It’s been 7 months since the stock market’s December 2018 bottom, and the S&P has rallied 28% since then. The rally is slowing down, and it is unreasonable to expect the next 7 months to be like the previous 7 months.
- Technicals (short term, next 1-3 months): lean bearish. Short term risk is higher than normal.
- Technicals (medium term, next 6-9 months): mostly bullish
- Fundamentals (long term): no significant U.S. macro deterioration, but the long term risk:reward doesn’t favor bulls.
Let’s begin with technicals because most traders prefer technical analysis over fundamental analysis.
Technicals: Short Term & Medium Term
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
Basic trend
The S&P is above its 20, 50, and 200 day moving averages. So from a basic trend following perspective, one would be bullish on stocks right now.
However, trend following strategies by definition cannot predict countertrend price movements.
The S&P has rallied significantly over the past 7 months. These strong rallies typically see choppiness over the next few months, and more gains afterwards.
As you can see, the S&P’s returns over the next 2 months are no better than random. But 3-6 month forward returns are mostly bullish.
Put/Call
As the stock market rallies, various sentiment-related indicators demonstrate optimism. For example, the index put/call ratio has been quite low for 4 consecutive days. The last time the index put/call ratio was consistently low, was January 2018, just before stocks crashed and volatility spiked in February 2018.
But to avoid recency bias, let’s look at all the historical cases in which the Index Put/Call ratio was consistently low.
The S&P’s forward returns over the next 2 months are slightly more bearish than random.
Breadth
The % of NASDAQ stocks above their 200 dma broke out to the highest level since September 2018. This “breakout” is quite weak, because it’s rare for the NASDAQ to be at an all-time high while only 53% of its components are above their 200 day moving averages.
Historically, these breadth breakouts were often followed by weakness in the stock indices over the next few weeks.
Sentiment
NAAIM is another popular sentiment indicator, which represents equity exposure among active managers. NAAIM is now at 95, the highest since October 2018 (just before stocks fell off a cliff).
When NAAIM exceeded 95 in the past (like right now), the S&P’s short term forward returns (e.g. next 1-2 weeks) are more bearish than random.
While most sentiment indicators demonstrate high levels of optimism, AAII is suggesting that sentiment is still rather pessimistic, at least among mom and pop investors.
As Bloomberg noted:
7 of the past 15 weeks have seen the S&P within -5% of a 1 year high, while there are more AAII bears than bulls. This is uncommon because there are usually more bulls than bears when stocks are sitting near record highs.
Historical cases were neither consistently bullish or bearish. Overall, AAII isn’t the best sentiment indicator, unless it is at extremes.
Volatility
The stock market’s volatility is low. The VIX:VXV ratio divides spot volatility vs. 3 month-forward implied volatility. A low VIX:VXV ratio implies that volatility is currently low compared to longer term expected volatility. Here’s the VIX term structure, from VIX Central.
The VIX:VXV ratio has now fallen to the lowest level since October 2018, when stocks tanked and volatility spiked.
Here’s what happened next to VIX when the VIX:VXV ratio fell to a new 9 month low.
This is short term bullish for volatility.
Sectors
The financial sector has underperformed significantly over the past year, and is finally catching up. XLF (finance ETF) has finally made a new 1 year high.
Such breakouts don’t usually work out for XLF on the first try. Similar breakout attempts for XLF all saw a pullback over the next 2 months.
Value Line Geometric Index
Unlike the market-cap weighted S&P 500, the Value Line Geometric is an equal-weighted index of approximately 1600+ stocks in the U.S. and Canada (mostly U.S.) And while the S&P pushes on to new highs, the Value Line Geometric Index continues to languish. This is due to many reasons, some of which may be related to weakness in smaller cap stocks.
*Small cap stocks outnumber large cap stocks. So a broad, equal-weighted index will be dragged down if small cap stocks underperform.
With the S&P sitting near all-time highs, the Value Line Geometric Index is nearly -10% below its 1 year high. There are only 2 other periods in which this happened:
- Late-1998 to 1999 (before the 2000 bull market top)
- May 1990 (before a -20% stock market decline and recession)
Here’s the 1998-1999 case.
Here’s the 1990 case.
Sample size is small, but at least this isn’t a bullish sign for stocks.
Fundamentals (is it a bull market or a bear market?)
If the stock market is choppy over the next few months, will the rally resume after a consolidation or correction? That depends on the economy. The stock market & economy move in the same direction in the long run.
- If the economy continues to improve over the next few months, then the stock market’s rally will probably continue into 2020.
- But if the economy deteriorates significantly over the next few months, then we will be long term bearish for 2020.
There are various pockets of macro weakness right now, but there is no significant deterioration. Absent significant deterioration, stocks tend to go up. Let’s recap some of the leading macro indicators we covered by beginning with the bad news:
Housing still a weak point
Housing is still a weak point in the U.S. macro picture. For example, year-over-year growth in Private Residential Fixed Investment (i.e. housing) has now turned negative.
While this isn’t a guaranteed long term bearish sign, it is a long term warning sign. There are some false bearish signals (e.g. 1995), but this usually happened as the economy was heading towards a recession over the next 1-2 years.
Personally, I am not extremely worried about the weakness in housing right now. But if this continues for another few months, then I would be much more worried.
Yield curve
The 10 year – 3 month yield curve briefly un-inverted this Tuesday, after a 40+ day streak of consecutive inversions.
In the past, this wasn’t too good for stocks over the next year.
Now onto the good news.
Labor market is still a positive factor
The labor market is still a positive factor for macro. Initial Claims and Continued Claims are trending sideways. In the past, these 2 leading indicators trended higher before bear markets and recessions began.
Financial conditions
Financial conditions remain very loose. In the past, financial conditions tightened before recessions and bear markets began.
Here’s the Chicago Fed’s Financial Conditions Credit Subindex
Here’s banks’ lending standards. Whereas lending standards remain loose today, they tightened significantly before the previous 2 bear markets and recessions.
Delinquency Rates
Delinquency rates continue to trend downwards. In the past, this indicator trended upwards before recessions and bear markets began.
Heavy Truck Sales
Heavy Truck Sales is still trending upwards. In the past, Heavy Truck Sales trended downwards before recessions and bear markets began.
Retail Sales
Inflation-adjusted Retail Sales are still trending upwards. This is different from the previous 2 bear markets and recessions, which were preceded by flattening real Retail Sales.
We don’t use our discretionary outlook for trading. We use our quantitative trading models because they are end-to-end systems that tell you how to trade ALL THE TIME, even when our discretionary outlook is mixed. Members can see our model’s latest trades here updated in real-time.
Conclusion
Here is our discretionary market outlook:
- Long term: risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
- Medium term (next 6-9 months): most market studies are slightly bullish.
- Short term (next 1-3 months) market studies lean bearish.
- We focus on the medium-long term.
Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward favors long term bears.
