Two key risks to the bull that no one is talking about

Posted by Cam Hui -

The S&P 500 has been in a steady uptrend for over two years and it just staged an upside breakout to an all-time high. It may seem counterintuitive to be discussing the risks of a major market top, but I am seeing some early warnings that few analysts are paying attention to.
 

 

 

The roots of its own demise

While I am not inclined to front run model readings, if the S&P 500 were to end January at a closing high, it would represent the roots of a bullish demise.

 

The accompanying chart shows a long-term buy and sell discipline that has served us well over the years. Here is how it works. A buy signal is triggered when the monthly MACD of the NYSE Composite (bottom panel) turns positive (dotted blue vertical lines). A sell signal is triggered when the 14-month RSI (top panel) flashes a negative divergence when the market makes a new high. If the S&P 500 were to close the month at current levels, it would represent a new monthly high, while the 14-month RSI is making a lower high, or a sell signal.

 

 

While it is said that there is nothing more bullish than a stock or index making a fresh all-time high, this might be an exception to that adage. In this case, weak RSI momentum is setting up the bulls with the roots of their own demise.
 

The weakness in NYSE Composite RSI is reflective of the weak breadth exhibited by the stock market. Even as the S&P 500 tests overhead resistance at its all-time high, no version of the Advance-Decline Line is nearing a fresh high.
 

 

It could be argued that my long-term model readings, which are based on the NYSE Composite, are misleading as the S&P 500 has been outperforming the NYSE Composite because of the strength of the Magnificent Seven. A similar monthly analysis based on the S&P 500 also shows a less pronounced but still negative RSI divergence.
 

 

To be sure, negative RSI divergences and negative breadth divergences are not immediate sell everything and rush into cash signals. Instead, they are warnings of faltering momentum, but these readings are warning of a potential Q1 or Q2 market top. The caveat is this is a monthly model and investors need to monitor how the market closes at the end of January.
 

MarketWatch recently also reported another long-term warning with no immediate bearish trigger. Ed Yardeni found that foreigners, who have a terrible market timing record, are piling into U.S. equities at a record pace.
 

 

 

The deportation growth threat

Markets turned risk-on after Trump’s inauguration, largely because many of the potential headwinds to growth did not immediately materialize. While Trump did sign a flurry of executive orders, most of them were either symbolic, cultural or only had economic effects that didn’t unsettle markets, such as the reversal of DEI initiatives, renaming the Gulf of Mexico and the withdrawal from the Paris Accords.
Trump didn’t immediately slap tariffs on China, though he did threaten Canada and Mexico with 25% tariffs and China with 10% by February 1, which the market interpreted as bluster. It seems that Trump 2.0 learned from the lessons of Trump 1.0 and the chaos of the Muslim ban when Trump first took office in 2017. The new Trump Administration is being more measured in the implementation of its campaign promises.

 

One of Trump’s signature initiatives is on deportation as he vowed in his inaugural address to send “millions and millions of criminal aliens back to the places from which they came.” The Peterson Institute estimated the effects of Trump’s major electoral promises in a study. It modeled the effects on GDP and inflation of light (1.3 million people) and severe deportation (8.3 million) over a four-year window, as well as the effects of different tariff rates and the revocation of Fed independence. The magnitude of the effects on growth and inflation of deportation is substantially higher than either tariffs or the revocation of Fed independence.

 

 

A different study by the Brookings Institute projected less alarming effects on growth, though there are different approaches to the two studies. The Peterson study projected the effects over four years and analyzed pure deportations, while the Brookings study modeled the effects in 2025 and focused on net migration, which includes the natural effect of legal immigration plus the negative effects of deportations.
 

The Brookings study, which assumed an extreme scenario of a mass deportation of over one million people in 2025 is reminiscent of the Eisenhower deportations of 1954, modeled a one-year GDP growth shock of -0.4%. To make an apples-to-apples comparison to the Peterson study, its assumption of the removal of 1.3 million illegals caused a negative GDP growth shock of -3.8% over four years, which averages to just under -1% a year.
 

 

Any way you look at it, there will be a negative growth surprise from mass deportation. Economists can make various assumptions in modeling but won’t know until it actually happens.

