Note: This article was originally published on Sunday, June 30, 2019 for ETFOptimize subscribers. The S&P 500 has since pierced the Overhead Resistance, as predicted in the article. However, there are a number of other profound observations provided in this article, based on objective macroeconomic and market indicators, making it well worth reading.
The Market's Trouble with Overhead Resistance
The week before last, on Thursday, June 20, the S&P 500 ran into a cement wall of Overhead Resistance, established just above the 2950 level – which was also the approximate high in early May. Then last week, this index of America's premier large companies floundered around below this level, and the situation stumps many investors. They wonder if stocks can break through that resistance and establish fresh new highs again in this market cycle – or if we have seen the last market high and the end of the line for the record-setting,10-year-long bull market following the Financial Crisis of 2008-2009.
You have to admit; it's certainly an exciting time to be an investor! To wit; today's investors have seen the worst market crash and recession in a generation (perhaps two generations), followed by the longest bull market in history. Okay, let's see what this astonishing investment market has to tell us today…
Chart 1 below shows a daily chart of the S&P 500 since last November, just before it took a -10% December dip below its Long-Term Support Line (LTSL, dotted-dark-green line), which got started back in October 2008. Here you can see that while stocks dipped below the LTSL in the fourth quarter last year, it recovered nicely in the first quarter this year before running into Overhead Resistance (horizontal, dotted-red-line), bouncing straight down to the dark-green Support Line, making a V-shaped bottom and heading straight back up to Overhead Resistance – below which it floundered around last week.
Chart 1: Still below its Overhead Resistance line, the S&P 500 remains between a rock (Long-Term Support Line) and a hard place (said Overhead Resistance).
We made the case in our June 2 Quick Look article that significant breaks of a bull market's Long-Term Support Lines (LTSL, dark-green line above), which markets regularly establish as diagonal bases for prices during extended rallies, are clear indications of the start of bear markets when pierced.
While there was a temporary, false-alarm break of the LTSL in the fourth quarter of 2018, so far the S&P 500 has avoided a substantive break of its Long-Term Support Line since that line first developed in late-2008. The critical component that determines whether a break of the trendline is going to be temporary or meaningful is the overall status of macroeconomic indicators and stock fundamentals when technical indicators begin to weaken. It is for this reason that we use composites of macroeconomic indicators, equity fundamentals, market breadth, investor sentiment, and technical indicators to determine the market exposure of our quantitative models.
When macro-conditions are still positive, as they were in the fourth quarter of 2018, that break of the LTSL was predictably only temporary. The fact that stocks have been unable to take off from here (so far) demonstrates a slowing of the economic growth that had previously pushed stocks far above the Long-Term Support Line with ease. We may see an increase in economic growth (which naturally stimulates corporate earnings and stock prices), but it's unclear from where that growth may emerge.
However, the S&P 500 is now butted up against Overhead Resistance, and if it is unable to break through soon, it could turn downward toward its Support Line once again, creating a ping-pong pattern between an ever-narrowing rock and a hard place. Moreover, the longer the S&P 500 stays just above its LTSL, the more likely it is that the threshold will give way, and that will be a significant signal of the beginning of the next bear market.
HOW LONG CAN THIS SITUATION LAST?
We might get into a situation where the S&P 500 remains barely above its Support Line, then a previously unforeseen economic shock will hit – causing a tsunami of fear to sweep the US and the world, prompting shoppers to stay home, business buyers to retrench, vacationers to cancel plans, corporate profits to sink, and the stock market to plummet. It's a classic tale that's been told hundreds of times before.
However, no one should take rash action! By all means, follow the instructions of your ETFOptimize model – stick with the plan! It's possible that the above scenario won't play out for months or even longer. If you take emotionally-driven evasive action, you could miss out on the last gasp – which is regularly the most profitable span in any bull market. Alternatively – while it's highly unlikely – the economy could take off again. After all, we are in a bull market following a Financial Crisis, which historically have resulted in very long, slow, and drawn-out recoveries – precisely like the one we have witnessed. How drawn-out is anyone's guess at this point, which is why we advocate investment models that react to real-time changes in the leading-indicator data.
So where is the market headed next? Let's take a look at two macro indicators, one from the economy and one from the market, to see what those signals are telling us is ahead should the LTSL be challenged once again:
May Through Mid-June Sector Trend was 100% Defensive
Following the epic, 23.54% market surge from the day after Christmas to early May, stocks in the Consumer Discretionary, Communications Services, Technology, Industrials, and Energy sectors went into a significant slump through the entire month of May and the first portion of June. It was a classic consolidation after a big run-up.
