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Market outlook: it’s been a terrific start to the year for stocks. What’s next

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Summary:
The stock market is on fire, with the S&P 500 up more than 12% this year so far. From 1950 – present, this is the 4th best start to a year. 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: The stock market’s long term risk:reward is no longer bullish. The medium term direction (e.g. next 6-9 months) is more bullish than bearish. The stock market’s short term has a slight bearish lean. We focus on the long term and the medium term. Long Term While the bull market could keep going on, the long term risk:reward no longer favors bulls. Towards the end of a bull market, risk:reward is more important than the stock market’s most probable long term direction. Some leading

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The stock market is on fire, with the S&P 500 up more than 12% this year so far. From 1950 – present, this is the 4th best start to a year.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Market outlook: it’s been a terrific start to the year for stocks. What’s next

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 medium term direction (e.g. next 6-9 months) is more bullish than bearish.
  3. The stock market’s short term has a slight bearish lean.

We focus on the long term and the medium term.

Long Term

While the bull market could keep going on, the long term risk:reward no longer favors bulls. Towards the end of a bull market, risk:reward is more important than the stock market’s most probable long term direction.

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 in the early stages of this process, but the deterioration is not significant.
  3. Other economic indicators start to deteriorate. The bull market is definitely over, and a recession has started. A U.S. recession is not imminent right now

*All economic data charts are from FRED

Housing remains in a downtrend, with New Home Sales still below its 12 month moving average. In the past, New Home Sales trended downwards before bear markets and recessions began.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

The labor markets are no longer improving. Initial Claims, Continued Claims, and the Unemployment Rate are trending sideways.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Market outlook: it’s been a terrific start to the year for stocks. What’s next

In the past, Initial Claims and Continued Claims trended higher significantly before bear markets and recessions began. This has not happened yet, but is something to watch out for throughout 2019

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Market outlook: it’s been a terrific start to the year for stocks. What’s next

The 4 week moving average of Initial Claims is trending higher. This is noticeably different from the rest of this economic expansion, in which Initial Claims was continuously falling.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

To calculate the trend in Initial Claims, we can look at the 4 week average’s 6 month rate-of-change.

This rate-of-change has risen for 10 consecutive weeks, while Unemployment is under 5% (i.e. late-cycle cases).

Historically, this is not a good combination for stocks, especially 6+ months later.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Financial conditions are still relatively loose. The Chicago Fed’s Financial Conditions Credit Subindex is still very low and flat. In the past, credit conditions tightened before recessions and bear markets began.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Banks’ Lending Standards have tightened a little in the most recent quarter. This is important, because credit is the lifeblood of the U.S. economy. One data-point does not make a trend, so this is not yet a long term bearish factor. But if Lending Standards continue to trend higher throughout 2019, long term bulls should watch out.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

The Freight Transportation Services Index continues to trend higher. In the past, Freight Transportation Services trended sideways before bear markets and recessions began.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

The yield curve continues to flatten and is close to completely inverting as the stock market rallies.

  1. The 10 year – 2 year yield curve is currently at 0.16
  2. The 10 year – 3 month yield curve is currently at 0.14

Market outlook: it’s been a terrific start to the year for stocks. What’s next

For reference, here’s what happens next to S&P 500 when the 10 year – 2 year yield curve inverts for the first time in each economic expansion.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to S&P 500 when the 10 year – 3 month yield curve inverts for the first time in each economic expansion.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Yield curve inversions typically occur before bull markets end. This is something that long term bulls should watch out for in 2019 as the entire yield curve inverts.

The 6 month rate-of-change in Retail Sales is now negative.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

As you can see, Retail Sales have fallen a little over the past 6 months.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to the S&P when Retail Sales’ 6 month rate-of-change falls below -0.5%

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Market outlook: it’s been a terrific start to the year for stocks. What’s next

This is somewhat of a worry for the stock market. I am not extremely worried about this because the trend in Retail Sales is more important than its 6 month rate-of-change

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Heavy Truck Sales have made a new high for this economic expansion.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

This is a late-cycle sign for the bull market and economic expansion. Here’s what happens next to the S&P when Heavy Truck Sales exceeds 540k

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Notice how these are all late-cycle dates.

