Most of the current arguments against the stock market rising to new highs are that we have hit the peak in terms of earnings, jobs, revenue or some other financial measures.
That may turn out to be true, but we can’t be sure about troughs and peaks until the turn has already begun.
Part of the problem may be how some investors are perceiving the data. For example, a frequently referenced chart of the unemployment rate shows that extremely low readings occur just a few months before recessions. However, that is only true if we assume that reaching a low rate is the benchmark, rather than reaching a low rate and then turning higher.
In the next chart, you can see the inverse correlation between the unemployment rate (green) and the S&P 500 (orange). The relationship is striking. However, it is important to note that the large declines in the S&P 500 came after the unemployment rate formed a bottom and began to rise.
Unemployment rate (green) versus S&P 500 (orange): Source — TradingView.com
There is a long list of metrics similar to the low unemployment rate, which can be a little worrisome, but it goes back to an unsolvable problem that traders have always struggled with: How low is too low, or how high is too high? Can the unemployment rate go lower? Yes. Can corporate earnings rise higher? Yes. Unfortunately, we can’t see the highs or lows until they start to appear.
However, there is one significant measure that can help provide additional clarity.
Earnings and Revenue Growth
Market corrections appear most frequently after a contraction in earnings growth on a quarter-over-quarter or year-over-year basis. That tends to be especially true if the contraction was not in the first quarter of the year, which can be naturally volatile.
This is a factor we have focused on over the last few weeks to justify maintaining some bullish exposure in our trades, and that part of the market’s fundamentals hasn’t changed. There was a quarter-over-quarter contraction at the end of 2017 (hence the pull back at the beginning of 2018), but the first and second quarters of this year have included significant gains in both top- and bottom-line numbers.
The Potential Spoiler
Although interest rates and stocks tend to be positively correlated, the current interest-rate situation is more complicated. If rates spike higher, we may see stocks drop significantly. The so-called “Goldilocks” situation of low interest rates and low inflation has likely made it possible for the market to reach its current highs. If inflation or interest rates rise too quickly, the market is likely to see a more severe correction.
As you can see in the next chart, the yield on the 10-year Treasury bond (the benchmark for overall interest rates) was higher than it is now just before two of the last three major drops in the S&P 500. The market declines didn’t lead to recessions, but they were still disruptive for investors. Interest rates were lower, but only by a small margin for the third correction the market experienced since the financial crisis, in 2014-2015.
S&P 500 (top) versus 10-Year Treasury Bond Yield (bottom): Source — TradingView.com
The Bottom Line
From a fundamental perspective, the market rally looks to be on firm footing. However, if yields rise unexpectedly (potentially driven by wage inflation), then the likelihood for a more significant bear market rises. Current interest-rate conditions are like those of the last three large corrections, but the monetary and earnings environment is much better.
On balance, we think this gives an edge to another bullish breakout in 2018, but the current channel hasn’t confirmed a breakout yet. While we are optimistic about the medium term, investors are likely to remain doubtful, and volatility could persist through the early summer weeks.
You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
