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More Trouble Ahead for Stocks?

 

• Earnings fundamentals are at a critical point and as a result, the direction that develops in the next week could have a dramatic impact on stock prices for the long term.

• Despite the five-week rally, the Relative Strength of the S&P 500 indicates that stocks have not broken free of a dominant bearish downtrend that began last October.

• Multiple relief-catalysts are set up as possibilities over the next week-plus. We review them and establish the critical levels for the S&P 500 ETF (SPY) going forward.

 

In our last blog post (January 22, "Sentiment Says: Monster Bull Market Rally Ahead"), we pointed out that Investor's Intelligence Advisor Sentiment data had reached lows at levels that previously set the stage for significant bull-market rallies. However, an analysis this week of both fundamental and technical data also suggests that the downturn that began last October may have some unfinished business in store for investors.

Bullish investors may be tempted to get back into the ring by the recent 5-week rally. However, evidence from both disciplines is suggesting that stocks are likely to reverse back in a downward direction, testing the prior lows, before (potentially) resuming the uptrend that began in December.

There is a significant likelihood the direction that stock prices take and levels they reach over the next 5-7 sessions will be a critical harbinger of the long-term course of stocks over the coming months.

Fundamentals: What are S&P 500 Earnings Telling Us?

in last week's (Jan. 22) blog post, we discussed the fact that the S&P 500 Trend and Breadth remained bearish, and provided this summary chart showing trend direction and three individual breadth indicators to prove that point. In a moment, were going to analyze the current support and resistance levels for the last two years and determine which market regime – bullish or bearish – is being suggested by Relative Strength (RSI).

However, we will first revisit our S&P 500 Progressive Blend Earnings Composite (PBEC), which we first explained in detail in a November 10, 2018, Optimized Insights report.

As the name implies, it is a progressively blended composite of three earnings data series, as follows: 1) S&P 500 Trailing 12-Month EPS (TTM), 2) Current Fiscal Year's S&P 500 EPS Mean Estimate (SPEPSCY) and  3) Next Fiscal Year's S&P 500 EPS Mean Estimate (SPEPSNY). A custom blending algorithm continuously uses more of the Current Year and Next Fiscal Year Estimates as each quarter of the year progresses and S&P 500 actual earnings and estimated earnings figures are released.

Chart 1 below shows the PBEC Indicator from 2000 to present (in red) using an exponential moving average (green) as a signal line to determine significant changes in earnings expansion and contraction. When use the PBEC in combination with other fundamental, macroeconomic, breadth, and technical measures, we are able to build highly accurate identifiers of changes to price trends and can identify the sector/industry that should dominate in the coming weeks and months.

 


Chart 1: The S&P 500 Progressive Blend Earnings Composite (PBEC) from 2000 to present shows signals of earnings expansion and contraction.

 

When used with other fundamental, macroeconomic, breadth, and technical indicators to build robust composites, we can refine these signals to create highly accurate markers of changes to price trends, avoiding risk and identifying the optimum ETF to hold at any given time. The result is a more consistent investment performance with drawdowns less than one-quarter the S&P 500 and Annualized Returns that average more than quadruple the long-term return of that index.

Chart 2 below shows the PBEC Indicator for the last ten years (2009 to present in red), and we can see how contraction and expansion of composite earnings trends were real-time signals for S&P 500 price changes. The red question mark hovering on the right side of the chart indicates the mystery surrounding today's situation, in which the earnings indicator (red) has turned sharply downward to meet the green signal line.

 

 


Chart 2: The PBEC for the last 10 years (2009 to present) shows the correlation between blended earnings and S&P 500 stock-price trends.

 

 

At the time of our November 10, 2018 report, blended earnings had been flat for two months (August-September), followed by a sharp rise in October. It appeared at the time of that article that stock prices would return to higher levels, and right on cue, the S&P 500 briefly turned higher. However, composite earnings then plummeted downward beginning in November, and S&P 500 prices resumed a matching sharp downtrend from mid-November to early December.

Chart 3 below shows the PBEC Indicator for the last six months (July 27, 2018 – January 27, 2019). Here we can see with far more clarity the confusion in blended earnings that has transpired. The two lines – indicator and signal – are running nearly perfectly aligned, on top of one another, in a sideways fashion that gives no hint of what lies ahead for stock prices.

 


Chart 3: The PBEC for the last six months shows a convoluted trajectory that is currently overlapping in a troubling sideways pattern. Which direction next?



Since the first week of December, stock prices have been on a tear upward – an assent that is not matched by a higher earnings trend. This disconnect causes us grave concern that the recent ascent of stock prices may not be much more than a classic dead cat bounce.

 

Using the S&P 500 Benchmark

Occasionally, we are asked why we regularly analyze various aspects of the S&P 500 in our articles. The reasons are multifaceted, but primarily it's because the most critical factor influencing individual stock prices is the trend and trend-strength of the S&P 500 index.

At any given time, about 75% of all individual stocks are moving in concert with the direction and pace of the S&P 500 index, and it's nearly impossible to predict which 25% of stocks will buck the trend at any given time (because different companies are influenced differently by changes in the economic cycle).

Comprising approximately 80% of all US equity market capitalization, the S&P 500 is the 's of indices. It is for this reason that we – and most other professional analysts – utilize the S&P 500 as the premier benchmark of stock performance, unless they are guiding mutual funds or investment approaches that focus on a specific size or niche of the market, such as small-cap stocks, technology, or similar.

Let's see what another indicator of the S&P 500, this time from a technical standpoint, can tell us about expectations for the future.

