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Will the stock market become more volatile?

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Troy
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Summary:
If you feel like the stock market has been quiet recently, then you’d be right. The S&P 500 has gone nowhere over the past 8 days, with very little intraday volatility. Go here to understand our fundamentals-driven long term outlook. Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day. *Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are blindly “guessing” the future. Low volatility Volatility has been notably lacking in the stock market recently. (Living in Australia, the U.S. CLOSE is my morning. Waking up and seeing the S&P close +3 or -3 points each day

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If you feel like the stock market has been quiet recently, then you’d be right. The S&P 500 has gone nowhere over the past 8 days, with very little intraday volatility.

Will the stock market become more volatile?

Go here to understand our fundamentals-driven long term outlook.

Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day.

Will the stock market become more volatile?

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are blindly “guessing” the future.

Low volatility

Volatility has been notably lacking in the stock market recently. (Living in Australia, the U.S. CLOSE is my morning. Waking up and seeing the S&P close +3 or -3 points each day almost makes me want to go back to sleep).

Such low volatility was very common in 2017. As you may call, the stock market grinded higher relentlessly in 2017. You may not want to be long, but don’t short a dull market.

Will the stock market become more volatile?

Here’s what happens next to the S&P when its daily range is less than 0.5% for at least 6 of the past 8 days, while fluctuating within a narrow 1% range over the past 8 days.

Will the stock market become more volatile?

As you can see, this is mostly bullish for stocks 3-12 months later. It’s interesting that this almost never happened before 1994 (pre-internet era).

Here’s what happens next to VIX.

Will the stock market become more volatile?

VIX has a strong bullish lean over the next 2 months. Perhaps it’s time to go long VIX?

Initial Claims

We had been worried about the upwards trend in Initial and Continued Claims over the past 2-3 months. Those fears have now been put to rest. Initial Claims made a new low for this economic expansion cycle, and is still trending downwards.

Will the stock market become more volatile?

This is important because Initial Claims trended upwards before historical bear markets and economic recessions began.

Will the stock market become more volatile?

Here’s what happens when the buy the S&P only if Initial Claims is below its 1 year moving average.

Will the stock market become more volatile?

As you can see, this underperforms buy and hold due to the false SELL signals, but the drawdowns are also much lower.

Indecision

While large caps and tech stocks are leading the rally, finance stocks and small cap stocks continue to lag. Here’s the Russell 2000 (small caps index) chopping up and down around its 200 day moving average.

Will the stock market become more volatile?

Is this a bearish sign of indecision?

Here’s what happens next to the S&P when the Russell crosses above and below its 200 dma at least 7 times in the past 50 days.

Will the stock market become more volatile?

Will the stock market become more volatile?

Here’s what happens next to the Russell 2000.

Will the stock market become more volatile?

You can see that the stock market’s 1 month forward returns lean bearish, and the 1 year forward returns are less bullish than random. (Random is not 50/50).

Will the stock market become more volatile?

Tech vs banks

The S&P 500 tech sector has made new all-time highs, which is bullish in terms of momentum. However, the S&P 500 financials sector is lagging badly. (Yield curve inversion = bad for banks’ profits because banks borrow short term and lend long term).

While the S&P tech sector has made new highs, the financial sector is still far below its January 2018 high.

Will the stock market become more volatile?

Will the stock market become more volatile?

Here’s what happens next to the S&P when the tech sector is at a 1 year high while the financial sector is more than -7% below its 1 year high.

Will the stock market become more volatile?

Here’s what happens next to the tech sector.

Will the stock market become more volatile?

Here’s what happens next to the finance sector

Will the stock market become more volatile?

Mostly random on all time frames, but it does appear that tech continues to outperform finance over the next 1 month.

What worked in the past stops working: things that have no upper bound

I see this quite often in financial media and social media:

  1. “The stock market’s valuations are TOO HIGH. It just can’t get any better!”
  2. “Consumer Confidence is TOO HIGH. It just can’t get any better!”
  3. “Unemployment is TOO LOW. It just can’t go any lower!”

Reality: these valuation and economic indicators have no upper or lower bound. (Except in the case of Unemployment – the lower bound is obviously 0%). Just because valuations or consumer confidence always peaked at XYZ in the past, doesn’t mean that they can’t go higher this time before peaking.

Here’s an example. This is the Shiller P/E ratio.

Will the stock market become more volatile?

You can see that it consistently peaked at approximately 22 from 1900 – 1994. Selling when Shiller P/E reached 22 would have enabled an investor to avoid significant bear markets.

But along comes 1994.

Will the stock market become more volatile?
  1. Bear in 1994: “valuations are too high! Can’t go any higher! Stocks will crash!”
  2. Bear in 1995: “valuations are too high! Can’t go any higher! Stocks will crash!”
  3. Bear in 1996: “valuations are too high! Can’t go any higher! Stocks will crash!”
  4. Bear in 1997: “valuations are too high! Can’t go any higher! Stocks will crash!”
  5. Bear in 1998: “valuations are too high! Can’t go any higher! Stocks will crash!”
  6. Bear in 1999: “valuations are too high! Can’t go any higher! Stocks will crash!”
  7. Bear in 2000: “valuations are too high! Can’t go any higher! Stocks will crash!”

Yes, “eventually” the bear is right. But “eventually” can take a long time. And even after the stock market crashed in the dot-com bubble, valuations never returned to prior lows nor did the stock market return to where it was in 1994.

Things that worked in the past stop working if there is no upper bound.

Here’s what happens if you sell the S&P when the Shiller P/E ratio reaches 22, and buy the S&P when Shiller P/E falls to 10.

Will the stock market become more volatile?

You can see that someone who used this strategy beat buy and hold from 1923 – 1994, and since then has lagged significantly.

Here’s what happens when you sell the S&P when the Shiller P/E ratio reaches 22, and buy the S&P when Shiller P/E falls to 15.

Will the stock market become more volatile?

You can see that someone who used this strategy beat buy and hold from 1923 – 1994, and since then has lagged significantly. Are valuations extremely high right now? Yes. Will the stock market “eventually” crash? Yes. But if you use this as a timing tool, good luck.

Remember: avoid 20/20 hindsight bias. Leave that to financial gurus who want to show you how smart they are (“see, I was right!” after being wrong 5 years in a row). You do not have the luxury of 20/20 hindsight bias as a trader or investor.

Read Is this rally all JUNK? Examining the short term bearish case

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 mostly mixed, although there is a bullish lean.
  3. We don’t predict the short term because the short term is always extremely random. At the moment, the short term does seem to have a slight bearish lean.
  4. In summary, 12-24 months = bearish, 12 months = neutral, 6-9 months = slightly bullish.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.

Will the stock market become more volatile?

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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