Market & fundamentals overview: new year and new decade
The U.S. stock market is starting a new decade near all-time highs. Momentum remains strong, but many of our core indicators are at extremes. Here's my market outlook:
- Long term risk:reward (e.g. 1-5 year basis) doesn’t favor bulls. Valuations are high, but valuations can remain high for years before stocks crash.
- Fundamentals (6-12 months): still bullish because there is no significant U.S. macro deterioration.
- Technicals (1-3 months): neutral/bearish
Fundamentals (6-12 months)
The economy and the stock market move in the same direction in the long term. Hence, leading economic indicators are also long term leading indicators for the stock market.
Overall, there is no significant U.S. economic deterioration right now. This is bullish for the stock market on a 6-12 month time frame. The main weak points in U.S. macro revolve around trade, manufacturing, and the yield curve. For more details and charts, please see the bottom of this post. In addition, here are some other important fundamental points that we covered this week:
- Goldman Sachs U.S. Financial Conditions Index demonstrates that financial conditions are loosening. In the past, this was quite bullish for stocks on a 6-12 month forward basis.
- The yield curve is steepening, which is a bearish factor for macro.
- The ISM Manufacturing PMI continues to deteriorate, but is now at a point in which "it's so bad that it's not consistently bearish anymore". When the ISM manufacturing PMI fell to 47.2 in the past, returns over the next 3 months were mixed, but after that turned bullish. Remember: manufacturing is not a leading sector of the economy.
Technicals (1-3 months)
Our outlook over the next 1-3 months is mixed/bearish. Momentum is strong (more useful 6-12 months later), but sentiment is extremely high (more useful 1-3 months later). Let's start with the bullish stats, and then we'll look at the bearish ones.
Bullish:
Economy & consumers
Jason demonstrated on Friday that while stocks have rallied, Consumer Confidence and Consumer Expectations about the future have not improved:
When stocks rallied significantly over a multi-month period to all-time highs while Consumer Expectations worsened, the S&P's returns over the next 6-12 months were quite bullish:
Momentum and breadth thrusts
The U.S. stock market remains in an uptrend despite its decline on Friday. With the overall index and many individual names making new 52 week highs as recently as Thursday, the NASDAQ New Highs/Lows ratio surged to the highest level since early-2018:
As you might expect, such breadth thrusts in the past usually led to more gains for the NASDAQ over the next month:
And it's not just U.S. markets that are seeing strong breadth readings. Emerging markets such as Brazil have surged in recent months, pushing the % of Bovespa Index members above their 200 dma to more than 95%.
Such strong participation in the past could lead to a short term pullback, but typically led to more gains for the Bovespa Index over the next year.
Bearish:
Sentiment
At the risk of sounding repetitive, many of our core sentiment indicators are demonstrating excessive optimism, which is a short term bearish factor for stocks right now. This has pushed the 20 day average in the % of our indicators showing excessive optimism - % of our indicators showing excessive pessimism to 0.41, which is rarefied territory.
Such extreme readings have only occurred a few times in the past 20 years, and usually led to weak returns over the next several months:
And as Jason noted on Thursday, options traders are really pushing the envelope on bullish options strategies.
Such aggressiveness didn't usually pay off, with the S&P struggling over the next 1-3 months:
High beta vs. low volatility
As Bloomberg noted, high beta stocks significantly outperformed low volatility stocks in Q4 as investors abandoned safe havens and chased risk.
Here's the difference between the S&P 500 High Beta Index's return over the past 60 days - the S&P 500 Low Volatility Index's return over the past 60 days:
When high beta rallied more than 18% over the past 60 days while low volatility rallied less than 3%, the S&P's returns over the next few weeks were quite weak:
Meanwhile, the S&P 500 High Beta Index usually underperformed the S&P 500 Low Volatility Index over the next week:
Seasonality
As Jason pointed out on Thursday, seasonality is a somewhat short term bearish factor for stocks. Years which saw the S&P 500 close at an all-time high in December were typically followed by weakness in the first 1-2 months of the next year (i.e. January-February).
I wouldn't consider seasonality to be an extremely important factor for the stock market due to its high failure rate, but this is a minor bearish factor for stocks right now.
To recap
- Long term risk:reward doesn’t favor bulls.
- Fundamentals (6-12 months): still bullish because there is no significant U.S. macro deterioration.
- Technicals (1-3 months): neutral/bearish
Got any questions? Feel free to contact me at [email protected]
January 4, 2019: Fundamentals Overview Part 2
This is Part 2 of a weekly update on the U.S. stock market's long term fundamentals. Part 1 can be found here.
Fundamentals 1-3 years: market timing
I don't try to predict the future of the economy. Plenty of very smart people try, and when you add up the successes+failures, the results are usually no better than a 50/50 coin toss. That's why I focus instead on leading economic indicators. Look at what has already happened instead of predicting the future.
The economy drives corporate earnings, which drives the stock market in the long term. As a result, bull markets usually coincide with economic expansions, and big bear markets usually coincide with recessions.
