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Late-Stage Bull Market Correction

Thu, Oct 25, 2018 - 4:34pm

Any time there’s a big correction in the market, there’s a temptation to fear the worst-case scenario. Since the most recent worst-case scenario—the 2008 financial crisis—happened to be one of the worst in modern history, psychologically speaking we are all pretty doomed to judge the likelihood of another 2008-like financial crisis with a much higher probability. This is commonly referred to as the availability heuristic:

The availability heuristic operates on the notion that if something can be recalled, it must be important, or at least more important than alternative solutions which are not as readily recalled. Subsequently, under the availability heuristic, people tend to heavily weigh their judgments toward more recent information, making new opinions biased toward that latest news. (Wikipedia)

At one point this week, after back-to-back declines for the entire month of October, the S&P 500 had lost all its gains for the year and, as of today, Thursday, Oct. 25, we’ve now seen a decent bounce with headlines attributing the rally to solid earnings reports.

A continuation of positive earnings releases for the third quarter will certainly help to buoy investor sentiment in the short-term but, keep in mind, this data is backward looking and not especially helpful for this quarter (Q4) nor for the next (Q1 2019).

In that light, when it comes to the question of whether we are looking at the start of a major market top, as discussed yesterday, the most important thing to look at is not just long-term measures of trend and momentum but also leading economic indicators (LEIs) and levels of financial stress.

There’s no such thing as a “holy grail” for stock market indicators but, when it comes to risk management and knowing whether to scale in or out of the market, these two are pretty high on my list in addition to the MACD I showed yesterday.

lei financial stress
Source: Bloomberg.com, Financial Sense® Wealth ManagementPast performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly

As noted in the chart above, the Conference Board’s US Leading Economic Index (US LEI) is still in very strong territory, coming in at 7 percent year-over-year growth. If you look back in time, you can see that the US LEI was either in the process of rolling over (2000 market top) or already contracting well before the market peak (2006-2007). Of course, the very fact that this indicator begins to deteriorate before recessions, which is when most major bear markets occur, is why it’s referred to as a leading indicator. Right now, it’s not giving a red flag that we’re at a major market top or that the U.S. is staring at an imminent recession.

Now, how about financial stress? This can be measured in a variety of ways and numerous Federal Reserve regional banks have developed their own indicators for doing just this. We have aggregated a number of them together into a single composite, as shown above in the second panel. Currently, financial stress is quite low and, in agreement with the U.S. LEI, not raising a red flag that we are near a major market top or looking at the beginning of a bear market the likes of what we saw after the burst of the tech bubble or during the 2008 financial crisis.

Bottom line: As we showed yesterday, the long-term MACD is close to making a bearish crossover and could signal an important shift in the market's trend and momentum. However, leading economic indicators and financial stress measures are not at levels consistent with a major market peak à la 2000 or 2007, which argues that we are witnessing a normal correction in the context of what is very likely a late-stage bull market.

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