The stock market gapped down today significantly on trade war news and rallied towards the close, which implies “buy the dip” strength. However, market history suggests otherwise, at least in the short term. Studying market history allows us to challenge our assumptions.
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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.
It’s not the PPT
The S&P crashed overnight on Trump’s trade war news and rallied towards the close. Here’s a 5 minute chart.
Such a gap down is uncommon when the S&P is so close to all-time highs. Here’s what happens next to the S&P when it gaps down more than -1.5% from within 1% of a 1 year high.
You can see that the stock market has a short term bearish lean over the next 1 month.
What about the Russell 2000? The Russell 2000 gapped down more than -1.5% and then closed positive.
While the snarky permabears think “haha, this is just the Plunge Protection Team and evil Fed again”, it’s not. This has happened 88 other times from 1987 – present. So either the Plunge Protection Team doesn’t exist, or the Fed must have a team of traders micromanaging the stock market all the time.
But what about the fact that the Russell rallied strongly into the close for 2 consecutive days?
Once again, not rare and consistently bullish or bearish. Don’t read too much into 1 day patterns.
Volatility of volatility
Even though VIX spiked today on the intraday, its volatility is still quite low. The 3 month standard deviation for VIX is now less than 1.24. The last time this happened was September 2018, just before the Q4 2018 crash (insert scary music).
To avoid recency bias and cherry picking historical cases that suit our bias, let’s look at the data holistically. Here’s what happens next to the S&P when VIX’s 3 month standard deviation falls below 1.24
You can see that there is a slight short term bearish lean, and a few of the historical cases were quite bearish in the short term (e.g. 2015, 2018). But most of these cases were bullish 6-12 months later.
Here’s what happens next to VIX.
VIX mirrors the S&P. VIX spiked more than 30% today on the intraday, and then closed in the bottom half of its intraday range.
Similar historical cases were almost exclusively short term bullish for the S&P and short term bearish for VIX.
Do you see how this contradicts with the previous short term bearish market studies? This illustrates the biggest problem with short term trading:
At any given point in time, there are always 1000 short term bullish reasons and 1000 short term bearish reasons. The short term is extremely hard to predict.
While trading gurus will only point to the factors that support their case (to sell you a message), a weight of the evidence approach almost always points to a 50/50 bet in the short run.
Focus on the medium-long term.
South Korea canary in the coal mine
I’ve seen charts like this a lot from financial experts:
South Korean exports are falling! This is the canary in the coal mine for global growth! Bearish!
Their rationale is simple. South Korea is an export-driven economy. So when South Korean exports fall, it must mean that global demand is weak, which is bearish for the global economy and global stocks.
Let’s test this rationale. Here’s what happens next to the S&P when South Korean export growth falls below -10%
You can notice a few things:
- There are some false signals (see 1998 and 1985)
- Even in real bear markets and recessions, this often happens towards the end of bear markets and recessions (hence why 6-12 month forward returns are mostly positive).
Sounding smart ≠ actually being smart. Instead of using the South Korean economy to predict the U.S. economy and stock market, I’d rather just use the U.S. economy.
More canaries in the coal mine
Here’s another “canary in the coal mine”. “Lumber prices have been falling, just like before the 2018 stock market crash!”
Once again, the rationale behind this statement is simple. To paraphrase others:
Falling lumber prices means that the housing market is weak. Housing is a leading indicator for the economy, which implies that this is bearish for the economy and U.S. stock market.
While this theory does hold some ground (housing remains somewhat weak right now), using it for trading is silly. Instead of using lumber prices to guess how strong or weak housing is right now, why not just look at the underlying housing data itself? Stop guessing and just look at the data (i.e. Housing Starts, Building Permits, New Home Sales).
Anyways, here’s what happens next to the S&P when it rallies more than 5% over the past 60 days while Lumber falls more than -20%.
Not consistently bullish or bearish for the stock market.
Here’s what happens next to Lumber.
Lumber has a short term bullish lean, probably because it is oversold.
S&P 500 Bullish Percent Index
The S&P 500 Bullish Percent Index is a popular breadth indicator. With the stock market rally slowing down (compared to January and February), this breadth indicator is also rolling over.
Here’s what happens next to the S&P when the Bullish Percent Index falls below its 50 dma for the first time in 3 months.
You can see that there’s a short term bearish lean over the next 2 weeks. Why? Because the Bullish Percent Index usually keeps on falling over the next month.
Russell 2000 and its not-so-golden Golden Cross
The Russell 2000 (small caps index) will probably make a golden cross tomorrow, whereby its 50 dma crosses above its 200 dma.
Here’s what happens next to the S&P and Russell when the Russell makes a golden cross.
Here’s what happens when you buy and hold the Russell only when its 50 dma is above its 200 dma (i.e. buy on a golden cross, sell on a death cross).
The golden cross isn’t great for market timing when applied to the Russell.
USD: is anybody home?
The U.S. Dollar’s volatility has been notably low over the past few months. Just look at the USD Index’s 3 month standard deviation.
Such a prolonged period of low volatility is uncommon, and has many traders thinking that the U.S. Dollar will make a big move in the 2nd half of 2019.
The last time volatility was this low for a prolonged period was in 2014, just before the USD soared.
To avoid recency bias, here’s what happens next to the USD when its 3 month standard deviation has been below 0.75 for 88 consecutive days.
While the 6-12 month forward returns are mostly bullish,
- The sample size is small
- Most of the historical cases occurred long ago in the 1970s
Regardless, a rising USD is not consistently bearish for the S&P.
Read The persistency of this rally is similar to the dot-com bubble?
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. When our discretionary outlook conflicts with our models, we always follow our models.
Here is our discretionary market outlook:
- The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
- The medium term direction (e.g. next 6-9 months) has a bullish lean.
- We don’t predict the short term because the short term is always extremely random, no matter how much conviction you think you have. Focus on the medium-long term.
Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.
Members can see exactly how we’re trading the U.S. stock market right now based on our trading models.
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