Those stock sectors had attracted and earned a great deal of money, and bullish investors were ready to take a well-deserved hiatus after driving stocks back above their pre-fourth-quarter-selloff level, to set a fractional new high, before heading for the Barcalounger to enjoy an ice-cold refreshment.
As shown in Chart 2 below, during the six weeks from early-May through mid-June (as the overall market slumped and floundered), it was the defensive sectors that began to push the market higher. This move was led by Real Estate, Utilities, Consumer Staples, and Healthcare shares, as institutional investors rotated into the unloved defensive sectors, shown by the bars on the right with an upward green arrow. The previous, cyclical market leaders went into a shallow decline, as indicated by the red arrow on the left side of the chart.
Chart 2: After its first impact with Overhead Resistance in early May, bullish sectors went into a slump and defensive stocks assumed a leadership role.
But Recent Sector Trend Turns Bullish...
However, since returning to the level of prior highs and being flummoxed again by the brick wall of the previously mentioned Overhead Resistance during the week of June 17, there has been another significant turnover of market leadership.
As shown in Chart 3 below, over the past two weeks since the mid-June impact with Overhead resistance, the defensive market leaders of Staples, Healthcare, Utilities, and Real Estate seem to have given up their campaign and returned to their slump (dotted-red-line, right side). The previously mentioned bullish sectors (dotted-green-line, left side) have resumed their leadership role – albeit rather limited, at this point. However, that's to be expected (can't go much hgiher) until the Overhead Resistance is pierced.
Chart 3: Since the S&P 500 bounced off the concrete wall of Overhead Resistance the week of June 16, market leadership has returned to the bullish sectors.
This change of leadership from defensive to bullish sectors bodes well for a final break-through of the Overhead Resistance, and the establishment of new, all-time market highs in the coming week (or perhaps two weeks at the most). However, sector leadership is only one factor that gives us insight into the overall direction of stocks. Other critical signals include Earnings Trends, Corporate Bond Yields, Housing Start Trends, Market Breadth Trends, Treasury Yield Differentials, Sector Earnings Trends, Unemployment Trends, and many more.
What are macroeconomic indicators telling us at this time? Rather than look at a composite of indicators, let's focus on a very critical component from the macroeconomic group...
Unemployment Suggests Continuing Gains are Ahead
Another positive indicator that is favorable for continuing to new highs is the fact that our proprietary Unemployment Signal is not giving a bearish sign of economic contraction at this time.
Chart 4 below shows the SPDR S&P 500 ETF (SPY, blue) in the top panel, and the actual US Unemployment Rate (purple) in the bottom window. The two middle windows show our Unemployment Signal (green, second from top) above, and a chart showing how the Signal is derived using black and red lines (third window from the top) for display. The black line signifies a two-month Exponential Moving Average (EMA) of the US Unemployment Rate (which helps smooth out short-term noise), while the red signal line is an offset of the two-month EMA.
The green Unemployment Signal Line (second from top) provides a binary indicator of those crossovers. You can see that it has some short-term, false signals, which is common in a crossover system, and that's one of the reasons why we always use a composite of indicators to provide more accurate signals with fewer whipsaws.
Chart 4: Substantive changes in the Unemployment Rate trend provides a 6-to-10-month leading indicator of economic contraction, and a coincident market downturn.
When the Unemployment Rate (black line in Chart 4, above) is above its red signal line, it indicates that Unemployment is climbing, which has proven historically to be an accurate, leading indicator of an imminent economic contraction.
Small and medium-sized business owners usually are very close to their market and have a keen sense for when a slowdown in their business is beginning. With employees generally being the most significant expense for a company, a payroll cut is the first step firms will take when preparing for a downturn. Larger businesses follow the same pattern not long after that, having a much more significant impact on the number of unemployed workers, which is why when Unemployment finally turns, it can accelerate higher quite rapidly.
A review of historical data shows that an upturn in the Unemployment Signal and a downturn in the stock market itself provide a 6-to-10 month lead time before a recession gets underway. For this reason, the Unemployment Signal offers a valuable coincident indicator for a near-term stock market downturn, and when the recession ensues – a -20% or more significant bear market.
However, an Uptrend in Initial Claims Could Soon Signal a Recession
Significant increases in the trend of Initial Unemployment Claims (IUC) is one of the best leading indicators of a recession. IUC is a weekly signal (rather than monthly like the Unemployment Rate), and is based on actual claims – i.e., cumulative counts of the documents filed with the Unemployment Offices across the US – rather than seasonally adjusted estimates based on surveys of businesses and the public, as is the case with the monthly Unemployment Rate.
While the two macro-indicators discussed above, one for the market (sector trend) and another for the economy (unemployment trend), are currently providing a near-term (and possibly intermediate-term) bullish signal, the trend in Initial Unemployment Claims appears to be very near to turning higher, and when it occurs, that is likely to be the death knell for this long bull market.
