Market Outlook: Stock Market Is Bouncing After Being Extremely Oversold

Last week I said that this is the stock market’s most likely path:

Source: Investing.com

And so far, the S&P is playing out to this case. The S&P continues its bounce, with the first real resistance at the 38.2% fibonacci retracement.

Source: Investing.com

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 stock market’s medium term leans bullish (i.e. next 3-6 months).
  3. The stock market’s short term has a slight bearish lean.

We focus on the long term and the medium term. Let’s go from the long term, to the medium term, to the short term.

Long Term

While the bull market could very well still last until Q2 2019, the long term risk:reward no longer favors bulls. Past a certain point, risk:reward is more important than the stock market’s most probable long term direction.

*I do not define “bear markets” via the traditional -20% decline. I define “bear markets” as 33%+ declines that last >1 year. E.g. 2007-2009, 2000-2002, 1973-1974, 1968-1970.

Some leading indicators are showing signs of deterioration. The usual chain of events looks like this:

  1. Housing – the earliest leading indicators – starts to deteriorate. This has occurred already
  2. The labor market starts to deteriorate. Meanwhile, the U.S. stock market is in a long term topping process. We are here right now.
  3. The labor market deteriorates some more, while other economic indicators start to deteriorate. The bull market is definitely over.

We are currently in phase 2. Let’s look at the data besides our Macro Index

The Goldman Bull/Bear Indicator determines if the economy is “as good as it gets”. And right now, it is very good indeed.

However, the economy and stock market do not fall just because “the economy is as good as it gets”. Record low unemployment can get lower, and record high valuations can get higher. The economy doesn’t “have to” deteriorate just because unemployment is low. The stock market doesn’t “have to” fall just because valuations are high.

That’s why we focus on leading indicators to identify turning points in the economy and stock market.

Unit profits have been trending downwards since 2014, which marked the halfway point of the bull market and economic expansion. This is a late-cycle sign.

The more important labor market is showing a few signs of economic deterioration, with Initial Claims trending sideways. This deterioration is not significant, but watch out if it persists over the next few weeks and months.

Source: FRED

The unemployment rate went up despite Friday’s amazing jobs report. How can the unemployment rate go up when the economy is adding so many jobs?

  1. The # of jobs added and the unemployment rate come from 2 different surveys.
  2. More importantly, the unemployment rate is a ratio of the “unemployed” / labor population. When the economy is red hot (i.e. right now), many discouraged workers join the “unemployed” line and start searching for jobs again. So when the economy adds a lot of new jobs but the unemployment rate rises, it’s because many more people are encouraged by the strong economy to start searching for work again. This is why unemployment rate tends to flatten out towards the end of an economic expansion.
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Disclosure:

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

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