Since the stock market tends to peak before recessions begin, we need to look at leading economic indicators, which also deteriorate before recessions begin. This doesn’t mean that the stock market’s exact top cannot occur before macro starts to peak. This happened in January 1973, when the stock market peaked a few months before macro started to deteriorate. However, the biggest part of bear markets always occur after macro has deteriorated significantly.
Here’s a brief summary of the leading and most important economic indicators I track, some of which I include in the Macro Index. The ones that are included in the Macro Index have an asterisk beside them**
Bullish factors right now
- Labor market**
- Housing**
- Financial conditions
- Heavy Truck Sales**
- Inflation-adjusted retail sales
Neutral/bearish factors right now
- Corporate profits
- High yield spreads
Bearish factors right now
- Yield curve**
- Manufacturing**
Bullish factors
Labor market
Labor market indicators do not show any significant deterioration right now.
Initial Claims
Initial Jobless Claims measures the number of jobless claims filed by people who are seeking to receive jobless benefits. In other words, this measures the number of people who are recently unemployed. This economic indicator continues to trend sideways. In the past, Initial Claims trended higher before a recession began. This is still a positive point for macro, but watch out over the next few months in case Initial Claims trends upwards because Initial Claims is very low right now.
Continued Claims
Continued Jobless Claims measures the number of people who are still filing jobless claims (past the initial claim). This economic indicator continues to trend sideways. In the past, Continued Claims trended higher before a recession began. This is still a positive point for macro, but watch out over the next few months in case Continued Claims trends upwards because Continued Claims is very low right now.
Housing
Housing market indicators do not show significant deterioration right now.
Housing Starts
Housing Starts measures the number of new homes that are starting to be built in the U.S., from the time of first excavation. This figure is trending sideways right now. In the past, Housing Starts trended downwards before recessions began. This is a positive for macro.
Building Permits
Building Permits are trending upwards right now. In the past, Building Permits trended downwards before recessions began. This is a positive for macro.
New Home Sales
New Home Sales are trending upwards right now. In the past, New Home Sales trended downwards before recessions began. This is a positive for macro.
Financial Conditions
Indicators related to financial conditions remain relatively loose. This is a positive for macro.
Chicago Fed Financial Conditions Credit Subindex
The Chicago Fed Financial Conditions Credit Subindex remains quite low. Looking at the bigger picture, the Credit Subindex is trending sideways right now. In a credit-driven economy, the Credit Subindex tends to trend solidly upwards (i.e. tighten) before a recession begins.
Loans
The Delinquency Rate on All Loans continues to trend downwards. In the past, the Delinquency Rate trended higher before a recession began. This is a positive for macro.
Banks’ lending standards
Banks are starting to tighten their lending standards right now. In the past, lending standards tightened for several quarters before a recession began, causing the Net Percentage of Banks Tightening Standards to trend higher. This was a positive for macro, but is now something that bulls should watch out for in case lending standards continue to tighten.
Inflation-adjusted retail sales
Inflation-adjusted Retail Sales continue to trend higher. In the past, inflation-adjusted Retail Sales trended sideways before recessions began. This is a positive for macro.
Neutral/bearish factors
Corporate Profits
Figures related to corporate profits suggest that the economic expansion is definitely late-cycle.
Unit Profits
Unit Profits continue to trend downwards, which is typically what happens in the second half of an economic expansion cycle. However, this indicator is not a timing tool. Unit Profits can fall for years before a recession begins.
Corporate Profits
Inflation-adjusted corporate profits are trending sideways. In the past, inflation-adjusted corporate profits trended downwards for several quarters before recessions began. If corporate profits start to trend downwards, this will be a negative for macro in 2020.
High yield spreads
From September 2018 – present, high yield spreads on the lowest rated bonds have been trending higher while the stock market has made higher highs. This is a necessary but not sufficient condition for bear markets and recessions. In the past, high yield spreads on these bonds trended higher before bear markets and recessions began. Meanwhile, high yield spreads in general are still trending lower. Overall, this is a neutral factor for stocks right now.
Bearish factors
Yield Curve
Both the popular 10 year - 2 year and 10 year - 3 month sections of the yield curve were recently inverted, and are now trending higher. Here's the 10 year - 3 month yield curve, which historically has been a better market timing indicator than the 10 year - 2 year yield curve:
Overall, the yield curve is a bearish factor for macro right now because inversions & post-inversion steepenings tend to occur 1-2 years before recessions and bear markets begin. HOWEVER, the yield curve is merely one of many factors to consider, and it is not flawless.
Manufacturing
The manufacturing sector remains one of the weakest parts of the U.S. economy, and this is probably related to the trade war. For example, the ISM Manufacturing PMI is currently below 50, which signals contraction. This is a bearish factor for our Macro Index.
Macro Index
The Macro Index includes:
- New Home Sales
- Housing Starts
- Building Permits
- Initial Claims
- Continued Claims
- Heavy Truck Sales
- 10 year - 3 month Treasury yield curve
- S&P 500's 10 month average
- ISM Manufacturing PMI
- Margin Debt
- Inflation