I didn't update my blog for two years as I went through a broad and deep discovery of fundamental and technical indicators for US stock market cycle. I felt that I need put these indicators into practice for investment/trading to test in real time and avoid 'look back bias'.
I felt lucky that I called out the top of the market in Sep'2018 before the market dropped ~20% in three months. Now with more gained knowledge about the market, I feel more comfortable to call out the market top. This time, the drop is bigger and will last longer, which is considered as the second leg of current recession and the first leg of bear market.
Fundamental Factor Analysis
Fundamentals factors we use here are CPI YOY% and 10-Year Interest Rate. We compared current cycle trend/pattern with historical ones and concluded why it makes sense for ending of the bull market.
Data source: https://fred.stlouisfed.org/series/CPIAUCSL#0
Since CPI YOY% peaked in 1980, it's in a down trend, has finished two economic cycles, and now is in the third one. The first one was in 1980-1991 and the second was in 1992-2008, and the third one started in 2009. If we compare 1992-2008 CPI cycle with current one, we notice many similarities, which could be used to predict possible market direction of current stock market cycle. For instance, in previous two down cycles, each cycle contains four sub-cycles with CPI re-bounces (1980-1991 CPI cycle down trend is so strong that the first two re-bounces were broken into 4 smaller ones in 1981-1983, and the 3rd and 4th ones were obvious). The current CPI cycle is in 3rd sub-cycle and we are at the end of it. The 2nd sub-cycle ending in 2015 was featured with bigger drop of CPI from late 2014 to early 2015, which is same as what happening in current 3rd sub-cycle and CPI big drop was caused by pandemic. When it bounced back, it's associated with strong rally in stock market.
What happened in second half of 2015 was stock market crashed in August, then Nasdaq 100 reached new high in Nov'2015. After market finished its final rally, SP500 dropped 324 points, ~15%, from its top in May'2015, the biggest points drop since recovery started in Mar'2009.
What will happen when this rally is over? Unless CPI can continue current re-bounce, which is unlikely as the recession continues, we should see CPI reverts back to down trend and break through the low of -0.2% in 2015. If it happens, it will be very bearish for the market, and it will form the second leg of this recession and a bear stock market. This pattern will be the same CPI pattern in 2002 from last cycle.
Given there were 3 crashes in last 2 years (Jan'2018, Oct'2018, and Feb'2020), the upcoming one will be bigger and last at least 6 months into next year. Different market sections may fare through the down turn quiet differently, like technology stocks from Nasdaq will be stronger than traditional industrial stocks from New York Exchange due to the pandemic economy, and Nasdaq 100 and Composite may not hit new low when the bear market ends.
The reason I applied 2002 CPI pattern here is because I am a believer that stock market is kind rhyme or echo the past cycle driven by macro economic factors, like CPI cycle here. It's not the simple repeat as different historical situations modify the details of each cycle, which causes variation. for instance, 1992-2008 CPI cycle is disinflation, marked by declining positive CPI YOY%. Current CPI cycle started in 2009 is a true deflation cycle with declining CPI YOY% and also trenched with negative CPI YOY%.
If we examine 10-Year Treasury Rate (TNX), we can find that it follows the similar down trend pattern as CPI YOY%. It makes sense as long term interest rate is the reflection of inflation along with embedded real interest rate. We can identify stock market cycle from 1990 to 2002 was associated with three TNX down waves (1990-1993, 1995-1998, and 2000-2003). TNX three waves down trend pattern (2010-2012, 2014-2016, and 2019-?) also showed up in current stock market cycle. If we assume TNX current down trend will last as prior one, it should extend to 2021. As the pandemic triggered TNX down trend pushed up stock market to new high, the next leg of TNX down trend would be stock bear market along with the continuing recession.
Technical Factor Analysis
SPX and other indices, like Nasdaq Composite (COMPQ), Nasdaq 100 (NDX) and New York Exchange Composite (NYA), are approaching important cycle timeline. Overall, these market indices have 6-8 months mid-term cycle, and when the cycle reach three, they form a complete long term cycle, which means a bigger correction is needed. If index price cycle matches the timeline of fundamental factors cycle, like CPI, it could mean the end of the market trend.
The below two years SPX chart shows that it had two cycles by Feb'2020, 7 and 6.5 months, respectively. this means current third cycle would last 6 months, and end on 9/23/2020. We should be very careful around this date and check out if the peak could be confirmed by other technical indicators.
One last technical and psychological indicator is AAII sentiment, and we noticed that the Neutral dropped to a new low since 2011 in March due to pandemic and Bearish is hovering around 40-50%, the highest since 2014. If the Neutral can't improve and break up through previous cycle high of 46.31 in Apr'2019, the bull market since 2009 will be ended. I mentioned in my last post about how bull markets in the past peaked with the Neutral signal, and now this signal is strong and clear.
Data source: https://www.aaii.com/sentimentsurvey
An extension of this discussion is how next economic cycle looks like after this recession ends. I think it will be a major inflation cycle with CPI YOY% and TNX on an uptrend, like what happened from 2003 to 2008. But we need to preserve our capital and wait for the bear market storm to pass...
