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BOTTOM LINE: The bull-market uptrend that began in March 2009, with renewal in March 2020, remains intact. However, now significantly over-extended, there are significant concerns ahead.
The head-spinning, -34% selloff for the S&P 500 in late-February and March 2020, driven by the worst economic conditions since the Great Depression (a result of Covid shutdowns), was alleviated by unprecedented Federal Reserve market manipulation. Nevertheless, in the real economy, millions of businesses were forced to shut down by the natural disaster dubbed 'COVID-19.' Many of those businesses are shutting down again now as the virus spreads prolifically. Many of those small companies will never return, and this is a significant concern for the health of the United States economy.
However, some businesses excelled during the challenges of 2020—i.e., tech companies that enable productivity at home and companies that thrive without face-to-face interaction with their customers. An example is Amazon (AMZN), which brings your orders to the door with a contactless delivery arrangement. Or Zoom, which has become the video service du jour for communicating at a distance.
The Federal Reserve's $3 Trillion infusion, and a matching amount of stimulus by the US Congress, may have saved the stock market, the nation's banks, and many businesses, but there are also many parts of the economy that remain in Depression-era conditions. Any business that depends on face-to-face or indoor interaction with customers has been radically affected by the Novel Coronavirus. For example, many in the foodservice industry have seen their incomes severely reduced or even eliminated by everything from restaurant limitations to severe closures.
Avoiding face-to-face interaction with customers has most affected the foodservice industry, travel, transportation, and retail market segments. However, online shopping has spiked significantly, and retail companies with an online presence are doing well. Many online retail outlets have seen a rise in sales of 100% to 200% since the pandemic began. With COVID infections, hospitalizations, and deaths still climbing at a parabolic pace in December 2020, these conditions have forced many restaurants and other businesses to close permanently.
These small-business closures directly affect the US economy, and the full repercussions of the virus on the economy have yet to be felt completely. To date, there are more than 16 million cases and 301,000 deaths in the US, and last week saw the most Coronavirus cases, hospitalizations, and deaths in history.
Chart 1 below shows the last three bull markets with their Long-Term Support Line (LTSL) drawn underneath each in dashed green. In every bull market in the previous 150 years, a break below the green LTSL would mark the start of a bear market. This dynamic occurred in both the Dot-Com bubble in 2000 and the Financial Crisis beginning in late-2007. However, notice the false break (highlighted in yellow) that happened in March 2020. Had this been a 'normal' recession, that -34% downturn would likely have turned into a full-fledged bear market that probably would have still been causing havoc today.
Chart 1: The S&P 500 is staying far above its Long-Term Support Line, indicating that the bull market is intact.
Nevertheless, it's clear that the market has broken with the economy, and we don't have a routine recession or a bear market. Instead, we see a potent bull-market pattern with stocks quickly recovering and today remaining far above their dashed-green LTSL. The bull market that began in March 2009 lives on, and what we are seeing is more like a classic cyclical recovery.
Earnings Growth
We calculate a custom S&P 500 Earnings analysis that progressively blends three components: the as-reported TTM earnings, Current Fiscal Year's (CurFYEPS) earnings estimates, and Next Fiscal Year's (NextFYEPS) forecasted earnings. The algorithm progressively factors more of the next quarter as each quarter passes. This algorithm creates a very accurate indicator of corporate profits aligned with bear markets and bull rallies.
Chart 2 below (Raw Data) shows the S&P 500's earnings record since January 1999, as presented by our Progressive Blend Earnings Composite (PBEC).
Chart 2: S&P 500 Progressive Blend Earnings Composite (PBEC) is a very accurate signal for market turns. As they say, "Earnings are the mother's milk of stock prices."
Last Five Years
Chart 3 below—Raw Data Focus: A zoom into the last five years of the PBEC chart above shows more clearly the radical decline of earnings in Q1-2020 (red line), the bottom for the S&P 500 (blue line) on July 6, and the subsequent sharp rise of profits. Today, S&P 500 earnings stand at $157.32, a dramatic surge of 20.39% in the five months since the low of $130.68 on July 6.
Chart 3: S&P 500 earnings rose more than 20% in the five months since its July 6 low, with a surge from $130.68 at the March low to $157.32 today.
