Market Outlook: Is The Stock Market Making A Head And Shoulders?

The stock market’s relentless rally continues. The S&P 500 (excluding dividends) is just 1% from a new all-time high, while the S&P 500 Total Return Index (including dividends) is already at an all-time high. While the chart may “look like” a bearish head-and-shoulders pattern, these patterns are only clear with the benefit of 20/20 hindsight. Too many potential head-and-shoulders patterns don’t work out in real-time (i.e. false bearish signals). And by the time you wait for a “bearish confirmation” break of the neckline, the S&P is already down -20%.

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 medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.
  3. The stock market’s short term leans bearish

We focus on the long term and the medium term.

Long Term

While the bull market could keep going on, the long term risk:reward no longer favors bulls. Towards the end of a bull market, risk:reward is more important than the stock market’s most probable direction over the next 12+ months

A few 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. The labor markets have not deteriorated significantly yet. 
  3. Other economic indicators start to deteriorate. The bull market is definitely over, and a recession has started. A U.S. recession is not imminent right now

*All economic data charts are from FRED

Labor market

Initial Claims is trending sideways/downwards while Continued Claims is trending sideways.

In the past, these 2 figures trended higher before bear markets and recessions began.

You don’t need to be worried about the most recent drop in Job Openings.

Month-to-month changes in economic data are notoriously noisy, which is why we focus on the trend.

Here’s what happens next to the S&P when Job Openings falls more than -7% in a single month.

The labor markets could deteriorate in the coming months, so pay close attention to the data as it is released. For example, the KC Fed Labor Market Conditions Index is trending downwards. (This is not yet a long term bearish sign for stocks. In the past, this index fell to zero when bear markets and economic recessions began.)

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