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Goldilocks and the Bear Market

Not too warm, not too cold, can describe many aspects of the US economy. Take last week’s jobs report as an example. According to estimates, 287,000 jobs were created, but this did little more than balance out the previous month’s weak 11,000 figure.

Taken together, the two months put us near the 172,000 monthly jobs that the economy has averaged during 2016.

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Wages fit into the same category, rising 2.6% in the 12 months through June 2016 (the highest during this recovery) but only up 1.3% in real terms during 2016.

What about the broader economy? First quarter GDP came in on the low side at 1.1%, but the Atlanta Fed’s GDP Now is pointing towards a 2+ percent second quarter (chart below).

Other forecasts are centering around 2.5% growth. This would keep us on pace with the 2% growth trajectory that our economy has managed for the last few years. Not great, but not in recession either.

Inflation tells a similar story. Headline inflation remains stuck around 1%, but core inflation (excluding food and energy) is at 1.6% and appears to be in a mild upward trend.

Thus inflation is not strong enough to warrant the threat of significant rate hikes, but we’re also not battling the throes of deflation and stepping into negative interest rates. Stable commodity prices seem to point to continued lukewarm inflation figures going forward.

The manufacturing and services sectors of our economy fit this paradigm as well. In June, the ISM services index rose to 56.5%, the highest reading since November of last year. The new orders component reached 59.9%, foreshadowing an increase in future activity.

Helping to balance that out, the June ISM manufacturing index came in at 53.2%. Not as strong a reading, but still signaling expansion and not contraction.

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What about the Conference Board’s Leading Economic Index? Same story there, with the LEI declining 0.2% in May, following a 0.6% increase in April and a 0.1% increase in March.

In chart below you can see that the LEI’s upward momentum has slowed, but it has not rolled over quite yet. The Coincident Economic Index also seems to be flattening out, but has not yet started to decline.

Similar developments can be seen elsewhere in the global economy, including the Baltic Dry Index (chart below). Back above 700, the Baltic Index has more than doubled from its February lows below 300.

The down side? It’s still fighting a major declining trend of lower lows and lower highs, which could continue in the months ahead.

Altogether, it’s hard to argue that our economy will take off in the months ahead, or plummet into recession. It seems there’s a good chance of more-of-the-same, with financial markets likely to follow suit.

So what’s an investor to do in this environment? Honestly, probably not much more than sit and watch … and wait for an inevitable opportunity.

With stocks and bonds both near all-time highs, it’s hard to find a compelling reason to add more long-term positions in either of those markets. On the contrary, it’s becoming more enticing to act as a trend trader, attempting to capitalizing on shorter-term market moves.

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When the stock market sits in an extended trading range, as it has for the last couple of years, the only people who are making money are those that are selling into strength and buying into weakness. Take this latest run for example.

Since the February lows, the S&P has gained more than 16%. That’s a fantastic return over a couple of years, let alone five months. But now we’re hitting the upper end of our trading range. Personally, I’m tempted to sell into this strength on the premise that I’ll have an opportunity to rebuild those positions on another leg down in the months ahead.

With shorter-term, multi-month trend trading strategies, one of the best ways to find good entry and exit points is to use the volatility index (2nd chart below). You want to sell into complacency (low VIX below 14), and buy on VIX spikes that reach around 25 or higher.

It’s by no means a foolproof strategy, but watching the VIX will tell you when the market is in panic mode (time to build positions) and when complacency is dominant (time to distribute positions). Right now, the VIX has once again fallen below 14 as the market soars to a new high.

If this were a typical bull market, one would be compelled to maintain and even add to long positions on strength, taking new highs as a signal of continued positive price momentum. But this doesn’t feel like a strong bull market, and Dow Theory would contend it’s actually a bear market.

It’s unfortunate that Dow Theory does not have a “neutral” signal. According to Dow Theory, the primary trend is either bullish, or bearish. This stems from the fact that the last signal is assumed to remain in effect until it is either reconfirmed, or the averages confirm in the opposite direction.

But over the last 18 months, the market has gone nowhere. If there is a primary bullish or bearish trend, it has a very shallow trajectory and is filled with noise. And with economic data continuing to paint a not-too-hot, not-too-cold picture, perhaps it’s time to become a bit more active on the secondary market moves.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()