Market Outlook: Stock Market Is Bouncing After Being Extremely Oversold

Net Earnings Revisions are solidly negative for the first time in 2 years. Net Earnings Revisions turns negative before economic recessions and equity bear markets begin. With many false signals, negative Net Earnings Revisions is a necessary but not sufficient requirement for bear markets and economic recessions.

This “necessary but not sufficient requirement for bear markets” is now a long term bearish sign.

Source: Yardeni

The housing sector is a key leading indicator for the U.S. economy. Housing has been deteriorating since summer 2018.

Source: FRED

*Granted, both of these housing indicators have several false SELL signals. But this late in the economic expansion, the chance of a false signal is less likely.

Based on the current rate of economic data, a recession right now is extremely unlikely. A recession is possible at the end of 2019 or early-2020 (which would significantly exacerbate the stock market’s decline). This is not a definitive prediction – it is a moving target as new data comes along.

The current economic expansion is tied for being the longest economic expansion in history. The permabears will tell you “the economy CANNOT keep growing because this expansion has been too long”. This is factually false.

Economic expansions have gotten longer and longer over the past 150 years. Recessions below in blue.

As you can see, “how long an economic expansion lasts” keeps setting new records. Expansions do not die of old age.

Similarly, valuations aren’t very useful for trading. The following chart plots the S&P 500’s valuations against its 2 year forward returns. Valuations explain only 6% of the stock market’s forward returns (R squared = 0.06).

Remember: valuations have been consistently elevated over the past 25 years. Anyone who sold stocks just because “stocks are overvalued!” would have missed out on massive gains over the past few decades.

Why have valuations been consistently elevated? Because inflation and interest rates today are much lower than where they were 30, 40, 50 years ago (and no, inflation going from 2% to 3% doesn’t count as “SOARING INFLATION”). The following chart demonstrates the inverse relationship between inflation and average valuations.

Here’s the more worrisome point right now:

Lagging economic indicators (GDP and earnings growth) have been very strong while stocks tanked in Q4 2018. Disconnect between the economy and stock market is normal during a bull market, but not this level of disconnect.

Earnings growth has exceeded 15% this year while the S&P fell more than -6%

Here’s every calendar year this happened, from 1928 – present

As you can see, the three historical cases were all long term bearish cases.

At the end of a bull market, leading economic indicators will deteriorate (which they have since August 2018), then the stock market will top while lagging indicators are still very strong (e.g. GDP and earnings growth).

In conclusion

While the bull market and economic expansion certainly can continue, the risk:reward doesn’t favor bulls. Risk:reward is more important than picking exact tops and bottoms.

Medium Term

Our medium term outlook (next 3-6 months) still leans bullish. Here’s the most likely medium term path.

Here’s a less likely, but still possible path.

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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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