Medium-Term Is Bullish, But Long-Term Risk:Reward Is Bearish

Our models have not yet turned long-term bearish, although they are getting close to turning long-term bearish. But while building new and better models like the Macro Index, I’ve come to realize that at least from a long-term risk:reward perspective, it doesn’t favor long-term bulls. Market outlook and risk:reward are not the same thing. Here’s an example.

Let’s assume that there’s an 80% probability that the stock market goes up from here, which means there’s a 20% probability the stock market goes down from here. While on the surface this seems bullish, it fails to take into account risk:reward. If the risk:reward is 5:1, then the expected outcome factors neither bulls nor bears. (5x probability of the stock market going up, but 5x the downside risk. These 2 things cancel each other out.)

Goldman Sachs has a very simple Bull/Bear Indicator which illustrates this point.

(Click on image to enlarge)

*This Bull/Bear Indicator is constructed by taking a percentile for the Unemployment Rate, Inflation, Yield curve, ISM manufacturing, and P/E ratio

As you can see, Goldman’s Bull/Bear Indicator is quite high, historically speaking. Is this immediately long-term bearish? No. This indicator can remain very high for 1-2 years. This means that while the indicator is not long-term bearish (i.e. it is not a timing indicator), it demonstrates that long-term risk:reward points to the downside.

Let’s determine the stock market’s most probable medium-term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

(Click on image to enlarge)

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

Russell’s significant underperformance

The small caps Russell 2000 Index has been much weaker than the large caps Dow. The Russell is more than -16% below its 1 year high, while the Dow is less than -10% from its 1 year high.

1 2
View single page >> |

Disclaimer: Read my full disclaimer here

How did you like this article? Let us know so we can better customize your reading experience. Users' ratings are only visible to themselves.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.