This is a Guest Post by Troy Bombardia of BullMarkets.co.
Market outlook: is the stock market about to soar after a big breakout?
The S&P 500 reached 3000 this week for the first time, and the broad stock market is breaking out from a range that has lasted from January 2018 – present. While there is still the ever-present group of market watchers who think that stocks will crash, more and more traders are seeing the possibility of a big post-breakout rally.
As I said last week, I think a middle ground scenario is more likely. This is just a normal rally towards the end of a bull market. A massive breakaway rally that will last years is unlikely, but neither is an imminent crash. Today is not “just like 2000 and 2007” and nor is it “just like 2002 and 2009”.
- Fundamentals (long term): no significant U.S. macro deterioration, but the long term risk:reward doesn’t favor bulls.
- Technicals (medium term): mostly bullish
- Technicals (short term): mixed
Let’s begin with technicals because most traders prefer technical analysis over fundamental analysis.
Technicals: Medium Term
*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.
Although the bull market is certainly late-cycle, the stock market’s medium term (next 6-9 months) leans bullish.
Breakout
Standard technical analysis teaches us that “the bigger the consolidation, the bigger the post-breakout/breakdown move”. The analogy is that of a rocket – the more time the rocket spends “preparing and gathering fuel”, the bigger the subsequent blastoff.
Looking at the Dow’s weekly chart, the market “looks like” it is making a sustained breakout.
From January 2018 – May 2019, all-time highs for the Dow had been fleeting. The Dow would make a marginal new high, and then immediately collapsed downwards. But the recent breakout has been different.
For the first time since January 2018, the Dow has made 2 consecutive weeks of all-time highs (sustained new highs).
These “first breakouts in a long time” usually see more gains for the Dow over the next 9 months.
*This is weekly data. Data for 7/8/2019 is for the recent week, starting on Monday July 8.
*Keep in mind that the Dow does not include dividends reinvested. Including dividends, forward returns over the next 6-9 months would be more bullish.
Here are some of the more similar cases. This is July 2016:
This is 1995:
Here’s 1991:
Here’s 1985:
Breadth
As the stock market rallies, more and more S&P stocks are above their 50 day moving averages. More than 85% of stocks are above their 50 day moving averages, which is a high figure. Is this something to be concerned about?
Here’s what happened next to the S&P when similar breadth readings occurred.
The S&P almost always pushed higher 3-12 months later.
Strong trend
The stock market’s trend has been quite strong this year. The S&P went straight up from January – April, it went straight down in May, and it has gone straight up since June.
As a result, the S&P has crossed its 20 day moving average (short term trendline) just 6 times in the past half year. This is rare. The market is usually more choppy, even when it is trending.
The last time such a persistent trend occurred was in January 2018, which was followed by a small stock market crash in February 2018.
Should stock market investors and traders be concerned? Here’s what happened next to the S&P when it rallied more than 15% in the past half year, while the S&P crossed its 20 dma fewer than 7 times.
The 1 week forward returns are more bearish than random, but the 6 month forward returns are more bullish than random.
Sentiment
As the stock market rallies, bearish sentiment is coming down. AAII Bears % is finally below 30% for the first time in 8 weeks
Historically, this was slightly more bullish than random for stocks 2-3 months later and mostly bullish 1 year later.
Small caps canary
Small caps continue to significantly underperform large caps, causing the Russell:S&P ratio to fall.
I wanted to test if this theory is true “when the Russell 2000 is underperforming, it suggests… the market is getting ripe for a selloff.”
Here’s what happened next to the S&P when it rallied more than 20% over the past 7 months, while the Russell:S&P ratio fell.
The Market Watch article does have some merit. More specifically, the S&P has gone up more than 20% over the past 7 months, while the Russell:S&P ratio fell more than -0.05. There is only 1 other historical case that is similar to today in this regard: July 1997.
Overall, small caps weakness is one of the few technically weak signs I’m watching.
Sectors model
I’m working on a new end-to-end trading model. The model is still a work in a progress, but I’d like to share the results so far.
This model uses relative strength/weakness among sectors to know if you should buy or sell the S&P 500 right now. Certain sectors tend to consistently outperform in a bull market and underperform in a bear market.
- From 1999-present, buy and hold the S&P = average annual return of 4.3% (excluding dividends).
- Model = average annual return of 10.6% (excluding dividends).
- This model is long stocks right now.
Moving on to fundamentals…
Looking at these stats, it’s tempting to think that the coast is all clear and that December 2018 marked a long term cyclical bottom. I think that cautious optimism is warranted. Now is not the time for unrestrained optimism. (While hype sells and works really well for financial marketers, it doesn’t work well for investors and traders. Unrealistic expectations don’t usually end well for those who have money on the line).
While macro does support the case for a bull market rally that lasts into 2020, it does not support the case for a bull market rally that will last many years.
Fundamentals: long term risk:reward
Yield Curve
As the Wall Street Journal reports, the 10 year – 3 month yield curve is close to normalizing again after being inverted for 8 consecutive weeks.
This is more important than a yield curve inversion. The yield curve tends to invert months/years before a recession and bear market begins. However, it’s a steepening yield curve that’s more worrisome. The yield curve tends to steepen in a recession as the Fed cuts short term rates faster than long term rates can fall.
On its own, an 8 week inversion (i.e. right now) is not bullish for stocks in the long run.
But if you look at the cases when the 10 year – 3 month yield curve rises above 0% after being inverted for more than 8 weeks, the S&P’s forward returns are even more worrisome.
Overall, the yield curve is a long term warning sign for stocks. While this may not mark the exact top of a bull market, it tells you that in an optimistic scenario, the bull market probably will not last beyond 2020.
Earnings growth
Q2 earnings season is just around the corner. According to Factset, this could be the 2nd consecutive quarter that saw a year-over-year decline in earnings. The decline in earnings growth raises the risk of an “earnings recession”.
*Corporate earnings and the stock market move in the same direction in the long term.
Here’s what happened next to the S&P when earnings growth fell for 2 consecutive quarters.
This is a risk for the stock market over the next 3-9 months.
Fundamentals: long term direction (is this still a bull or a bear market?)
While the bull market does not have many years left, macro still suggests that a bear market and recession are not imminent. Let’s recap some of the leading macro indicators we covered:
*The stock market and the economy move in the same direction in the long run.
Housing is a slight negative factor, but could improve
Housing – a key leading sector for the economy – remains weak. Housing Starts and Building Permits are trending downwards while New Home Sales is trending sideways. In the past, these 3 indicators trended downwards before recessions and bear markets began.
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.
Baltic Dry Index
The Baltic Dry Index measures global shipping. This indicator is rather obscure until it crashes – then everyone talks about how a falling Baltic Dry Index is bearish for stocks. But few people talk about it when the index surges. (You know the drill – bad news sells).
The Baltic Dry Index has now surged to new multi-year highs.
This is the first new high for the Baltic Dry Index in a long time.
Similar “breakouts” in the Baltic Dry Index were mostly bullish for stocks over the next year.
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 bullish.
- Short term (next 1-3 months) market studies are mixed.
- We focus on the medium-long term.
Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward favors long term bears.
This was a Guest Post by: Troy Bombardia you can follow him on Twitter at @bullmarketsco and his website is BullMarkets.co.
***All content, opinions, and commentary is by Troy Bombardia and is intended for general information and educational purposes only, NOT INVESTMENT ADVICE.