Proceed With Caution Going Into 2019

With the start of a new year, some of these market studies are going to look at the stock market in 2018 and see what that implies for 2019.

Let’s determine the stock market’s most probable medium-term direction by objectively quantifying technical analysis.

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

The Rising U.S. Dollar Versus Stocks

Contrary to popular belief, a rising U.S. dollar isn’t consistently bearish for stocks.

1. Sometimes stocks go up when the USD rises
2. Sometimes stocks go sideways when the USD rises
3. Sometimes stocks go down when the USD rises.

However, when stocks do fall while the USD goes up, stocks tend to fall more in the future.

Here’s what happens next to the S&P 500 when the S&P falls during a calendar year while the U.S. dollar Index goes up:

You can see the stock market’s bearish tendency over the next 2 months.

Another Volatile Day

It was another volatile day for the stock market. The S&P gapped down more than -1.5% but managed to close higher than the previous day’s close.

From 1900 – present, such a large gap down and then an intraday reversal has only happened three other times.

With n = 3, I wouldn’t read too much into this.

XLY:XLP

The XLY:XLP ratio (consumer discretionary vs. consumer staples) tends to move in the same direction as the U.S. stock market. But when this ratio moves in a different direction from the S&P 500, it’s a long-term warning sign.

The S&P tanked in December 2018 while the XLY: XLP ratio went up.

Here are XLY’s largest holdings:

Here are XLP’s largest holdings

Here’s what happens next to the S&P when the S&P falls over the past calendar month, while the XLY: XLP ratio goes up:

*Data from 1998 – present

All 3 of these cases happened in bear market years.

Banks

While the S&P fell -6% from the start to end of 2018, bank stocks fell much more. This is the KBW Bank Index

Here’s what happened next to the S&P when KBW fell more than -15% over the past 12 months while the S&P fell less than -7%:

While there are 2 warning signs (2000 and 2007), the rest were bullish (2009, 2011, 2016).

Emerging markets

When the U.S. stock market falls, emerging markets tend to fall even more (EM is more volatile). But when the U.S. stock market falls and EM falls less, that is usually a medium term or long term bullish sign (selling exhaustion).

While the U.S. stock market tanked in Q4 2018, emerging markets didn’t fall significantly because they had already cratered from Q1 – Q3 2018.

Here’s what happened next to the S&P when EEM (emerging markets ETF) falls more than -8% over the past 3 months while the S&P falls more than -13%:

Interestingly enough, this is a long-term bullish sign.

I wouldn’t see it as a long-term bullish sign because both of these happened after a massive 50% decline, but I do see it as a medium-term bullish sign.

Silver and gold

Precious metals have rallied over the past few months. Silver has broken above its 200 dma for the first time in more than half a year.

Such breakouts after a long uptrend:

1. Can lead to more upside in the short term
2. Are usually medium-long term bearish (because long downtrends don’t usually happen in bull markets).

Here’s what happened next to silver when it closed above its 200 dma for the first time in 6 months.

You can see how silver leans bearish over the next 3-6 months

Seasonality

The stock market’s seasonality in January is moderately bullish. Seasonality factors are of secondary importance, so take this with a grain of salt.

*Seasonality was completely flipped on its head in 2018.

Q1 2019 GDP

Just a heads up: Q1 2019 GDP will probably be weak. According to FRED, this is due to “residual seasonality” (Q1 is almost always weak). This is why we focus on leading economic indicators instead of lagging indicators like GDP.

Conclusion

Here is our discretionary market outlook:

1. The U.S. stock market’s long-term risk: reward is no longer bullish. This doesn’t necessarily mean that the bull market is over. We’re merely talking about long-term risk: reward. Since no one can consistently and accurately predict every top & bottom, it’s better to focus on risk: reward than trying to catch exact tops and bottoms.
2. The medium-term direction is still bullish (i.e. trend for the next 6 months). However, if this is the start of a bear market, bear market rallies typically last 3 months. They are shorter in duration.
3. The stock market’s short-term has a slight bearish lean. Focus on the medium-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.

Our discretionary outlook is not a reflection of how we’re trading the markets right now. We trade based on our quantitative trading models.

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