn into a loss.
The best thing to do if you’re 100% in cash is to go half long right now (SSO or UPRO). Use the other half as a cash reserve. If the market goes up, you will participate and profit partially from what’s left of the bull market. If the market goes down, you can scale in, lower your average price, and then scale out on the bounce. No bear market goes down in a straight line without a bounce.
If you are heavily long right now
Be greedy, but not too greedy. A wise course of action is to scale out throughout 2019. Here’s an example:
- Go from 100% long SSO to 75% long SSO in January 2019.
- Go from 75% long SSO to 50% long SSO in April 2019.
- Go from 50% long SSO to 25% long SSO in July 2019.
- Keep the final 25% long SSO until the Medium-Long Term Model turns bearish.
So why not remain 100% long SSO until the Medium-Long Term Model turns bearish? Why scale out before the model turns bearish?
Simple. You always want to consider the possibility that you are wrong. By scaling out of a position, you will not be hurt badly if your model is wrong. Always trade what’s highly probable, but be prepared in case a low-probability event occur.
What I’m doing right now.
I will receive a cash injection that quadruples my current portfolio size in the next few weeks. In other words, I’ll have a lot of cash to work with. This is my conundrum right now. I need to show my investor solid returns at a time when we are rather close to the end of this bull market.
I don’t want to plow this cash completely into SSO or UPRO right now. Doing so this late in the uptrend is dangerous. Instead, I will probably go 50% long SSO, and keep the other 50% in cash.
- If the market goes up, I profit (equivalent to being 100% long the S&P).
- If the market goes down, I will scale-in when it gets oversold and then scale-out on the bounce. In other words, the cash saves my position.
Here’s something else you can try. Over the past week I have been calling a lot of people in the Membership Program. A recurring question I heard was “I will be eligible for long term capital gains tax if I hold onto my current position until the middle of 2019. Do you think I should wait until mid-2019 before selling? Or do you think the market will tank before mid-2019 (i.e. I should bite the bullet and accept the short term capital gains tax)?”
I have been learning about options trading recently, and a thought crossed my mind. Instead of selling and incurring a short term capital gains tax, why not hedge that position by buying some put options? Your put options will cover some of your losses if the market goes down, and you won’t have to sell your stocks and incur a short term capital gains tax.
Anyways, just some food for thought. I’m still learning about options trading right now. Trading truly is a never-ending learning experience!