Stock Market Bouncing From Oversold Levels

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Last week I said that this is the stock market’s most likely path would be:

Stock Market Bouncing From Oversold Levels

S&P 500 Chart

Source: Investing.com

Thus far, the S&P 500 is playing out this case. The S&P continues its bounce, with the first real resistance at the 38.2% Fibonacci retracement.

Stock Market Bouncing From Oversold Levels

S&P 500 Chart

Source: Investing.com

The economy’s fundamentals determine the stock market’s medium-long term outlook. Technicals determine the stock market’s short-medium term outlook. Here’s why:

  1. The stock market’s long-term risk: reward is no longer bullish.
  2. The stock market’s medium-term leans bullish (i.e. next 3-6 months).
  3. The stock market’s short-term has a slight bearish lean.

We focus on the long-term and the medium term. Let’s go from the long-term to the medium term, to the short term.

Long Term

While the bull market could very well still last until Q2 2019, the long-term risk: reward no longer favors bulls. Past a certain point, risk: reward is more important than the stock market’s most probable long-term direction.

*I do not define “bear markets” via the traditional -20% decline. I define “bear markets” as 33%+ declines that last >1 year. E.g. 2007-2009, 2000-2002, 1973-1974, 1968-1970.

Some leading indicators are showing signs of deterioration. The usual chain of events looks like this:

  1. Housing – the earliest leading indicators – starts to deteriorate. This has occurred already.
  2. The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long-term topping process. We are here right now.
  3. The labor market deteriorates some more, while other economic indicators start to deteriorate. The bull market is definitely over.

We are currently in phase 2. Let’s look at the data besides our Macro Index

The Goldman Bull/Bear Indicator determines if the economy is “as good as it gets”. And right now, it is very good indeed.

Stock Market Bouncing From Oversold Levels

However, the economy and stock market do not fall just because “the economy is as good as it gets”. Record low unemployment can get lower, and record high valuations can get higher. The economy doesn’t “have to” deteriorate just because unemployment is low. The stock market doesn’t “have to” fall just because valuations are high.

That’s why we focus on leading indicators to identify turning points in the economy and stock market.

Unit profits have been trending downwards since 2014, which marked the halfway point of the bull market and economic expansion. This is a late-cycle sign.

Stock Market Bouncing From Oversold Levels

The more important labor market is showing a few signs of economic deterioration, with Initial Claims trending sideways. This deterioration is not significant, but watch out if it persists over the next few weeks and months.

Stock Market Bouncing From Oversold Levels

Stock Market Bouncing From Oversold Levels


Source: FRED

The unemployment rate went up despite Friday’s amazing jobs report. How can the unemployment rate go up when the economy is adding so many jobs?

  1. The number of jobs added and the unemployment rate come from 2 different surveys.
  2. More importantly, the unemployment rate is a ratio of the “unemployed” / labor population. When the economy is red hot (i.e. right now), many discouraged workers join the “unemployed” line and start searching for jobs again. So when the economy adds a lot of new jobs but the unemployment rate rises, it’s because many more people are encouraged by the strong economy to start searching for work again. This is why unemployment rate tends to flatten out towards the end of economic expansion.

Stock Market Bouncing From Oversold Levels

Net Earnings Revisions are solidly negative for the first time in 2 years. Net Earnings Revisions turns negative before economic recessions and equity bear markets begin. With many false signals, negative Net Earnings Revisions is a necessary but not sufficient requirement for bear markets and economic recessions.

This “necessary but not sufficient requirement for bear markets” is now a long term bearish sign.

Stock Market Bouncing From Oversold Levels


Source: Yardeni

The housing sector is a key leading indicator for the U.S. economy. Housing has been deteriorating since summer 2018.

Stock Market Bouncing From Oversold Levels

Stock Market Bouncing From Oversold Levels


Source: FRED

*Granted, both of these housing indicators have several false SELL signals. But this late in the economic expansion, the chance of a false signal is less likely.

Based on the current rate of economic data, a recession right now is extremely unlikely. A recession is possible at the end of 2019 or early-2020 (which would significantly exacerbate the stock market’s decline). This is not a definitive prediction – it is a moving target as new data comes along.

The current economic expansion is tied for being the longest economic expansion in history. The permabears will tell you “the economy CANNOT keep growing because this expansion has been too long”. This is factually false.

