Is Our Simple Rule about to Reverse?

In a remarkable series of events, the S&P500 continues to power higher, almost continuously, since the beginning of this year. Last week, the S&P closed up 0.6%, and that’s on top of the prior week’s massive 2.5% gain. Volume unfortunately is not jumping higher along with the price gains; instead it’s lagging badly. This suggests that new investor money is not pouring into the stock market, and that much of the recent gains have occurred due to short-covering and corporate buybacks. Meanwhile, volatility continues to creep lower, and this is consistent with the recent price increases in the stock market indices.

So is the US economic data consistent with the big stock market recovery? In other words, are US economic reports surprising to the upside? Interestingly, the answer is no. In fact, recent US economic data—as well as recent corporate earnings results—have been mostly disappointing.  Retail sales, for example, missed badly. Industrial production also missed. These two reports are very important…..and they both disappointed. In addition, core durable goods orders missed.

At the same time, for the first time since 2016, US corporate earnings growth is slowing substantially. Back then, the S&P500 followed the corporate earnings slowdown and also declined notably. This time, the S&P500 is ignoring the earnings slowdown, at least for now. The question is will this divergence continue? Historically, stock prices and corporate earnings track each other.

Another interesting development is that our Simple Rule is now approaching a reversal point. Our rule has two major components—a fundamental economic piece and a technical market component. And over the last couple of months, both components turned bearish. Today, the fundamental component (US economic results) remains bearish. But the technical component is on the verge of turning bullish, primarily due to the massive stock market recovery over the last two months. This upcoming week, at the close of February, we will test the technical signal and if the S&P500 closes where it is today, then our Simple Rule will flip from bearish to bullish.

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