Summary: After falling into their first correction in two years, US equities regained half of their loses in just 6 days. The rebound has been strong enough and persistent enough to suggest that it has further to run. Sentiment and volatility backwardation support that view. However, a low retest over the coming weeks is still a viable risk.
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In just one week, US indices regained about half of their losses during the prior two weeks. SPX gained more than 4% and NDX more than 5% (from Alphatrends). Enlarge any chart by clicking on it.
Summary: Corrections during bull markets have had a strong propensity to form a double bottom. Since 1980, only 16% of corrections have had a "V bounce" where the low was never revisited.
The current bull market has been different. Since 2009, about half of the corrections have had a "V bounce." So what happens this time?
Sentiment can be reset through both time and price. It's a good guess that if price recovers quickly, sentiment will again become very bullish, making a retest of the recent low probable. A slower, choppier recovery will keep investors skeptical, increasing the odds that the index continues higher.
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Our weekend article summarized the outlook for US equities following the first 10% correction since early 2016 (read it here). Prior swift falls of this magnitude have led to quick recoveries that eventually retested prior highs. That view is further supported by the washout in breadth, volatility and several measures of sentiment. Overall, risk/reward appears heavily biased towards upside in the near term. The strong rally today seems to support that view.
But our article also showed that while equities sometimes "V bounce", they more often form a double bottom as the strong down momentum is worked off over time.
This article provides 25 examples of roughly 10% falls in SPX over the past 38 years to demonstrate the strong propensity of the index to form a double bottom. We have not been a slave to the fall being at least 10% and we have deliberately excluded examples from the four bear markets where equities were clearly trending downward.
In the charts below, a red arrow is the initial 10% fall and the green highlight is the retest of the low in following weeks. 84% of the corrections have had a low retest (or a lower low).
There are 4 cases (16%) marked with a green arrow showing the initial 10% fall to also essentially be the low (a "V bounce").
While the "V bounce" has been rare, it's notable that 3 of the 4 cases since 1980 have taken place during the current bull market. If you just consider the past 9 years, the odds of a "V bounce" are a coin toss.
So which happens this time?
Sentiment turned very bearish during the past two weeks. It's a good guess that if equities now quickly recover, and if sentiment also quickly becomes very bullish, then a retest of the recent low is probably ahead. A slower, choppier recovery will keep investors skeptical, increasing the odds that the index continues higher. Enlarge any chart below by clicking on it.
Summary: After gaining more than 7% by late January, US stocks have fallen into a 10% correction. It's the quickest decline of that magnitude from an all-time high in 90 years. While a fall in stocks was not a surprise, the speed and severity certainly were.
So what happens next? Prior falls like this have led to quick recoveries. That likelihood is further supported by a washout in breadth, volatility and several measures of sentiment. Moreover, the fundamental backdrop remains excellent. Risk/reward is heavily biased towards upside in the near term.
That said, strong down momentum normally reverberates into the weeks ahead. Equities sometimes "V bounce" but more often form a double bottom. A low retest in the not too distant future remains a greater than 50% probability. The longer term outlook for US equities is unchanged and favorable.
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Two weeks ago, all of the US indices made new all time highs (ATHs). SPX and DJIA were up 7% and NDX was up 10% YTD. VXX, the ETF based on the VIX, was down for the year (the next two charts from Alphatrends). Enlarge any chart by clicking on it.
Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.
The bond market agrees with the macro data. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (arrows). The lag between inversion and the start of the next recession has been long: at least a year and in several instances as long as 2-3 years. On this basis, the current expansion will likely last through 2018 at a minimum. Enlarge any image by clicking on it.
Summary: US equities have already gained more in the first few weeks of January than they do in many full years. The recent trend is being termed unprecedented, but these types of gains have happened before. The current trend is also being called unsustainable, but in most prior cases, equities have continued higher. The equity market is undeniably hot, and that can often lead to a period of retracement and decline, but trends weaken before they reverse, and this one has not shown any sign of weakness. The longer term outlook remains favorable.
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All of the US indices made new all time highs (ATHs) again this week. This includes the very broad NYSE (composed of 2800 stocks) as well as the small cap index, RUT. The dominant trend remains higher.
US markets have started the year like a rocket. SPX and DJIA are up 7.5% and NDX is up 9.7% YTD (from Alphatrends). Enlarge any chart by clicking on it.