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Market outlook: is this the start of a much bigger decline?

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Summary:
With the stock market falling on trade war fears, the pullback/correction that many traders have waited for has finally arrived. Considering that this pullback is so close to the October 2018 high, many traders are wondering “is this the start of a much bigger decline, like Q4 2018?” 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 6-12 months) has a bullish lean. The stock market’s short term is neutral (last week it was short term bearish). We focus on the long term and the medium term. Long Term The stock market and the economy move in the same direction in the long

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With the stock market falling on trade war fears, the pullback/correction that many traders have waited for has finally arrived. Considering that this pullback is so close to the October 2018 high, many traders are wondering “is this the start of a much bigger decline, like Q4 2018?”

Market outlook: is this the start of a much bigger decline?

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 6-12 months) has a bullish lean.
  3. The stock market’s short term is neutral (last week it was short term bearish).

We focus on the long term and the medium term.

Long Term

The stock market and the economy move in the same direction in the long run, which is why we pay attention to macro.

U.S. macro is decent right now, which suggests that:

  1. A recession is not imminent.
  2. The risk of a big bear market decline like 2007-2009 or 2000-2002 is low right now.

This stands in contrast with Q4 2018, when macro was deteriorating from August – December 2018.

However, the U.S. economy is also in the vicinity of “as good as it gets”. This means that while the stock market can keep going up for another year, the long term risk on the downside is much greater than the long term reward on the upside.

Let’s recap some of the leading macro indicators we covered:

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.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

You can see that the deterioration right now in housing is not as severe as it was before historical recessions. Hence why this is a slight negative factor for macro.

Labor market is still a positive factor 

The labor market is still a positive factor for macro. Initial Claims and Continued Claims are still trending sideways. In the past, these 2 leading indicators trended higher before bear markets and recessions began.

Here’s Initial Claims.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

And here’s Continued Claims

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Corporate profits

Inflation-adjusted corporate profits are still trending higher. Corporate profits leads the stock market by approximately 5-6 quarters. This remains bullish for stocks in 2019.

Market outlook: is this the start of a much bigger decline?

Financial conditions

Financial conditions remain very loose and banks have not significantly tightened their lending standards. In the past, financial conditions tightened along with banks’ lending standards (i.e. trended higher) before recessions and bear markets began.

Here’s the Chicago Fed’s Financial Conditions Credit Subindex

Market outlook: is this the start of a much bigger decline?

Here’s banks’ lending standards.

Market outlook: is this the start of a much bigger decline?

Yield curve

The 10 year – 3 month yield curve has already inverted, while the 10 year – 2 year yield curve is close to inverting.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

While this may seem ominous (especially considering all the media hype around the yield curve), it’s important to remember that the yield curve tends to invert before recessions start.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

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: is this the start of a much bigger decline?

The stock market’s medium term (next 6-12 months) leans bullish. There is a theme that’s common among most of these market studies: the first pullback/correction after a very strong rally is usually not the start of a major bear market. Bull markets peak on weakened rallies that are more volatile.

Still in a short term uptrend

By one measure, the NASDAQ still remains in a prolonged short term uptrend.

Both the S&P and NASDAQ remain above their 50 day moving average this week, a prolonged streak that could soon end.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Here’s what happens next to the NASDAQ when it is above its 50 dma for 81 consecutive days.

Market outlook: is this the start of a much bigger decline?

Here’s what happens next to the S&P when the NASDAQ is above its 50 dma for 81 consecutive days.

Market outlook: is this the start of a much bigger decline?

There is a bullish bias for both indices over the next 9 months, and a slight bullish bias for the S&P over the next 2 months.

Bull traps and flat tops

Considering that the S&P today is exactly where it was at the January 2018 high, many traders are thinking “is this just a big flat top?”

Market outlook: is this the start of a much bigger decline?

Here’s what happens next to the S&P when it is within 1% of where it was 321 days ago, while still within 3% of a 1 year high (e.g. flat top from January 2018 – present).

Market outlook: is this the start of a much bigger decline?

