The Medium-Term Bullish Case for the U.S. Stock Market

Troy Bombardia  |

Fundamentals determine the stock market's long term outlook while technical analysis determines the stock market's short term outlook. This implies a few things:

  1. Understanding leading economic indicators is important. Leading economic indicators lead the U.S. economy. And since the economy and stock market move in sync over the long term, then leading economic indicators lead the stock market as well.
  2. If the stock market deviates from the economy's direction in the medium term, it will eventually move back inline with the economy's direction. So if the stock market makes a correction but the economy continues to improve, the stock market will eventually make new all-time highs. The correction won't turn into a bear market.

*The stock market and economy don't have a one-to-one relationship over the long term. A 1% increase in the economy usually leads to a >1% increase in the stock market. But it's the DIRECTION of the economy (is the economy getting better or worse?) that counts.

I think that this equities bull market still has 1-2 years left, after which we will get a 40%+ bear market. Here's why.

The economy right now

The U.S. economy is growing at a healthy rate right now. You have to look at the data ON BALANCE when you look at the economy. The data will never be 100% positive or 100% negative. In addition, you should focus on the TREND in the data instead of the month-to-month fluctuations. Most of the month-to-month fluctuations in the economic data is random.

The major leading economic indicators point to continued growth:

The jobs market continues to improve. Both Initial Claims and the Unemployment Rate are trending down.

The housing market continues to improve, although growth is slowing down a little. New Home Sales, Housing Starts, and Existing Home Sales are still trending higher.

The U.S. consumer is still optimistic. Consumer sentiment is making new highs (consumption accounts for 70% of U.S. GDP).

Industrial Production growth (a leading indicator for the economy) continues to trend higher.

Hence, we can see why this bull market isn't over. The economy continues to improve and shows no signs of significant deterioration right now.

However, that the economy is also telling us that this bull market doesn't have too many years left. The economy is approaching full capacity, which means that there isn't a lot more room left to grow. You can see how low the unemployment rate is when compared to history.

This is why we think that the bull market and economic expansion still have 1-2 years left to go.

The stock market right now

The stock market was insanely overbought by every account as of January 2018. Momentum was INSANELY strong. Hence, this correction is a way to wash out that momentum. Volatility was very low in 2017, which is not characteristic of the last year before a bear market begins. The last year of a bull market is usually characterized by high volatility (see study), which is what the market is doing right now.

The final 1-2 years of a bull market is characterized by bearish divergences. This did not happen in 2017 but is happening in 2018. That's why various internal market indicators will deteriorate but the stock market should make new highs.

  1. The S&P 500's momentum (RSI) was insanely high in January. When RSI is this high (historically), it needs to make a medium term bearish divergence (see study). This means that the stock market will make a correction and then a new high, but momentum will not recover to its January 2018 highs.
  2. The rally that ended in January 2018 was the longest rally without a 3%+ pullback. When the stock market's trend was this persistent (historically), the S&P made a correction and then a new all time high. The bull market didn't just end with that correction (see study)
  3. Bull market tops see a bearish breadth divergence in the cumulative A/D line (see study). There was no breadth divergence in January 2018, which suggests that this bull market isn't over.

Hence we can see why the January 2018 top wasn't this bull market's top from a technical analysis point of view.

The current correction is a very standard correction: crash, bounce, and retest. We are close to making a medium term low. The retest typically involves a marginal new low, which suggests that the S&P will close a little lower than its February 9, 2018 lows before this correction is over.

This was the S&P 500 in 2015-2016.

This was the S&P in 2011.

On Trump

If Trump does start a trade war that gets out of control, then that is a long term bearish factor for the stock market. But this is unlikely.

Trump is known to have a much louder bark than bite. (Remember when Trump threatened to obliterate North Korea in 2017?) The key point to remember is that none of these proposed tariffs have been implemented.

Trump is using these threats as a way to bring China to the negotiation table. His goal is not to start a trade war that destroys the economy. For a president that loves to tweet about the stock market and the economy, single handidly starting a bear market would destroy everything that he stands for.

Troy Bombardia is a private trader who blogs at BullMarkets.co. You can go here to see why he is medium-long term bullish on the U.S. stock market.

DISCLOSURE: I am currently long SSO, the S&P 500's 2x leveraged ETF.


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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