Chart 5 below shows the pattern of Initial Unemployment Claims (green line) for the last two market cycles and today. The dotted-blue line indicates the trend of the highs of Initial Claims, but there are other ways to draw these lines. When Initial Unemployment Claims begin to shoot higher, breaking above that blue trendline, it is a definitive indicator that the top of the bull market is behind us and a downturn has started. Invariably, in the coming months, a recession will accompany that significant increase in the trend of unemployment claims.
Chart 5: Weekly Initial Unemployment Claims is a sensitive, accurate, and consistent
leading indicator of recessions and a coincident indicator of bear markets.
On the far right of the chart, you can see that trend of the decline of Initial Unemployment Claims began to slow somewhat as far back as 2015 and has flatlined at an average of about 210,000 claims per month for the last year. Looking back at 2007, just before the Financial Crisis and Great Recession, you can see that Initial Claims also flatlined for about a year at approximately 310,000 per week before turning sharply higher.
The public report of a surge in Unemployment Claims in 2007 accompanied the beginning of the market selloff in October that year – almost to the day – which indicates that savvy investors are keen to use this indicator, and justifiably so. When we see the weekly report of Initial Unemployment Claims break above this trendline, it's time to switch investment regimes to defensive and inverse positions, depending on your risk (volatility) tolerance.
That said, a market selloff is nothing to be feared, and there is certainly no reason to panic just because a recession is imminent. Economic contractions are a natural part of the business cycle, restoring equilibrium and resetting prices to more reasonable levels – indeed, preparing the ground for the launch of the next great bull market. The approach that we offer to subscribers is to utilize changes in key data to determine the optimum ETF to hold at any given time – bullish or defensive/inverse (depending on the model used), and select the optimum ETF for that situation – so we can profit in any market environment.
Always Be Profiting
Rather than using one or two market indicators (as most investors/advisors do), the ETFOptimize models rely on a composite of as many as 38 different data sets from multiple disciplines (macroeconomic, stock fundamentals, investor sentiment, market breadth, and technical indicators) for our signals, thereby making those signals far more accurate and robust than any alternatives of which we are aware.
We believe the only intelligent approach to the market is to eschew the plethora of market guesses by modern-day market soothsayers and TV-business-news talking heads – instead, allowing the decisions to be made for you by super-fast, state-of-the-art computers analyzing the highest quality financial data available today. This approach will provide far more accuracy and consistent performance than the best instincts the greatest market forecaster could ever hope to possess.
The computers utilized for our selections can crunch hundreds of thousands of data points at nearly the speed of light, providing you with the signals and ETF selections you need to 'ABP' – Always Be Profiting – regardless of the direction of the market. The algorithms, formulas, and sophisticated mathematical relationships utilized to build our models are constructed by professional quantitative designers with more than 50 years of collective experience in the investment market and developing systematic investment strategies.
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Asset Allocation: Equity/Fixed Income Combo (4 ETF) Strategy
Chart 6: The ETFOptimize Asset Allocation: Equity/Fixed Income (4 ETF) Combo Strategy produces a consistently positive return regardless of the market direction.
New Article Coming for ETFOptimize Insights
We are preparing and this week will publish a new article about the signal from one of our most important and accurate proprietary indicators. This indicator taps into a little-known – but incredibly valuable – financial relationship, and provides a highly-accurate reading for what's coming next in the market.
Remember that the ETFOptimize research and analysis articles are provided to keep you abreast of the underlying trends in the economy and the market, not to offer guidance on the appropriate investment appraoch. We identify when our key indicators modify their signal so you're not caught off guard by a significant change in the trend of stock and bonds, and are tempted to succumb to a knee-jerk reaction out of fear.
Savvy, experienced investors also see these macroeconomic changes approaching, and usually prepare defensive measures for when the signals do turn bearish. However, without a systematic discipline, driven by the weekly analysis of thousands of data points and the subtle relationships between them – which is an impossible task for a single human being – this effort is often futile – too early or too late, and causing losses and stress. This situation explains the embarrassing long-term annual performance of just 2.6% (slightly above inflation) for mutual fund managers and professional money managers. Individual investors do even worse over the long haul, with some studies indicating slightly negative returns after expenses over the long run.
As an ETFOptimize subscriber, you have already done your preparation for the next marekt change, are well ahead of 99% of investors, and have taken the most intelligent and logical step you can for avoiding losses and earning profits regardless of the direction of the market.
Our consistent advice: follow the guidance of your ETFOptimize investment model – to the letter – and never be tempted to override it with discretionary (read: emotional, even if they seem rational) decisions based on temporary market noise. We promise – you won't be disappointed by the results!
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