As traders, we must always think about what happens if our case is wrong. And that’s what I’m going to do in this post. As you know, the Medium-Long Term Model doesn’t think that we’re in a significant correction or bear market. But I’m going to think about this from a discretionary point of view.
Considering the long term bearish case
I think the bull market has 1-2 years left. So thinking about this from a risk:reward perspective:
- The stock market tends to go up 15-20% per year in the final 2 years of a bull market.
- This means that IF the bull market isn’t over and it continues to last for 2 years, the stock market will go up 30%-40%.
- Bear markets are >40% declines in the stock market.
So if you buy and hold right now to the bottom of the next bear market, you would lose money. A 16-22% loss to be exact.
As you can see, from an EXTREMELY long term perspective (i.e. over the next 5 years), holding stocks is not a good idea. In 5 years time we will either be in the midst of a bear market or at the bottom of one.
So why risk it?
Well for starters, the risk:reward isn’t as bad as it seems. The upside is 30-40% on a plain vanilla $SPY.
We would not be riding the bear market all the way down if that happens. The Medium-Long Term Model’s stop loss would kick in, probably at around the -10% level for the S&P 500.
Hence the potential reward is 30 to 40% for $SPY, and the potential risk is -10% to the downside. Even if the odds of both cases are 50-50, the risk:reward ratio still favors the bulls at 1:3 or 1:4.
The model has not failed to predict a bear market before. Nevertheless, it still has a stop loss indicator IN CASE it fails. Since the model hasn’t failed before, the stop loss indicator has never been used before. The stop loss indicator sends a SELL signal near the beginning of every bear market. This indicator is logical. It combines fundamentals with price-related indicators. I explain the exact calculation behind this indicator in the Trading Strategies membership program, along with the rest of the Medium-Long Term Model.
But from a discretionary point of view, I still don’t think that we are already in the beginning phase of a bear market.
I know the standard case for a bear market “valuations are too high, there’s too much debt, etc.”
For starters, valuations cannot be used to predict the start date for bear markets. Not even close. Valuations tell you what the stock market will probably do 5 years down the line, but valuations can’t tell you what the stock market will do in 1-2 years.
From the 1980s to present, the U.S. has consistently had “too much debt”. Legendary investor Jim Rogers has been ringing this alarm bell since the late 1980s, but there has been no debt-induced crisis over the past 30 years. Rising debt is ok as long as it is serviceable (i.e. you can repay the interest + loans). And debt is servicable because despite the Fed’s rate hikes, interest rates are still historically low. They will remain historically low throughout 2018, even after another 3 rate hikes.
I think people misunderstand the 2008 Great Financial Crisis. The tipping point wasn’t that “debt was too high” or “there were too many mortgage loans”. The tipping point for the economy and stock market was that these bad mortgage loans had started to really hurt the economy via hurting the housing sector. See how Housing Starts cratered after 2005.
The point is, you really can’t be able to predict what will impact the economy until it actually does impact the economy. But the beauty is that certain economic indicators LEAD the economy (GDP) and stock market. If anything happens that has an adverse effect on the economy, it will first show up on these economic indicators.
This means that you don’t need to GUESS what impact certain events will have on the economy. You just need to recognize it when it first starts to happen.
And the leading economic indicators are still trending higher.
But I want you to think about why the economy leads the stock market. Think about the logic behind this. The stock market is dominated by mom-and-pop investors, pension funds, companies (via share buybacks), etc. These people are all LONG TERM buy and hold investors. They buy much more often than they sell, because every financial planner preaches “stocks yield 7-8% over the long term, so you should just buy and hold until retirement”.
It’s this nationwide psychology – the American (and global) BELIEF in stocks, regardless of valuations – that encourages people to plow their savings into the stock market. I can’t tell you how many times I’ve heard “it doesn’t matter if valuations are expensive right now. You just have to buy, and given enough time, you will always make money”. (Which is true by the way, but sitting through a 50% bear market sucks. Remember 2008.)
So this means that as long as people are earning more money (i.e. as long as the economy continues to grow), there will be more buyers than sellers over the long run. So this means that until the economy starts to deteriorate and people start making less money, the “buy the dip” mentality will prevail because the average Joe has the financial capability to buy the dip.
As you can see, the stock market follows an easy to understand logic. Or as Steve Jobs would say, “simplicity is the ultimate sophistication”.
Considering the medium term bearish case
So what about the current “small correction”? (The S&P has fallen -11.8% from top to bottom). The model doesn’t think that this “small correction” will turn into a “significant correction”. But more importantly, I don’t think it will either from a discretionary perspective.
The fact that the S&P 500 is holding on its 200sma doesn’t mean anything. The stock market is different from other markets in that standard technical analysis doesn’t work that well. You can say that the S&P found support on its 200sma, or its 210 sma, or 220sma, or its 230 sma. There’s nothing “magical” about the 200sma. Just because the S&P touched its 200sma twice instead of once doesn’t make it more or less likely to hold this support level. “The S&P touched its 200sma twice” is just stating a fact. It’s neither bullish nor bearish.
Even if the S&P does break below its 200sma, that doesn’t mean a “significant correction” is likely. Please consider this:
The stock market has had successive rounds of “problems” since January 2018. The media has constantly shifted its focus back and forth between these problems.
- Rising interest rates
- Tariffs & trade war threats
- NAFTA threats (which are slowly dissolving).
- Rising oil prices.
- Potential weak earnings (even though earnings reports have been very strong this season).
Despite all these problems, the stock market is only down -11.8%, and it can hardly break below its February 9 lows.
This is bullish price action. In spite of all these problems, the S&P has a very hard time just making a new low and falling more than -11.8%.
To put things into perspective, the S&P today is where it was in December 2017. This is more of a mean-reversion driven correction, and the S&P has used everything it could (all those bearish triggers) to push the stock market down. And despite these nonstop triggers, the stock market hasn’t gotten to “significant correction” territory.
So what happens if these bearish factors disappear? The underlying bullish factor is still there – the economy continues to improve. The longer this correction drags out, the less likely it is to become a “significant correction”. The “buy the dip” investors are at the bottom.
You can also see that the stock market is having a smaller and smaller reaction to bearish pieces of news. The first tariff-related news saw the stock market tank. Subsequent tariff-related news saw tiny dips in the stock market. “Interest rates reaching 3%” was a big fear a few days ago. The stock market fell 2%. Hardly a “disaster”. (Because no matter how scary “3%” sounds, it is hardly any different from 2.9% of 2.8%).
This tells you that there is a very strong “buy the dip” mentality in this market. There are big, long term players at work here, such as the record corporate buybacks we’re seeing in 2018.
Also, be skeptical when big-name investors tell you to be bullish or bearish on CNBC. They often do one thing and say another. Telling other investors to sell when they’re buying helps them buy stocks on the cheap.
Focus on the REASON behind their bullish/bearish outlook. For example, I demonstrated that PIMCO said it was very bearish on long term bonds. In their latest filing, PIMCO had a record net long position in long term bonds. Actions speak louder than words.
Oh, and one more thing… (doing my best impression of Steve Jobs here) 🙂
Just because this correction is taking so long doesn’t mean that this has bearish implications. In fact, you should be more concerned about corrections that are short in terms of TIME. Look at the following chart.
This chart demonstrates the S&P’s forward returns when a correction lasts longer than 52 days, like it has in this current correction. Notice how the forward return is pretty much 50-50. TIME doesn’t tell you anything about what happens next in the stock market.
Look at what happens when the S&P’s correction lasts less than 52 days. The forward returns are decidedly more bearish.