Chart 4—PBEC Signals: We then convert the raw data above into signals of 1 and 0 that indicate bullish conditions and bearish conditions, respectively. We use these signals and more than 50 others in our quantitative investment strategies to identify risk and produce profits every year for 81 of 81 profitable years, collectively. Below, we can see this indicator is on '1.0,' or 'risk-on' and bullish on the far-right.
Chart 4: The raw data for PBEC S&P 500 earnings is converted into a quantitative signal we can use in our models.
Another excellent indicator of economic growth comes from the industrial-metals industry. While gold (GLD) was a superb hedge through the first part of the year, after the March crash and the subsequent massive infusion of cash by the government and the Fed, industrial metals have taken off. Unlike their precious-metal cousins, industrial metal prices usually only rise when economic and demand activity is vigorous. That's what copper is showing us right now.
Chart 5 below: Often dubbed 'Doctor Copper' because the metal is said to have a Ph.D. in predicting the market, the chart below shows the Copper-to-Gold Ratio comparison in the top window, we display the price of copper in the middle window and show the Gold price chart in the bottom pane. Notice the strong performance by Copper since March and the recent slump in Gold prices since August. These charts imply increasing industrial demand (which includes the need for more Copper) and fewer investors seeking refuge in defensive assets (Gold).
Chart 5: The Copper/Gold ratio is a good indicator of the beginning and end of economic cycles.
Sector Rotation is Bullish for Early-Phase Bull Market
Another excellent indicator of an early-phase bull market comes from the specific sectors leading the market since June.
Chart 6 below shows the 11 S&P Sector performances since June, with Industrials (XLI), Materials (XLB), Technology (XLK), and Consumer Discretionary (XLY) leading the way. These are the sectors we would expect to see outperforming in an early-phase cyclical recovery.
Chart 6: The eleven S&P 500 Sectors show that since June, Industrials, Materials, Technology, and Consumer Discretionary are leading.
After the March crash, stocks quickly recovered and staged one of the most potent recoveries in history. Since the March low, the SPDR S&P 500 ETF (SPY) has gained 64.30% – an incredible performance. During that rally, there were two distinct consolidations, the last of which began in early September and ran through early November. A breakout followed in early November, and another rise before large-cap stocks took a breather last week.
Chart 7 below shows the S&P 500 ETF (SPY) for the last year with the two consolidation breakouts identified by yellow circles. The S&P 500 ETF (SPY) has gained 64% from the March low to the present.
Chart 7: The S&P 500 has staged an unprecedented 64% rally since the March low.
Chart 8 below shows the Nasdaq 100 ETF (QQQ) presents similar characteristics with a wedge consolidation in September-October and a breakout (yellow circle) in early November. The ETF has gained 79% from the March low to the present.
Chart 8: The Nasdaq 100 ETF (QQQ) has a similar pattern to SPY with a volatile breakout in November.
Chart 9 below shows the last year for the Russell 2000 Small-Cap ETF (IWM). Small-cap has outperformed its larger brethren since March with a 92.6% gain. After the recent breakout (yellow circle), IWM has attracted the most buyer attention as investors turned away from overvalued large-cap stocks and enormous technology companies. However, it's challenging to see IWM going significantly higher now after a 24.8% gain since the November breakout and gap higher.
Chart 9: The Russell 2000 ETF (IWM) is the top performer with a 92.61% gain since the March low and a 25% gain since its November breakout.
Incredible Performance – But…
Despite all these positive fundamental and technical indicators telling us we are in the early stages of a cyclical business-cycle recovery and the bull market remains intact, many analysts worry that stocks have gotten too far ahead of their fundamentals. However, bullish investors are betting that stock fundamentals will soon catch up with stock prices as the economy recovers and grows.
Strong earnings growth, now discounted far into the future, means that disappointing returns are likely in the coming months and years. Equity price growth has more than tripled the growth of earnings since the March crash. Since March, a 20.39% recovery of profits is very impressive, but we're also seeing the most robust rate of change for stocks in S&P 500 history, with a gain of more than 64% since the March 23 low at 2,237 to 3,700 today.
Overvaluation is another real concern for investors. While significant overvaluation won't cause stocks to sell off, it does act as a weight on shares and also causes more severe selloffs after they begin. The current S&P 500 10-year P/E Ratio is 33.79. This ratio is 72% above the modern-era market average of 19.6, putting the current P/E more than a full standard deviation above its average since 1990.