 

So far, the Trump Administration is taking more disciplined measured steps to implement its campaign promises. The House just passed the Laken Riley Act, which will deport illegal immigrants charged, but not necessarily convicted, with certain crimes. The Act is certain to be signed into law by Trump, though it’s unclear whether it will survive a court challenge because it denies due process to deportees. While there were stories of scheduled immigration raids in sanctuary cities like Chicago and San Diego, the raids have been put on hold, though there were a raid reported in Boston. In short, the extent and scale of deportation efforts remains to be seen. If the measured pace of Trump 2.0 continues, investors will see more substantial signs of deportation by Q2 or Q3. This is consistent with the scenario of a cyclical stock market top in Q1 or Q2 signaled by negative breadth divergences, as markets tend to be forward-looking.
 

So far, two industries that depend on undocumented worker labour, homebuilding and restaurants, have lagged the S&P 500 but price action shows increasing concern but no panic.
 

 

In conclusion, nascent signs of a major market top are appearing even as the S&P 500 tests its all-time high. A growing negative breadth divergence and a potential growth shock of mass deportations could sideswipe stock prices. The scenario of a major market top in Q1 or Q2 2025 is building. The caveat is these are very early and preliminary warning signs of risk that should be monitored before taking action.

 

3 thoughts on “Two key risks to the bull that no one is talking about”

  1. We are in an era of fiscal dominance which really alters the picture.
    The AD line is affected by breadth, the nasdaq in the dot com bubble had a lousy adline along with a bad rsi and yet even though the ADline peaked in April of 98, the advance melted up by around 150%.
    Complacency means we ignore warnings like RSI divergences and greedily hold on to our winners instead of deleveraging our risk.
    When will the honeymoon with Trump end? Ask Melania or the priors.
    What about the refinancing wall that is coming?
    What to make of this dollar strength? We hear about trouble in China which must affect Asia. All these years of a US trade deficit, maybe they are buying dollars to deleverage USD debt because there is a squeeze, and they are able to. I don’t know about that one, but there is something wonky when a country can run trade deficits of 1 trillion a year and yet the currency strengthens.
    For those of you who have played Jenga, or watched, you know how it gets shaky and yet may not topple for a few more turns. Instability, it makes me think of the Yen Carry scare of a few months back.
    When rates started to rise, mortgage rates shot up, no more sub 3% 30 years, and yet home prices kept going up, the golden handcuffs of a sub 3% in a 6 to 7 % era makes people reluctant to move unless they have to or they can avoid a mortgage after downsizing (blame the boomers again ).
    So there is a lot wrong with the markets, but they can go much higher.
    We need to keep an eye on bonds, they are more real and if bond yields keep going up and the refinancing wall decimates the zombie companies they should warn us.

    1. I do a lot of data analysis and put outputs in various types of time series. The goal is to observe how markets change over time and how I can adjust acordingly. These are biomarkers of the markets which reflect interactions of many things. If you do bottom-up or fundamentals-based analyses the models often are not predictive enough to be useful. But if you approach it from the other direction it gets easier and more reliable. I learned this from one of my mentors the late jim Simons who passed away last year. Simons is a math genius and also very practical, a great quant trader, compared to a lot of people with strong ties with academia. You can dynamically adjust or modify sets of parameters to improve the odds of winning. If you win your algos work. If not, go back and tweak. There is nothing for all four seasons. If you abandon perfectionism you can greatly simplify things and make life a lot more enjoyable. Simple and consistent.

      There are two things, among several others, I think I noticed about markets. You probably did too.

      The gamification of investing and proliferation of trading vehicles. Some people really like it, but it also poses as problems to a lot of rules-based managers because markets are interconnected. At the very least several past reliable indicators are starting to lose its effectivensss.

      And this recent one. The latest correction is stair-down and elevator-up, opposite of traditional style. The drop is very small but breadth became vey poor. This is due to megacaps and rotation. Is it going to be like this from now on?

      1. The Mag 7 is starting to look like the NIfty 50. This isn’t the dot-com bubble, where the companies weren’t profitable. The Nifty 50 were all profitable and fast growing.

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