Economic expansions have gotten longer and longer over the past 150 years. Recessions below in blue.

Stock Market Bouncing From Oversold Levels

As you can see, “how long an economic expansion lasts” keeps setting new records. Expansions do not die of old age.

Similarly, valuations aren’t very useful for trading. The following chart plots the S&P 500’s valuations against its 2 year forward returns. Valuations explain only 6% of the stock market’s forward returns (R squared = 0.06).

Stock Market Bouncing From Oversold Levels

Remember: Valuations have been consistently elevated over the past 25 years. Anyone who sold stocks just because “stocks are overvalued!” would have missed out on massive gains over the past few decades.

Stock Market Bouncing From Oversold Levels

Why have valuations been consistently elevated? Because inflation and interest rates today are much lower than where they were 30, 40, 50 years ago (and no, inflation going from 2% to 3% doesn’t count as “SOARING INFLATION”). The following chart demonstrates the inverse relationship between inflation and average valuations.

Stock Market Bouncing From Oversold Levels

Here’s the more worrisome point right now:

Lagging economic indicators (GDP and earnings growth) have been very strong while stocks tanked in Q4 2018. The disconnect between the economy and stock market is normal during a bull market, but not this level of disconnect.

Earnings growth has exceeded 15% this year while the S&P fell more than -6%

Here’s every calendar year this happened, from 1928 – present

Stock Market Bouncing From Oversold Levels

As you can see, the 3 historical cases were all long-term bearish cases.

At the end of a bull market, leading economic indicators will deteriorate (which they have since August 2018), then the stock market will top while lagging indicators are still very strong (e.g. GDP and earnings growth).

In conclusion

While the bull market and economic expansion certainly can continue, the risk: reward doesn’t favor bulls. Risk: reward is more important than picking exact tops and bottoms.

Medium Term

Our medium-term outlook (next 3-6 months) still leans bullish. Here’s the most likely medium-term path.

Stock Market Bouncing From Oversold Levels

S&P 500 Chart

Here’s a less likely, but still possible path.

Stock Market Bouncing From Oversold Levels

S&P 500 Chart

In other words, a retest is more likely than no-retest. As I said last week:

After such crashes, the stock market typically makes a quick bounce, a retest, and then a medium-term rally. What follows the medium term rally depends on macro (the economy).

  1. If the economy continues to improve, then the stock market will push on to new highs, even if the rally is very choppy. (This was the case in 1987-1988 and 1998-1999. Macro improved after the crash, pushing the stock market higher).
  2. If the economy deteriorates, then the stock market will go on to make new lows.

We are watching macro carefully in 2019 through our Macro Index.

Let’s get into the quantitative market studies.

*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

Stock Market Bouncing From Oversold Levels

We rank our market studies in order of importance.

  1. The stock market’s own fundamentals and technicals (primary importance)
  2. Correlation and specific sectors (secondary importance)
  3. Seasonality, short term factors (tertiary importance)

The stock market’s own fundamentals and technicals (primary importance)

Wall Street conventional “wisdom” states that “big rallies only happen in bear markets”. This is partially true, but only when these big daily rallies occur AFTER the stock market has fallen -30%, -40%, or -50%

Big rallies also happen in -15% to -20% declines that are followed by new all-time highs.

The S&P has rallied more than 3.4% in 2 of the past 10 days, while within 20% of a 2 year high.

Stock Market Bouncing From Oversold Levels

Here are similar cases, from 1950 – present

Stock Market Bouncing From Oversold Levels

Even in the bear market cases (2008), the stock market made a 2 month rally.

Here’s the same chart, but including data from 1929 – present

Stock Market Bouncing From Oversold Levels

You can see that this was clearly not bullish in the Great Depression. But context matters. Comparing today to 1933 (at the bottom of the Great Depression) is silly. Leave that to the world-is-ending people.

Technical traders often look for “breadth thrusts” to confirm bottoms. Over the past 2 weeks, there have been 2 days in which more than 90% of issues on the NYSE went up.

Here’s what happened next to the S&P 500 when it fell to a 1 year low, and then witnessed 2 breadth thrusts in 2 weeks.

*Idea from member Bret Zimmerman

Stock Market Bouncing From Oversold Levels

This is pretty consistently bullish for the stock market, especially 6+ months later.

