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Recession probabilities are increasing. Beware of a stock market crash?

by Troy

The stock market’s rally is slowing down while volume is falling. This is normal. It’s impossible for the stock market to keep rallying at the pace it did in January and February – otherwise it would rally 60%+ in one year.

Go here to understand our fundamentals-driven long term outlook.

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.

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

Recession Probabilities

The New York Fed has created a Recession Probability Index by inverting the 10 year – 3 month yield curve.

As you can see, the Recession Probability Index is now at 27%. If I wanted to trigger your greed/fear, I would tell you “Recession Probability today is as high as it was in 2000 and 2007!”

Here’s what happens next to the S&P when the probability of a recession exceeds 27% according to this index.

Yes, “this happened before 2007 and 2000”. But this also happened in 1998 and 2006: 1.5 years before a bear market began. In my mind, a 1998 or 2006 scenario represents the most optimistic case.

Momentum

The week isn’t over yet, but barring a big decline tomorrow, the S&P’s weekly RSI (momentum indicator) will close above 60 this week.

Now of course you can look at the following weekly RSI chart and think “BEARISH DIVERGENCE!”

But divergences on a weekly chart aren’t very useful.

  1. Because the S&P’s weekly RSI in January 2018 was so high, it’s guaranteed that the S&P will make a weekly RSI divergence, no matter what it does. It is impossible for the S&P’s RSI to become higher than it was January 2018 unless the S&P soars 50%.
  2. Weekly RSI “divergences” can last years, if not half a decade. When a “divergence” lasts 1-5 years, it’s not called a “divergence” anymore. It’s a useless timing indicator.

With that being said, the S&P’s current weekly RSI reading is significant because bear market rallies typically see lower RSI readings.

Here’s what happens next to the S&P when its weekly RSI exceeds 60 for the first time in 6 months.

Initial Claims

As you may recall, I have been concerned about the labor market over the past 2-3 months.

Last week I said that the uptrend in Continued Claims is not bullish for stocks. But I also said:

This is worth monitoring, but do not panic immediately. It’s best to use Initial Claims together with Continued Claims. While Continued Claims is trending up, Initial Claims is still mostly trending sideways.

*Initial Claims also tends to lead Continued Claims by a week or two.

This week, the latest reading for Initial Claims made a new low for this economic expansion.

As we’ve said before, Initial Claims tends to trend upwards before bear markets and recessions began. This has yet to happen.

Nevertheless, Initial Claims remains extremely low. As a hypothetical thought excercise, here’s what happens next to the S&P after Initial Claims hits bottom in each economic expansion cycle.

Late-cycle.

The problem with this is that it’s impossible to know if Initial Claims has hit rock bottom without 20/20 hindsight.

  1. How many bears thought that Unemployment would bottom at 6%? It didn’t.
  2. How many bears thought that Unemployment would bottom at 5.5%? It didn’t.
  3. How many bears thought that Unemployment would bottom at 5%? It didn’t.
  4. How many bears thought that Unemployment would bottom at 4.5%? It didn’t.
  5. How many bears thought that Unemployment would bottom at 4%? It didn’t.

Stop thinking “Unemployment is TOO low, it CAN’T get any lower”. It’s impossible to predict turning points in leading economic indicators, so just watch the trend in these indicators.

NAAIM

Active managers have increased their exposure to stocks as the stock market rallies.

Here’s a longer chart for NAAIM.

Is this bad news for stocks?

Here’s what happens next to the S&P when NAAIM exceeds 91.

*NAAIM data is extremely limited. Be careful of indicators with less than 40 years of history.

China

Chinese stocks continue to rally, and the Shanghai Index’s weekly RSI is now at 74.

Here’s what happens next to the Chinese stock market when the Shanghai Index’s weekly RSI exceeds 74

It seems that the Chinese stock market does slow down over the next 1-3 months.

Here’s what happens next to the S&P.

Not consistently bearish for the S&P on any time frame.

Sectors

One of the things that does worry me is the clear risk-on vs. risk-off relationship between the stock market’s sectors.

  1. When defensive sectors like XLU (utilities) do well, growth sectors like XLK (tech) do poorly.
  2. When defensive sectors like XLU do poorly, growth sectors like XLK do well.

The recent stock market rally has been driven by tech. Here’s XLK (tech sector ETF) and XLY (consumer discretionary ETF).

As a quick reminder, XLY reflects XLK because XLY’s biggest component is Amazon.

Over the past 7 days, XLY and XLU have diverged significantly.

Here’s what happens next to the S&P when XLY rallies more than 3.5% over the past 7 days while XLU falls more than -2.3%

*Data from 1998 – present

The stock market’s future returns are slightly more bearish than random.

Breadth

Here’s a quick reminder for breadth. Breadth remains strong, with the S&P 500 Bullish Percent Index now at 74.

Here’s what happens next to the S&P when the Bullish Percent Index exceeds 74

Forward returns are mostly random.

Recession?

The Philly Fed produces a coincident index for each state, looking at whether a state’s economy is improving or deteriorating.

As of the latest reading (January 2019), most states are improving.

We can plot the 3 month diffusion index for the Philly Fed State Coincident Index against historical recessions.

It’s clear that a recession is not imminent.

*Granted, this data is as of January 2019. Data was delayed due to the government shutdown and will be made available again next week. Based on our own leading indicators, the Philly Fed State Coincident Index will probably improve a little in next months’ readings.

How to be successful in finance

I’m a big fan of Ray Dalio. He sounds smart, knows a lot of things, and his hedge fund’s average historical performance is good. For example, Ray Dalio’s hedge fund returned 14.6% in 2018.

But “average” figures can hide a lot of things.

Consider this. Prior to 2018 (according to Bloomberg), Ray Dalio’s fund had 6 years of extremely mediocre returns. The investment industry’s alpha is shrinking as the competition becomes more and more fierce. Most of Ray Dalio’s outperformance came in earlier years, and his performance over the past decade has been lackluster.

I increasingly think that the most important thing for success in the finance industry is marketing. It’s unfortunate, but it’s where this industry is headed. Economics majors should know this. In an increasingly undifferentiated market (perfect competition), the only way to stand out is with better marketing. I.e. if your performance is not different from random (the rest of the industry), dress yourself up to seem “better” than your competitors.

I.e. can you say popular things that sound “smart” so as to convince potential customers (e.g. hedge fund clients) to hand over their money to you?

The trend in shrinking alpha probably explains the proliferation of scams and trading gurus over the past decade. If you can’t make money trading because you’ve been too bearish over the past decade, just turn yourself into a guru and sell subscription services.

Remember: when someone tells you “the market is broken”, it’s probably because the market broke them.

Read The best trader in the world is bullish on U.S. stocks

Conclusion

Here is our discretionary market outlook:

  1. 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.
  2. The medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.
  3. In other words, 12-24 months later bearish, 12 months neutral, 6-9 months slightly bullish.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.

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