Market & fundamentals overview: the relentless rally continues
The U.S. stock market has thusfar refused to pullback despite many sentiment & contrarian 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): 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.
With that being said, a significant macro "concern" highlighted in the media recently is that lack of earnings growth. This could be seen as a sign that the stock market's rally is based on hope rather than reality.
But as Jason demonstrated on Tuesday, this hasn't been a real reason to be bearish. Moreover, earnings are expected to increase in 2020, so perhaps this is just a temporary blip.
Meanwhile, Continued Claims has risen to the highest level since April 2018:
This is somewhat worrisome because Initial Claims and Continued Claims tend to trend higher during a recession and bear market:
The following table illustrates what happened next to the S&P 500 after Continued Claims increased to a 1 year high:
We can further narrow down the cases in which Continued Claims rose to a 1 year high, while being low (i.e. late-cycle in the economic expansion):
While I wouldn't consider this to be an outright long term bearish factor for stocks right now, it is something to watch out for. The economic expansion is late-cycle, and labor market indicators (which are extremely useful in market timing) could deteriorate at any moment. There has been no sustained deterioration yet, but this is something to watch out for over the next few months in case it does happen.
Technicals (1-3 months)
Our outlook over the next 1-3 months is 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 work our way to the bearish ones.
Bullish:
Trend & breakouts
From a pure trend following perspective, there's little reason to be bearish on global equities right now. For example, the S&P 500 is above all popular moving averages right now:
HOWEVER, it's important to remember that trend following does not work equally well across all markets, and it can go from being effective to ineffective over time. For example, the DAX is on the verge of breaking out:
However, "almost-breakouts" were not consistently bullish for DAX over the next year...
...while it was much more bullish for the S&P 500:
Mixed:
Momentum
The market's momentum is incredibly strong right now, and such strong momentum is hard to sustain indefinitely. The NASDAQ Composite has rallied 13 of the past 15 weeks:
When it did so in the past, returns over the next 2 weeks were usually bearish:
But as is the case with most momentum studies, strong momentum is usually bullish for stocks over the next year. The only real failure was in January 2000, just as the 1990s bull market ended.
As a result of the global rally in equities, the MSCI Emerging Markets Index's 14 week RSI has been pushed above 70 for the first time since early-2018:
When emerging markets' momentum became overbought, returns over the next week leaned bearish:
Bearish:
Sentiment
As Jason and I noted over the past week, the stock market has climbed over the past 2-3 months in the face of extreme sentiment.
While this is a bullish sign for stocks on a more long term basis, it was hard for the stock market to escape unscathed in the short term:
Too much, too fast
As Jason noted on Thursday, the market has gone from "split" (many winning and losing stocks) to "un-split" (mostly winners)
When most stocks surged after split market breadth, the stock market faced weakness over the next month (i.e. January 2020), but mostly surged over the next year.
Overall, the sentiment story remains the same: sentiment is extremely optimistic, which is short-medium term bearish for stocks. It doesn't matter what you look at - Smart Money/Dumb Money, Intermediate Term Optimism Index, equity Put/Call, etc.
The 50 day moving average of the % of indicators showing excess optimism - % of indicators showing excess pessimism is at the highest level since 2000:
The 3 comparable cases all led to at least a pullback:
Little volatility
The S&P 500 has now gone 62 consecutive trading days without a +/- 1% daily move (using today's CLOSE price vs. yesterday's CLOSE price).
When low volatility streaks lasted this long, the S&P's returns over the next 2 months were more bearish than random:
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): bearish
Got any questions? Feel free to contact me at [email protected]
January 11, 2020: 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