 

Relative Strength's Assessment: Bearish Downtrend

The turbulence through 2018 and into the first months of 2019 have taken investors on a wild ride that shows no signs of being over soon. Those who expect a V-shaped bottom to have formed in late December that will bring prices to new highs are likely to be extremely disappointed in the coming weeks. The volatility is, in fact accelerating rapidly, and this week is going to be a critical one in determining the direction of stock prices for the coming months.

Chart 4 below shows that the S&P 500 remains in a sharp, bearish downtrend (top window) – despite the spirited 13.5% gains over the last five weeks. Prices are currently just below the critical resistance level of 2675, which marks the top of a 50-point zone (shaded red) between the October/November lows and the highs from early-December and Friday, January 18. The lower window shows that RSI remains trapped in the zone between 0 and a high around 60 – conventionally considered to be Bearish. The zone between 40 and above signifies Bullish conditions.

 


Chart 4: The top window shows the S&P 500 in a rare, 'expanding wedge' downtrend, while the bottom pane shows RSI is in the bearish zone with a high of 60 (shaded red).

 

The pattern indicated by the dotted red lines on the right side of the top window in Chart 4 above has created a relatively rare expanding wedge pattern. These unusual patterns are indicative of expanding volatility and are usually precursors to significant events. It's unusual because volatility typically contracts as a market move it develops, a result of investors calming down as the emotions created by an event unwind, and a consensus forms around a direction and target for prices.

From a technical standpoint using the closes on a weekly chart for more accuracy, the S&P 500 retraced 50% of its decline between October 1 and late December 2018 before meeting resistance in a zone below 2675 (shaded in red on right side of top window). 50% is a common Fibonacci retracement level before another decline often begins, which would probably retest the December lows around 2375. If those lows are retested, it would mean investors face another -10% decline in the coming weeks before a significant rally might get underway. As mentioned previously, most of our strategies are in risk-off mode holding fixed-income ETF investments.

Only if the 2675 level is pierced will risk begin mitigating, and only after a new high is set above 2940 will the coast be entirely clear for aggressive long positions. Until that happens, we consider the primary trend of the market to be downward with a high risk of loss.


Catalysts

The outcome of the coming five-seven market sessions may determine stock prices for many weeks and months ahead. Many analysts believe that the recent, forceful five-week rally was nothing more than a classic dead cat bounce. As a result, they expect to see another downlink that is just as forceful as that balance, taking stocks back down to the prior lows. However, should resistance levels just above current prices be pierced, that would signify continuing positive momentum in the rally that began at Christmas.

Show to return downward be in the cards, the question is whether the December 24 threshold around 2350 on the S&P 500 will hold as support – creating a 'W' double-bottom pattern – or will that level be broken and the downturn continue unabated and possibly enter into a full-blown bear mode? The outcome is likely to be influenced by the direction of earnings in the weeks ahead, as well as the resolution of several troubling issues.

So far, the 4Q-2018 earnings reports are surprisingly bullish, not the slowdown that we were warned about throughout 2018, but investors may also get spooked by the political shockwaves that could lie ahead later this year. Can surprisingly good corporate earnings overcome all the headline-generating madness emanating from Washington, DC? Will stocks resume the five-week rally that began in December?

The catalysts for a resumption of the rally could be driven by investor relief over resolution of the following troubling concerns, some of which have been in play for more than a year:

        • The government shutdown has a temporary, three-week reprieve. However, it’s out of the hands of the president and in the hands of Congress now. There’s a good likelihood that both sides of the aisle will want to make a deal, which is, after all what they did initially. However, don’t expect any "grand bargains" that puts the immigration issue to rest. Both Democrats and Republicans will likely want to continue to milk immigration as a reason to demonize the other side and drive their voters to the polls.

        • Cabinet-level delegations between China and the US are set to resume negotiations over a potential solution that could end the tariffs from the trade war launched by Pres. Trump in July 2017. A resolution to the standoff could trigger a huge surge in stock prices as investors celebrate their relief.

        • Despite some high-profile disappointments, fourth-quarter earnings are coming in surprisingly strong and have reached record high of $130.18 per share for the S&P 500. If that pace holds, it will mark the fifth straight quarter of double-digit earnings growth for the S&P 500 index, at an annualized pace of 21.77% according to multpl.com – well above the median of 12.35%.

        • With stock prices declining, valuations have also come down to more reasonable levels, with a forward 12-month P/E ratio for the S&P 500 of 15.4, returning it to the long-term average.

 

Conclusion

First and foremost, the long-term trend remains down because a 52-week low was set in late December and stocks remain below their prior peaks. As another rule of thumb dictating the trend, stocks are below their 200-day moving average, and the 50-day moving average is below the 200-day moving average, making the long-term evidence favor the Bears. That said, the S&P 500 breaking through the 2675 level would be bullish for the broader market.

 

Using This Analysis with a Systematic Investment Model

Quantitative investment models avoid the most severe market drawdowns by occasionally moving into a risk-off asset, while systematically buying the most favorable ETF positions during bull markets – i.e., the solution offered by ETFOptimize.com. However, to take full advantage of these systematic models, subscribers must follow the recommendations of their model to the letter.

"Following the recommendations of your model to the letter" often means doing things that seem counterintuitive. However, always remember that whenever a recommendation from your model feels counterintuitive, there's a high likelihood that it is one of those moments that separates a quantitative system's superior, emotionless judgments from our own, all-to-human, emotional decision-making.

That's why we always strongly recommend that you use our analysis articles for informational purposes, but do not act on them. Instead, closely follow the recommendations of your model and buy/sell the ETF it does – at the same time it does. That is the approach investors must take to ensure they are following a systematic method – and not overriding that systematic approach with discretionary decisions that can devastate your savings.

 



 



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