Just to recap:
- Based on current data, the Medium-Long Term model doesn’t foresee a significant correction or bear market in 2018.
- The S&P 500 will be more volatile in 2018 than in 2017, although it’ll probably close higher at year-end. (See the latest study here).
That’s the medium-long term outlook based on my model & discretionary outlook. Now let’s understand the short-medium term outlook.
The S&P 500 will probably make a 6%+ “small correction” in Q1 2018. I think a magnitude of 6-10% is most likely.
We can look at this from 2 perspectives: technicals and fundamentals.
Technical reason for a small correction
Let’s put aside the obvious for now
The current rally is the longest rally in history without a 6%+ “small correction”.
From a pure probability perspective: the longer this rally goes on, the higher the probability of a small correction beginning tomorrow.
Other studies show that the S&P will probably begin a small correction in 1-2 months (i.e. by the end of Q1 2018)!
The S&P hasn’t been more than 5% below its 52 week high in 384 days!
This study is similar to “this rally is the longest rally in history”, with one caveat. It expands the data pool because the S&P will sometimes make a muti-month flat top.
There were 3 historical cases similar to the present. In all of these cases, the S&P went more than 370 days without being more than 5% below the its 52 week high. In other words, these are all extremely long and low volatility uptrends.
- May 14, 1965: the S&P began a 10.9% “small correction” the next day.
- March 28, 1994: the S&P was in the middle of a 9.7% “small correction”
- June 7, 1996: the S&P was in the beginning of an 11% “small correction”.
These 3 historical cases have 2 things in common.
- The S&P was either already in a “small correction”, or very close to one. Today, the S&P 500 is making new highs, so a “small correction” has not begun yet.
- These “small corrections” were on the big side as opposed to the small side. They were all approximately 10%.
Fundamental reason for a small correction
For starters, there are no long term fundamental problems with the U.S. stock market. U.S. corporate earnings are rising and the U.S. economy is growing nicely. This is why our Medium-Long Term Model doesn’t foresee a bear market.
Here’s the unemployment rate. It’s still going down.
Here’s YoY Industrial Production. Still trending higher.
Here’s New Home Sales. Also trending higher.
Here’s Retail Sales. Flat to trend higher.
You can see that the economic data’s long term trend is strong. There is no reason for a bear market in stocks.
HOWEVER, January’s economic data (to be released in February) will probably make a short term dip.
Economic data released in February tends to fall due to the weather in January. This has been the pattern over the past 7 years, and it’s only getting more extreme thanks to climate change.
This January is extremely cold on the East Coast. Look at these news headlines.
In addition, the economic data right now is about as good as it gets in the short term. It can’t get much better than this. Soon the data will have to make a temporary dip. Here’s Citigroup’s Economic Surprise Index, which aggregates various U.S. economic indicators.
I know a few hedge funds that try to trade the S&P 500 based on short term fluctuations in U.S. economic data. Here’s the conclusion.
There is a weak-moderate positive correlation between the economy and U.S. stock market in the short term. This correlation isn’t very strong, but it exists.
Combining these 2 things
When you combine..
- 2 long term technical extremes with…
- economic data weakness in February…
The odds of a 6%+ “small correction” beginning in Q1 2018 are very high.