However, the regular S&P 500 PE ratio, without adjustment for the cyclical 10-year average of earnings, is 41.52 (the historical median PE is about 16). The Nasdaq 100 Index PE Ratio is 38.21 (median PE is 19.71). And the Small-Cap Russell 2000 PE Ratio is off the charts—literally; the Wall Street Journal cannot record a PE ratio for Small-Cap stocks and is showing 'NA.'
We have long said that Reversion-to-the Mean is the most powerful force in investing. That's why the following chart causes some serious concerns for investors.
Chart 10 below shows the historical record for three critical indicators that have been prescient in identifying significant near-term selloffs:
1) The Percent of S&P 500 Issues Above Their 200-day Simple Moving Average (SMA),
2) The Percent the S&P 500 ETF is Above Its Simple Moving Average (SMA), and
3) RSI (Relative Strength Index) Above 70.
We can see these three indicators were all showing elevated convulsions before the March 2020 selloff, which is why our more conservative models moved to defensive positions before the crash and lost nothing. Also notice that at least two of the indicators are now warning of trouble (right side of the chart).
Chart
10: Two of the three indicators we use to identify overbought conditions are signaling trouble ahead.
Today, two of three of those indicators (numbers #1 and #2) are at extreme levels, causing concern about the potential for a coming selloff. We are maintaining a daily closing-price stop-loss on each ETF position in our models to prevent losses. (Note: Please DO NOT put a trailing stop on your positions using your broker's TSL feature. Our Stop-Loss is based on the Average True Range (ATR) of the CLOSING Price.
Chart 11 below: Another excellent sentiment indicator is a composite tracked by Sentimentrader.com in their Excess Optimism/Pessimism Indicator. This indicator cumulatively summarizes the dozens of sentiment indicators followed by the site. We are big advocates of indicator composites that give a consistent 'weight-of-the-evidence' approach. We can see this indicator has recently been at record levels of optimism (the highest in 16 years), which is perilous territory.
Chart 11: Investor optimism is at an all-time high according to this Sentiment Indicator. These levels historically resulted in a sharp correction, selloff, or crash.
Sentimentrader did a threshold analysis on the Excess Optimism/Pessimism Indicator and derived the figures displayed below. When the indicator was above extreme values—as it is now, the return was -3% annualized. When below oversold levels, the return was 45% annualized.
Conclusion
Stocks have provided a remarkable—yet confounding—performance in 2020, recording new all-time highs in the face of disastrous economic forces. Businesses have collapsed at a phenomenal pace, yet stocks have reached all-time highs. This new paradigm has caused markets to attain nose-bleed valuation levels and, recently, nose-bleed investor optimism levels. The indicators associated with these conditions have always been reliable signals for investors to exit stocks and move to defensive positions.
However, we have never had a Fed willing to prop up markets by throwing money at any significant dip. The 'Powell Put' may be the most potent exogenous factor ever seen, with the Federal Reserve Chairman throwing trillions of dollars at every substantive market decline. Will Chairman Powell continue this practice even with stocks at such overwhelmingly overvalued levels (and the election over)? No one knows, but everyone assumes the past is prologue and is betting on higher prices. Put succinctly: It's a potential recipe for disaster.
However, as the famous John Maynard Keynes trope goes, "Markets can remain irrational longer than you and I can stay solvent." The revised ETFOptimize Premium Strategies, several of which are already operating, will follow markets higher rather than depend on macroeconomic indicators and stock fundamentals. The new market paradigm is that the Federal Reserve can prop up markets and send prices higher any time it chooses—despite pervasive market indicators that have historically predicted significant downturns.
For this reason, we have added the Federal Reserve Balance Sheet to the indicator composites we use for our strategies. When the balance sheet is increasing, it adds a bullish weight to the Composite Signal, and when the balance sheet is contracting, it is a bearish weight on the composite.
Economy slumping and the market selling off? No problem—throw several trillion dollars into the financial system, and stocks will quickly recover to new highs. We have entered a new paradigm in the publicly traded stock market in 2020. But how much longer will the Fed continue to send prices higher when conditions are so overdone and dangerous? We will soon discover…
Coming Soon...
Our ETFOptimize Premium Strategies—while still profitable—had one of their worst years for performance in 2020. The specific reason for this issue was massive Fed intervention. We have learned from this new market paradigm and are adjusting our models appropriately. We hope to implement further modifications by January 1.
We plan to post a series of articles providing subscribers with details about these improvements in the next few weeks. Stay tuned...