Market History

Using the past to rationally predict the future.

Will the S&P 500 consolidate within a range in the next few months?

As we highlighted in previous posts, the U.S. (and global economy) is growing nicely. Thus, the U.S. stock market is still in a long term bull market.

However, there are various bearish factors that are going against the U.S. stock market in the medium term.

What are the bearish factors

Factor 1

As of this week, it seems like suddenly everyone realized that the U.S. stock market’s valuation is high.

  1. Legendary bond market hedge fund manager Jeff Gundlach said valuations are high. Based on the S&P’s price to sales ratio, the S&P’s valuation today is almost as high as it was in 1999. That was just 1 year before the bull market ended in 2000.
  2. Blackrock CEO Larry Fink agrees that stocks are overvalued.
  3. David Tepper agrees that U.S. equities are relatively overvalued compared to foreign equities (e.g. Europe, China, Russia).

Some people believe that these valuations will cause a bear market. We disagree. Bear markets only happen after the market becomes overvalued. But in order for the market to go down, the U.S. economy must go down first. In other words, overvaluation is a necessary but not enough condition for a bear market.

Factor 2

Global inflation is taking a temporary pause. In the last stage of an economic expansion, inflation drives stock prices higher because the nominal prices of assets go up.

Since Trump won in November, inflation and U.S. stocks went up together. This is what the media called “the reflation trade”.

This rising inflation was driven by rising oil prices throughout 2016. With oil settling around $45-$55 a barrel, inflation will stop rising for the next few months. Thus, this bullish factor for equities will temporarily disappear.

Factor 3

Trump’s pro-growth policies are either coming late-2017 or are already dead in the water. Without an Obamacare repeal, Trump simply cannot pass significant tax cuts for federal budgetary reasons.

Thus, this big bullish driver of U.S. stocks from December 2016 – February 2017 is gone.

Congress comes back from recess at the end of April. Thus, the Trump vs. Everyone Else fight to pass pro-growth policies will rage from May onwards. This is not bullish for stocks.

Factor 4

From a seasonality factor, May through summer tends to be the worst months of every year for the S&P 500. We do not take seasonality into consideration for our investments because seasonality factors do not have a high accuracy rate. For example, the “Sell in May and go away” only has an accuracy rate of around 30%!

Factor 5

Our model has great accuracy at predicting big corrections. We’re adding a component to predict small corrections. If stocks go up this earnings season (in mid-late April), then our model states that a small 7-10% will probably happen.

However, the component of our model that predicts small corrections is less accurate than the component that predicts big corrections (75% accuracy vs. 92% accuracy). So if stocks rise this earnings season, we will cut our long position from 100% long UPRO (3x S&P ETF) to 2/3 long UPRO. Then we’ll buy on the dip and switch back to 100% long when the S&P falls approximately 7-10%.

Why a consolidation for the next few months is most likely

Our model is not predicting a big correction. Although the S&P is facing bearish headwinds in the next few months, these headwinds are not strong enough to push stocks down significantly.

The S&P’s biggest headwind is overvaluation. The best way to solve the S&P 500’s valuation problem is to WAIT. Over time, U.S. earnings will increase, U.S. corporations will become more valuable, and with a flat price, valuations will decline on their own.

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