  1. March 1973: bull market already over
  2. September 1999: bull market has 6 months left
  3. February 2006: bull market has 1.5 years left

Conclusion: The stock market’s biggest long term problem right now is that as the economy reaches “as good as it gets” and stops improving, the long term risk is to the downside.

Economic deterioration is not significant yet, so the “bull market is over” case is not clear right now. We’re in a “wait and see the new data” mode. As long as the economic data doesn’t deteriorate significantly, the bull market case is still valid.

The end of a bull market is always very tricky to trade. The stock market can go up a lot in its final year, even if the macro economy is deteriorating. That’s why it’s better to focus on risk:reward instead of trying to time exact tops and bottoms. Even when you think the top is in, the stock market could very well surge for 1 more year.

Medium Term

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

Market outlook: it’s been a terrific start to the year for stocks. What’s next

S&P 500

The S&P 500 has “decoupled” from the 10 year Treasury yield. This has some traders on edge.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

In reality, this is completely normal and is not consistently bearish for stocks. Here’s what happens next to the S&P when it goes up more than 13% over the past 50 days, while the 10 year yield’s % change is less than -5%

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Likewise, the 10 year – 3 month yield curve continues to flatten while the S&P continues to rally.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

And once again, this is not consistently bearish for stocks, especially 6-12 months later.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Volatility

VIX continues to make new lows for this year. VIX is now below 13.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to the S&P when VIX closes below 13

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Once again, this is good for stocks 6-12 months later.

Other Indices

Since the start of January 2018, bank stocks have significantly underperformed tech stocks. This is a bit of a worry because this is how the 2000-2002 and 2007-2009 bear markets started.

  1. Cyclical stocks start to underperform first (e.g. bank stocks)
  2. High flying tech stocks outperform because every kid and their grandmother wants to make 70% a year on high-flyers like Netflix. Momentum chasing.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to the S&P when the KBW Bank Index falls more than -7% over the past 300 days while the NASDAQ goes up more than 10%.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

As you can see, this starts to become a problem for stocks 1-2 years later.

XLU (utilities sector ETF – defensive sector) is on fire. XLU is up 8 weeks in a row.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to the S&P when XLU is up 8 weeks in a row.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to XLU

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Short Term

The stock market’s short term has a slight bearish lean, but once again with the caveat that the short term is always extremely hard to predict. Focus on the medium-long term.

Tech stocks are leading the rally, and the NASDAQ has now gone up 11 of the past 12 weeks.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to the S&P when the NASDAQ goes up at least 11 of the past 12 weeks.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

There is a slight short term bearish bias for stocks over the next 1 month.

Growth stocks have significantly outperformed value stocks since January 2018. Here is the S&P 500 Value Index vs. the S&P 500 Growth Index

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to the S&P 500 when Value falls more than -1% over the past 300 days while Growth rises more than 10%.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

There is a short term bearish bias for the S&P, but nothing more.

Here’s what happens next to Value

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Here’s what happens next to Growth

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Short term forward returns for Growth are slightly worse than short term forward returns for Value. Perhaps high-flying tech stocks will lead the pullback.

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction (e.g. next 6-9 months) is more bullish than bearish.
  3. The stock market’s short term has a bearish lean due to the large probability of a pullback/retestFocus on the medium-long term (and especially the 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.

Market outlook: it’s been a terrific start to the year for stocks. What’s next

Our discretionary outlook does not reflect how we trade the markets right now. We trade based on our quantitative trading models. When our discretionary outlook conflicts with our models, we always follow our models.

Members can see exactly how we’re trading the U.S. stock market right now based on our trading models.

Click here for more market analysis

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