Two Outlooks for 2018

Stock market gains for 2017 were strong, and it is reasonable to wonder: Where will the market go from here? Will it continue to go higher? Will it stumble and fall in 2018?

Two well-known and respected investors have come out with very different forecasts for 2018. Jeffrey Gundlach says (link) stocks are in an accelerating phase now but will ultimately post negative returns for 2018.

The S&P 500 “may go up 15 percent in the first part of the year, but I believe, when it falls, it will wipe out the entire gain of the first part of the year with a negative sign in front of it” – Jeffrey Gundlach

Or, are we poised for a jump in stock prices as global growth accelerates, as Bill Miller suggests (link)?  

I think we could have the kind of melt-up we had in 2013, where we had the market go up 30 percent," -- Bill Miller

The tone of these statements is different, but they could both be true. The market could go up 15 to 30% in the first part of the year and then decline.

The CPM investment approach does not make or use such forecasts. Instead, we evaluate the market’s current ability to recover quickly from bad news and events. This assessment is based on our Market Resilience Indexes (MRIs) and typically remains relevant for a three-to-six week horizon.

Let’s review what the Market Resilience Indexes are currently telling us, and identify past periods that are similar to the current environment. This will give us a sense of where we might be in a broader cycle of stock market returns.

As of January 5, 2018, the Macro MRI, which tells us about the longer-term price cycles and trends, is at the 97th percentile of all weeks since 1918 clearly a high level. Yet, the direction of the index’s change is still positive, and decidedly so. Based on past cycles, the Macro trend could remain positive for a few months.  

The Micro MRI, which tells us about the bursts of resilience lasting 6 to 13 weeks, indicates that we have already experienced a period of short-term vulnerability and that the market is likely to become more resilient in the coming weeks.

Considering all the MRI together for the Dow Jones Industrial Average, our assessment is that the market can recover quickly from any bad news and events. Thus, our portfolios continue to be fully invested. 

Greater resilience at both the Macro and Micro levels is consistent with Miller’s “melt-up” statement and also with Gundlach’s view that prices will move higher in the early part of the year.
Historical Precedents

To see how the current market environment compares with past periods in terms of its particular mix of Macro, Exceptional Micro, and Micro MRI, we compared twelve different statistics related to MRI levels, direction of movement, and pace of change. Over 5000 weeks covering almost 100 years of weekly statistics were evaluated for the DJIA.

We determined the fifteen weeks most similar to the status as of January 5, 2018.  The fifteen weeks clustered into five different periods:
1996 – 6 similar weeks
1959 – 2
1955 – 4
1937 – 2
1926 – 1

The graph below shows these dates on a price chart of the DJIA. “Price” is on a log scale to appropriately show the magnitude of early price changes in percentage terms.

Based on the number of weeks identified as similar, the 1996 cluster of six weeks is most similar to the current environment. It is near the beginning of a strong move upward in prices that lasted for four years until 2000.

The next largest cluster occurred in 1955, with four similar weeks. This too was followed by a strong market that moved upward, with some volatility, for about 10 years until 1966.

The 1959 cluster of two similar weeks was followed by generally higher prices. It is within the upward trend following the 1955 cluster. 

Two similar weeks occurred in 1937. This cluster was followed by a sharp price decline and a negative trend in prices that lasted until 1942, which is discussed below.

The week in 1926 was also followed by a strong market for three years until the 1929 crash.

Across all the historical weeks most similar to last week, about 75% of the subsequent 13-week periods had positive returns. This pattern suggests a strong market in early 2018. However, as mentioned for the 1937 cluster, some of the similar weeks in the past were followed by declines. Two periods are noteworthy.

In the 1937 case, prices dropped by 11% over the following 13 weeks. This period became known as the “1937 Recession.” It occurred at the end of the Great Depression when an initial industrial recovery faltered. Unemployment jumped from 14.3% in 1937 to 19.0% in 1938.[1] However, our current unemployment statistics are quite different they are low.  Furthermore, growth is accelerating globally. Thus, the 1937 period may not be similar to our own in an economic sense.

Another cluster that is somewhat similar to the current week is just prior to the decline of 1987. The week of September 4, 1987 is not shown above because it is outside of the top 15 shown, but it is in the top 30 of similar weeks. September 4th was followed by a 30% decline over the next 13 weeks. While this is a chilling prospect and deserves consideration, a case can be made that the broader conditions are different. First, the market had appreciated 97% in the two years prior to September 4, 1987, whereas the market appreciated 56% in the two years prior to last week. While both are large numbers, the appreciation prior to the 1987 date is greater.

Second, in 1987, the market had been moving contrary to its resilience levels for about a year prior to the crash.  This is often seen in the late stages of bull markets, which are overly euphoric. This stage can last for several quarters.  Today, the market has been performing in a manner generally consistent with its MRI levels, with the exception of the last month or so (noted below).   

Thus, today’s conditions are different.  The positive aspect of the 1987 decline is that it was followed by 10 years of strong market returns.

While acknowledging the cautionary precedents of 1937 and 1987, the cases of 1996 and 1955 do have the highest number of weeks similar to the current environment.  These cases support a more optimistic view or where we are in a broader cycle. 

Recent stock market behavior relative to our assessments of resilience gives additional perspective.  During the recent two months of greater vulnerability, as measured by our MRI, the US stock market did not decline it went up.  

This recent market behavior could be telling us that we may be moving into a more euphoric stage, where vulnerability does not result in price declines.  If so, this heightened euphoria is just beginning.

However, we may find that the last two months of defiance could more reasonably be attributed to the passage of the tax bill, which may boost corporate profits.  Either way, the current market environment does not yet appear to be excessively euphoric the way it was prior to September of 1987 and in other major declines of the last 100 years. 

This evaluation leans more toward the view expressed by Bill Miller stock market prices will move higher.

That said, it is important to remember that our approach does not rely on forecasts.  The analysis driving our research and model portfolios is based on readings of the market done every week. We will evaluate the market another 51 times in 2018 and will change our model portfolios as needed. We can see the dynamics shift and the algorithms will shift the portfolios in response to the changing dynamics so that if the stock turns down as predicted by Gundlach, we will respond.

[1]                      Economic Fluctuations, Maurice W. Lee, Chairman of Economics Dept., Washington State College, published by R. D. Irwin Inc, Homewood, Illinois, 1955, page 236.