The U.S. stock market faces several headwinds right now. Perhaps these headwinds will cause a small correction before this summer is over. However, we will remain 100% long UPRO (the 3x ETF for the S&P 500) because:
- Our model says that this is still a rally within a bull market. The model does not see a significant correction on the horizon.
- Perhaps the S&P will rise first before a small correction begins. So if the S&P rises 8% and then makes a small correction, anyone who sells stocks now will actually be buying back their stock at a higher price!
- If the S&P rises 3% and then falls 6%, there’s no point in avoiding the small correction. You’re only adding a 3% profit to your portfolio, which in the grand scheme of things is chicken scratch. The real money is made by riding big waves.
Here are the bearish factors affecting the U.S. stock market right now.
It has been a little more than 10 months since the last small correction in June 2016 (on Brexit). This is exceptionally long. Most rallies between small corrections last less than 8 months. In fact, only the rally of 1995 lasted more than 12 months without a small correction!
Hence, this bearish factor states that the U.S. stock market might begin a small correction very soon. By the time we approach July, the S&P 500 will have gone 12 months without a small correction. This is a time extreme.
We mentioned before that “Sell in May and Go Away” is not a good idea, because the S&P ends up higher more often than it ends up lower from May to October.
More specifically, the S&P’s weakness tends to happen in June-August. This is because the economic data tends to deteriorate a little in summer when many workers go on vacation and the pace of business slows down. This is why bond king Jeff Gundlach thinks that a small correction will happen this summer.
Disappointment in Trump
The House has passed an Obamacare replacement bill. The bill barely squeaked by (217 for vs. 216 required.) However, this bill is almost guaranteed to fail in the Senate. The Republicans have a tiny majority in the Senate. No Democrat Senator will support this bill and some moderate Republicans have already spoken out against it.
Right now the Trump administration is pushing its tax plan and exploring various infrastructure options. On the table is a collaboration with Chinese, Japanese, and private American investment. However, any pro-growth policies will have to wait until after Congress comes back from its summer recess. So don’t expect any good news on this front until September.
Will oil continue to fall?
The real medium term concern is that oil prices will continue to fall.
Right now, sentiment is extremely bullish. With oil falling to $45, most investors are screaming “this is the time to buy! This is just a technical correction!”.
Perhaps they are right, but perhaps they are wrong. The odds of the bulls being right is probably 40%. The U.S. keeps pumping more oil every time OPEC and the Saudis cut production. OPEC is not as strong as it used to be in the 1970s, which means that OPEC cutting production does not mean the global supply of oil will decrease. The supply glut continues, and there are fears that Chinese demand for commodities will temporarily slowdown.
The recent decline in oil prices has caught many serious investors flat footed. When Jeff Gundlach created his inflation predictions for the rest of 2017, he didn’t even consider that oil would be at $45! He thought oil would be between $50-$60. (see here)
If oil does remain in the low-high $40’s range for the next few months, there are three bearish impacts on stocks.
- Oil in the $40’s means that inflation in the U.S. will fall below 2% (to 1.6% or 1.5%). Likewise, inflation around the world will fall. There is a tight correlation between inflation and interest rates. There is also a tight correlation between interest rates and financial/bank stock prices right now. If inflation falls a little, interest rates will fall a little. If rates fall, earnings growth for the financial sector will deteriorate a little. This means that the S&P’s earnings growth will slow down a little. This is a short term bearish factor for the S&P 500.
- Falling oil means that headline figures for economic data like Retail Sales will come down a little.
- Oil below $50 means that year-over-year earnings growth for the energy sector will be negative! This puts downwards pressure on the S&P 500’s earnings growth.
- A decline in oil is not like a “tax cut”. Falling oil prices do not really have a significant positive impact on consumers. Gas accounts for just more than 5% of the typical consumer’s spending.
In addition, the economies of oil producing states like Canada, Russia, OPEC countries, etc are weak. They cannot afford to cut back on oil production because doing so would kill their economies, which are already on life support. So as the price of oil goes down, they are forced to pump EVEN MORE oil just to sustain their current levels of spending. This is part of the reason why oil prices fell so rapidly in 2014 and 2015. As the price went down, countries like Russia were forced to pump more and more oil.
If we had to guess, the odds of a small correction happening before the summer is over is 80%. The odds of a small correction beginning right now (i.e. before May is over) is 60%.
But we are still 100% long stocks. We do not care about small corrections. In fact, these small corrections are good for the stock market in the long term. If stocks remain flat or fall a little over the next few months, earnings and the fundamental valuations for Corporate America will keep improving. This means that stocks are actually becoming cheaper in terms of valuations!