So why isn’t this flat top consistently long term bearish? Because major historical bull market tops were usually more V shaped over a 1+ year basis.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

“Flat tops” are usually bull market continuation patterns, like the most recent case in this market study.

Market outlook: is this the start of a much bigger decline?

But what about the S&P’s bull trap? Is it normal for the S&P to make a new all-time high, and then promptly pullback?

Market outlook: is this the start of a much bigger decline?

It is normal.

Market outlook: is this the start of a much bigger decline?

Breadth

Various breadth indicators are starting to weaken as the stock market falls. For example, the NYSE McClellan Summation Index has fallen below 730 for the first time in 2 months.

Market outlook: is this the start of a much bigger decline?

Here’s what happens next to the S&P when the NYSE McClellan Summation Index falls below 730 for the first time in 2 months.

Market outlook: is this the start of a much bigger decline?

While the NASDAQ has rallied over the past 3 months, the % of NASDAQ stocks above their 50 dma has been trending downwards.

Market outlook: is this the start of a much bigger decline?

Is this a bearish breadth divergence?

Here’s what happens next to the NASDAQ when it rallies more than 5% in the past 56 days while the % of NASDAQ stocks above their 50 dma falls more than -34%

Market outlook: is this the start of a much bigger decline?

This is rare, but not consistently bearish. Why not?

Because the % of NASDAQ stocks above their 50 dma closely mirrors the NASDAQ’s distance from its 50 dma. When the NASDAQ first rallies after a big decline, it goes very high above its 50 dma. Then as the NASDAQ’s rally inevitably slows down (it can’t go up at a rate of 5% per month forever), it gets closer to its 50 dma. Hence the % of NASDAQ stocks above their 50 dma falls.

Market outlook: is this the start of a much bigger decline?

This is a normal feature of strong medium term rallies like the one we’ve seen from January-April.

The same thing applies to the S&P’s “deteriorating breadth”.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Sentiment

AAII Neutral % is finally starting to fall after remaining high throughout this entire rally.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Here’s what happens next to the S&P when AAII Neutral falls below 35% for the first time in 2 months.

Market outlook: is this the start of a much bigger decline?

Mostly bullish for stocks 2-12 months later.

Short Term

*The stock market’s short term is always extremely hard to predict. This is because too many random and unpredictable factors impact the short term (e.g. trade war news), no matter how much conviction you have.

While the stock market’s short term was bearish over the past few weeks, the short term is now neutral. Perhaps the stock market will fall for a few more days on more trade war news, but remember that this is the first pullback in a very strong rally. The first pullback usually isn’t the end.

Momentum

After a long streak of strong momentum, momentum is weakening. The S&P’s 14 daily RSI fell below 45 on Thursday for the first time in 4 months.

Market outlook: is this the start of a much bigger decline?

Historically, this was mostly bullish for the S&P over the next 1 month.

Market outlook: is this the start of a much bigger decline?

Put/Call

The Equity Put/Call ratio spiked on Friday to its highest level since December.

Market outlook: is this the start of a much bigger decline?

Market outlook: is this the start of a much bigger decline?

Historically, the forward returns were mostly random up to 2 months later. You can see a clear dichotomy in the 1 month forward max drawdowns:

  1. Either the max drawdown over the next 1 month was very large (e.g. -5%), or…
  2. The stock market went straight up from here (i.e. no drawdown).

Most market studies consistently demonstrate “red” max drawdowns.

Short term moving average

The S&P’s 20 day moving average fell on Wednesday for the first time in more than 3 months.

That’s the end of a very steady short term uptrend. (The 20 dma can be used to measure short term trends).

Market outlook: is this the start of a much bigger decline?

Historically, this was mostly bullish for the S&P over the next 1 month and 3 months.

Market outlook: is this the start of a much bigger decline?

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. When our discretionary outlook conflicts with our models, we always follow our models.

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 6-12 months) leans bullish
  3. We don’t predict the short term because the short term is always extremely random, no matter how much conviction you think you have. Focus on the medium-long term.

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

Market outlook: is this the start of a much bigger decline?

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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