Let's get one thing straight...
Stock prices continue moving higher -- and that is bullish. I'm not going to suggest anyone fight the trend. As long as stocks are rising, we should be aggressive.
This week, I want to consider why stocks are rising. In general terms, uptrends are driven by economic data, fundamentals, sentiment, or a combination of those three factors. Understanding the primary factor behind a move can help us prepare for the inevitable reversal.
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First, uptrends driven by economic or fundamental data tend to be the strongest. That's the case with the current uptrend.
Economic data measures what has already happened and is useful for determining whether investors are being overconfident or overly cautious. The official data coming in right now is even stronger than analysts had expected, which is making investors confident that the current market uptrend has been built on a solid foundation (versus having been built on what turns out to be a shaky economy).
The Lumber-Construction-Economy Connection
But to assess what is likely to happen in the economy, I like to review market-based indicators. One such indicator that I follow is the price of lumber. It's been in a downtrend recently, as the chart below shows.
Lumber is important because it is used in construction and other industries. It's prominence in home construction makes lumber an excellent leading indicator of the economy. One study found "an average new home built in the U.S. contains over 14,000 board feet of lumber." The study also noted the demand for lumber is uniquely sensitive to housing activity. Another study found that each new home creates three full-time jobs.
That means home construction trends, lumber prices, and the economy are all inherently connected. Changes in lumber prices can tell us to expect changes in home construction trends, which in turn can predict changes in the economy.
In other words, the current trend downtrend in lumber is bearish in the long run.
The next chart shows that lumber prices (blue line) tend to reverse direction before the S&P 500 Index (black line); however, the lead time is unpredictable, so we can't use this indicator as a precise timing tool.
Despite the stronger-than-expected economic data we've been receiving, the stock market's rally has not been confirmed by lumber, as shown in the chart below comparing lumber prices and the S&P 500 over the past six years.
This indicates there is underlying weakness in the economy. And even though this indicator can't tell us when to expect the next bear market, it does suggest that the next bear market is likely to be deep (since the economy is weak).
Fundamentals are summarized in the next chart, which shows the profit margins of companies in the S&P 500.
Margins are the percent of revenue that show up as profits. At the highest point, in the third quarter of 2018, companies in the S&P 500 were reporting $12 million in profits for every $100 million in sales. (Note that there is an error in the original chart labeling two bars as Q318. The second bar from the left should be labeled Q418.)
Lately, higher costs are reducing profit margins, and this will adversely affect earnings. Because earnings per share (EPS) can be temporarily maintained with share buybacks, margins are a better indicator of the trend in fundamentals.
Like the economy, fundamentals are also in decline, which means neither factor is actually supporting the current rally in stocks.
So, if the rally isn't being driven by a strong economy or strong fundamentals, that leaves us with sentiment.
How We'll Handle This Sentiment Rally
As I mentioned earlier, sentiment alone can be strong enough to drive an uptrend. In fact, sentiment is what drove prices all the way to their bubble extremes in 1999, even as the economy and fundamentals deteriorated.
Sentiment also drove markets higher in 1987. In fact, The New York Times recently noted that "the stock market is off to its best start since 1987." But it's similarities like this that I'm watching out for.
The next chart shows the S&P 500's performance in 1987 (black), as well as its year-to-date performance for 2019 (blue).
In 1987, there was considerably more upside to be had between May and the index's peak in August. But the crash in October wiped out all of the year's gains. That's the risk we need to be prepared for, and why I'm watching my indicators so closely.
The good news? We should be able to see the crash coming, giving us time to prepare for its impact.
In the next chart, I've applied my Profit Amplifier Momentum (PAM) indicator to the 1987 market action. In the bottom panel, you can see PAM turned bearish ahead of the crash. The 40-week moving average (MA), shown as the solid blue line, also confirmed the bearish outlook a week before the crash.
If we had used my PAM indicator back in 1987, we would have received a strong warning signal (as well as a confirmation) with enough lead time to prepare our portfolios. Granted, this is not a guarantee that we will definitely receive the same signal ahead of the next crash, but it does give me hope.
Action To Take
For now, this is still a bull market -- albeit a potentially dangerous one. As such, we should follow our indicators rather than the emotions of the crowd to determine when it is best to decrease exposure to stocks... and that's exactly what I'll do.
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(This article originally appeared on StreetAuthority.com.)