While stocks have performed poorly in 2018, investors allocation to equities has fallen. The following chart demonstrates AAII’s Ratio ot Equities allocation to Cash allocation.

Stock Market Bouncing From Oversold Levels

There is only 1 such decline in Equities allocation that is similar to today’s: March 1999.

Stock Market Bouncing From Oversold Levels

Stock Market Bouncing From Oversold Levels

In that historical case, the bull market continued for another year (everyone thought the 1998 -20% decline was the start of a much bigger bear market). Towards the end of a bull market, you just don’t know if bull market has 1 more year (blow-off top) or not. “The bull market is dead” is not a foregone conclusion.

Momentum has bounced from extremely oversold levels.

The S&P 500’s 30 daily RSI has gone from under 30 to above 43 (bounce from extreme oversold levels).

Stock Market Bouncing From Oversold Levels

S&P 500 Chart

Historically, this can lead to short term weakness in the stock market over the next 1-2 weeks, but after that forward returns were random.

Stock Market Bouncing From Oversold Levels

Technical studies can be improved with macro context. Here’s the same study, but only looking at the cases in which the unemployment rate was under 6% (i.e. late-cycle cases)

Stock Market Bouncing From Oversold Levels

Once again, there is a bearish lean over the next 1-2 weeks. Extreme crashes (very oversold) + bounces = usually a retest

The most important 10 year – 3 month yield curve will invert soon

Stock Market Bouncing From Oversold Levels


Source: FRED

This isn’t necessarily an immediate long-term bearish sign, but it is a warning sign of late-cycle activity. You can see that forward returns start to deteriorate 1 year later.

Stock Market Bouncing From Oversold Levels


Correlation and specific sectors (secondary importance)

Sometimes other markets and specific sectors can give us a clue about where the S&P 500 will go.

Right now, many sectors are flashing warning signs. While these may seem bearish, they are of secondary importance to the S&P 500’s own factors (as mentioned in the market studies above).

As we mentioned on Friday, safe haven assets gold and yen have been going up while the S&P has been trending down from December – present.

Stock Market Bouncing From Oversold Levels

Stock Market Bouncing From Oversold Levels

Stock Market Bouncing From Oversold Levels

Gold’s uptrend is not bearish for the S&P.

Stock Market Bouncing From Oversold Levels

And the yen’s uptrend (USD/JPY’s downtrend) is not consistently bearish for the S&P either

Stock Market Bouncing From Oversold Levels

*It’s interesting how many of these cases happened after the S&P crashed 30%, 40%, 50%

However, the rising U.S. dollar is a bearish factor for U.S. stocks. Stocks don’t always fall when the USD rises, but when stocks do fall when the USD rises, stocks tend to fall more over Q1 (retest?)

Stock Market Bouncing From Oversold Levels

The upwards trend in interest rates is also a slightly bearish factor. In 2018, the 10 year yield went up while the S&P fell. When this happens, the S&P’s Q1 of next year (Q1 2019) tends to be weak.

Stock Market Bouncing From Oversold Levels

XLY:XLP usually moves in the same direction as the S&P. But in December, XLY: XLP went up while the S&P went down.

Stock Market Bouncing From Oversold Levels

From 1998 – present, this has happened only in bear markets

Stock Market Bouncing From Oversold Levels

*Be careful when using 1998 – present data. Such data overestimates the probability of a 50% decline. More data is better than less data.

Conclusion

  1. The S&P 500’s own factors point to a medium term bounce.
  2. Correlated sectors and markets point to a 1-3 month decline (retest?)

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long-term risk: reward is no longer bullish. This doesn’t necessarily mean that the bull market is over. We’re merely talking about long-term risk: reward. Long-term risk: reward is more important than trying to predict exact tops and bottoms.
  2. The medium-term direction is still bullish (i.e. trend for the next 6 months). However, if this is the start of a bear market, bear market rallies typically last 3 months. They are shorter in duration.
  3. The stock market’s short-term has a slight bearish lean. Focus on the medium-long term because the short term is extremely hard to predict.

Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk: reward does favor long-term bears.

Stock Market Bouncing From Oversold Levels


Our discretionary outlook is not a reflection of how we’re trading the markets right now. We trade based on our quantitative trading models.

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