The stock market bounced this week after it tanked last week on trade war news. Is the stock market making a V-shaped recovery? Probably not.

1. Technicals (short term, next 1-3 months): mixed. If I had to assign a probability to a V-shaped recovery, it would be < 40%
2. Technicals (medium term, next 6-9 months): mostly bullish
3. Fundamentals (long term): no significant U.S. macro deterioration, but the long term risk:reward doesn’t favor bulls.

Technicals: Short Term & Medium Term

*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

6% corrections

Traders usually define “corrections” as S&P declines that exceed 10%. I usually define them as declines that exceed 6%, because most 6%+ declines have at least 2 DOWN waves.

*I’m not a big fan of “waves” because there is no clear way to define a “wave”, but there is some validity to this concept.

The current decline has only seen 1 wave, which suggests that there is more selling ahead. Here are some examples from this bull market.

Here’s the S&P from 2018-present

Here’s the S&P from 2015-2016 (we exclude 2017 because there was no correction that year).

Here’s the S&P from 2013-2014

Here’s the S&P from 2011-2012

Here’s the S&P from 2009-2010

In this bull market, 11 corrections have seen multi-waves and 3 have been V-shaped. This ratio holds true in previous bull markets as well (e.g. 2003-2007, pre-2000). If I was forced to assign a specific probability to another DOWN leg, I would probably say probably 2/3

But keep in mind that the short term is always very hard to predict, no matter how much confidence you have in your predictive ability. Too many unpredictable events impact the short term. The news-driven environment doesn’t help either.

Patterns

The stock market reversed this week, forming something akin to a “hammer” pattern. This kind of weekly reversal pattern occurred during the first leg of other market selloffs.

When this happened in the past, the S&P often made lower lows over the next 2 weeks. The following table looks at what happened next to the S&P when the weekly LOW is more than -3% below last week’s LOW (i.e. intraweek plunge), but this week’s CLOSE is above last week’s LOW (recovery later in the week).

S&P was weak over the next 2 months.

Gold

This was a volatile week for markets. While stocks tanked, bonds and gold rallied in the face of extremely optimistic sentiment. As a result, the S&P:gold ratio plunged more than -9% over the past 2 weeks.

*This ratio typically declines during a correction, see 2016 and 2018.

When this happened in the past, the S&P was weak over the next 2 months. This has also been particularly bearish for the S&P over the next 2 weeks since 1987.

On the other hand, this isn’t particularly good for gold either. Gold’s 1 month forward returns are weak.

However, I want to remind investors and traders that there is no guarantee that the stock market will make another DOWN leg. The data is not irrefutably short term bearish right now. There are other short term bullish factors to consider.

Back-to-back volatility spikes

CNBC published an interesting article that looked at back-to-back volatility spikes.

VIX spikes tend to occur when the stock market makes a correction. The current correction comes just 2 months after another correction in May.

Back-to-back corrections (and back-to-back VIX spikes) are uncommon. They’re mostly bullish for the S&P over the next 2-3 months….

…. and bearish for VIX.

The signal date in the above charts (8/5/2019) was on Monday. If we add another 4 days (to move the signal date to 8/9/2019), it is still bullish for the S&P.

Volume

As is the case in most stock market declines, volume surged. SPY’s volume increased than more than 150% from 2 weeks ago. So much for a summer vacation.

When volume surged this much, this quickly in the past, the S&P mostly rallied over the next 2 weeks.

Yield

Bond prices continue to rally, even though sentiment and momentum have been “too high” for weeks. This happens from time to time – no indicator is perfect, and when a trend gets going it can seem unstoppable for a while. Hence the momentum effect.

The following is a weekly chart for the 10 year Treasury yield.

The 10 year yield’s weekly RSI has been below 30 for 8 of the past 11 weeks. This demonstrates the phrase “oversold can become even more oversold, and overbought can become even more overbought”.

Nevertheless, we seem to have hit an extreme scenario in which a bottom is either already here, or is very close.

In the past, rising bond yields have not been bearish for the S&P:

Trends: medium term

The S&P’s long term trend (200 day moving average) has been in a consolidation for months.

There are many different ways to define the phrase “200 day moving average has gone nowhere”. One such way is to look at the 200 day moving average’s standard deviation.

1. When the standard deviation is low, it means that the 200 day moving average isn’t fluctuating significantly.
2. When the standard deviation is normal or high, it means that the 200 dma is going up or down.

The 200 dma’s standard deviation has been below 1% of the S&P’s value for 78 consecutive days. That’s a long streak.

Similar periods of trendless markets mostly saw gains over the next year.

Sentiment

Due to the stock market’s rapid decline last week, various sentiment indicators plunged. For example, the AAII Bull-Bear spread fell below -26% (26% more bears than bulls).

Sentiment readings this low were mostly bullish for the S&P after 1 month.

Gold’s momentum

And lastly, gold’s weekly RSI (momentum indicator) is incredibly high. Currently > 80.

In the past, this wasn’t good for gold over the next few weeks.

Fundamentals (is it a bull market or a bear market?)

Will the bull market resume after this correction? That depends on the economy. The stock market & economy move in the same direction in the long run.

1. If the economy continues to improve over the next few months, then the stock market’s rally will probably continue into 2020.
2. But if the economy deteriorates significantly over the next few months, then we will be long term bearish for 2020.

There are various pockets of macro weakness right now, but there is no significant deterioration. Absent significant deterioration, stocks tend to go up. Let’s recap some of the leading macro indicators we covered by beginning with the bad news:

Housing is still a weak point

Housing – a key leading sector for the economy – remains weak. Housing Starts and Building Permits are trending downwards while New Home Sales is trending sideways. In the past, these 3 indicators trended downwards before recessions and bear markets began.

I am not extremely worried about the weakness in housing right now. But if this deterioration continues for another few months, then I would be much more worried.

Yield curve and its accompanying recession probability models

Many popular recession probability models are based on the yield curve. And since the yield curve is mostly inverted, most of these recession probability models are long term bearish right now.

The New York Fed’s Recession Probability Model has now been above 30% for 2 months in a row.

In the past, this wasn’t too good for stocks over the next 6-12 months.

Copper

Copper made a 2 year low this week.

Many traders like to use “Dr. Copper” as a barometer for the global economy. We’ve examined this in the past, and usually came to the conclusion that:

1. Copper isn’t terrific for understanding the U.S. economy and stock market. (It’s better to use economic data to understand the U.S. economy than to use market data to understand the U.S. economy).
2. Copper is more useful for understanding ex-U.S. economies and stock markets, particularly those in emerging markets that are more infrastructure-dependent.

Anyways, here’s what happened next to the S&P when copper fell to a 2 year low. Forward returns over the next few weeks were poor.

Now onto the good news.

Labor market is still a positive factor 

The labor market is still a positive factor for macro. Initial Claims and Continued Claims are trending sideways. In the past, these 2 leading indicators trended higher before bear markets and recessions began.

Financial conditions

Financial conditions remain very loose. In the past, financial conditions tightened before recessions and bear markets began.

Here’s the Chicago Fed’s Financial Conditions Credit Subindex

Here’s banks’ lending standards. Whereas lending standards remain loose today, they tightened significantly before the previous 2 bear markets and recessions.

Delinquency Rates

Delinquency rates continue to trend downwards. In the past, this indicator trended upwards before recessions and bear markets began.

Heavy Truck Sales

Heavy Truck Sales is still trending upwards. In the past, Heavy Truck Sales trended downwards before recessions and bear markets began.

Retail Sales

Inflation-adjusted Retail Sales are still trending upwards. This is different from the previous 2 bear markets and recessions, which were preceded by flattening real Retail Sales.

We don’t use our discretionary outlook for trading. We use our quantitative trading models because they are end-to-end systems that tell you how to trade ALL THE TIME, even when our discretionary outlook is mixed. Members can see our model’s latest trades here updated in real-time.

Conclusion

Here is our discretionary market outlook:

1. Long term: risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
2. Medium term (next 6-9 months): most market studies lean bullish.
3. Short term (next 1-3 months) market studies are mixed.
4. We focus on the medium-long term.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward favors long term bears.