ETFOptimize Insights


Quantitative Research & Market Analysis Using the ETFOptimize Strategy Indicators


 

 

TYPICAL CORRECTION - OR SOMETHING MORE?

 

 

•  At the end of January, the S&P 500 had an exceptional two-year run going with an average return of 27% per year

• Then a frighteningly rapid -10.10% selloff woke investors out of their complacency

•  Is this week's 4%-plus mini-rally the set up for a major buying opportunity?

• Our proprietary Market Reversal Indicator says "Not so fast!" – we could have more downside ahead!

 

Last Friday (Feb. 9), the two most well-known stock market indices, the Dow Jones Industrial Average (DIA) and the S&P 500 (SPY) entered into official 'correction territory' after two weeks of intense declines. Yet, this week stocks have been rising over the first three sessions after stopping their sharp plummet at a key support level. Is this one of those rare, low-risk, high-profit buying opportunities that will pay off handsomely – or simply a pause before a continuation of the storm?

The quick, nearly straight-downward drop of -10.10% shocked many investors who had, apparently, settled into a comfortable complacency as steadily climbing gains came easily during the last year. The rapid-fire correction came without warning and was a rude awakening delivered by an unusually fast tumble during the weeks of January 28 and February 4. Investors, shocked by the intensity, withdrew $75 billion from equity ETFs and US stock mutual funds during that 10-session period, according to fund tracker EPFR Global.  According to court records, that's the most massive net outflow in that span of time in history.

Taking a pause in the first few days this week and recovering 3% of the loss, many wonder if the downturn is over – or just taking a breather before resuming the collapse. Let's see what answers to that question the market is revealing…

EQUITY'S OUTSTANDING TWO-YEAR PERFORMANCE

The seemingly effortless, low-volatility gains that have transpired for the S&P 500 stocks and most major indices since the last correction two years ago (ending February 11, 2016) had many investors feeling quite insouciant about stock's prospects for the future. Notably, confidence-inspiration arose from the fact that the S&P 500 had gone a record-breaking 455 days without as much as a -3% pullback. Investors had begun to feel that it was easy to make money in the stock market. According to InvestorsIntelligence.com, advisor sentiment had risen to the point where bulls outnumbered bears by more than 50%. That's always a harbinger of an adverse outcome.

Then a milestone tax-reform plan passed by Congress at the end of 2017 prompted an acceleration in prices beginning in mid-November, recently accelerating earnings and the recent significantly ratcheted-up 1st Quarter 2018 S&P earnings estimates induced a re-acceleration in January.  However, that quickening upward pace resulted in an auspicious parabolic pattern that veteran traders know signals nothing but trouble.

Chart 1 below shows the S&P 500 ETF (SPY) gaining 61% during the two-year span following the last market correction in early-2016 and concluding that run with a parabolic acceleration higher (red) in the pattern of a mini-"blow-off top." The ETF then gave back -10.10% of those gains in the previous two weeks, which accounted for about -17% of that 24-month run. Nevertheless, to-date, large-cap stocks still show an average 25% gain for each of the last two years, about which no one can much complain (the long-term average for stocks is 7.4% annually).


 

Chart 1: The S&P 500 Large-Cap Equity ETF (SPY) took on a parabolic shape as it accelerated in January and Relative Strength skyrocketed higher.

 

 

 

SEVERAL 50%-PLUS ANNUAL RETURNS

Three of our systematic strategies featuring equity ETFs scored exceptional returns of more than 50% in the last 12 months, as a result of dynamically switching to the optimum ETF at just the right time. For some strategies, this was a 2x-leveraged selection when a robust expansionary signal was sent by the economy, stock fundamentals, and market internals, as assessed by our algorithmic systems. While a few other companies offer ETF-strategy services, ETFOptimize is unique in that to-date, we offer one of the only (perhaps THE only) algorithmic trading systems that monitors macroeconomics, stock fundamentals and market internals to collectively and dynamically determine the optimal ETF-selections at any point in time.


Our subscription model portfolios have recorded an exceptionally high return in the last 12 months as they systematically rotated to the optimal ETF(s) with the best opportunity for gains. In fact, three of our strategies more than doubled the performance of the S&P 500 benchmark with returns greater than 50%

• Asset Allocation: Equity & Fixed Income (4 ETF) Combo generated a return of 53.69% in the last 12 months (view)

S&P 500 Aggressive (1 ETF) Strategy scored a 52.15% return over the last 12 months (view)

Adaptive Equity Rotation (2 ETF) Strategy was the big winner with a 78.94% performance in the last 12 months (view)

(See the ETF Investment Strategy Suite for complete details.)



SIMPLY AN OVERDUE CORRECTION - OR SOMETHING MORE?

For investing veterans, it was easy to see that over the last few months the market had gone into a parabolic acceleration higher and was ripe for a correction back to its mean (as shown in Chart 1, above). After all, it had been two full years since the last correction – when the average is every 11 months. Many investors, watching the increasingly overextended prices, placed stop-loss orders to ensure they captured the recent gains. These stop orders, combined with automated responses from algorithmic trading programs, are the obvious explanation for that two-week, -10% correction.

At this writing, the market's most important moving average/mean, i.e., the 20-week moving average, has been re-attained with prices just above that critical level. Chart 3 below shows the S&P 500 ETF (SPY) with the key, 20-week moving average (red):

 

 
Chart 3: The 20-week moving average is perhaps the most important technical level in investing. Stock prices above this level are usually bullish and when below, bearish. Prices plummeted to just below the key, 20-week moving average last week and this week have recovered to above it.
 


In the market's favor is the fact that the profit picture looks strong, even with an uptick in inflation. So, was the recent two-week correction like the stock drops of 1998, 2006, or 2011 – frightening but of little lasting consequence? Or was it more like 2007 when the collapse of several subprime lenders revealed the tip of a systemic credit iceberg that ultimately sank the world economy?

There is no doubt that investment markets are facing some challenges that have taken down past bull markets; i.e., the threat of inflation, a weak dollar, and rising bond yields. One of the most serious concerns today is the fact that central banks are now unwinding Quantitative Easing (QE), the easy-money stimulus program that the Federal Reserve instituted in late 2008 as a desperate measure to stave off the crisis. As much as QE was designed to boost stock prices and help return asset prices to a more normal level, the unwinding of QE, with the steady release of more than $2 trillion of bonds into the marketplace is expected to have a significant headwind effect. However, since this massive experiment with the US economy has never occurred before, no one knows exactly what's going to happen.

So, was the previous two-week plummet just a one-time blip to correct short-term overextended prices or are we seeing the beginning of a significant change in trend for stocks? One of our most essential proprietary indicators we use to identify trend direction changes is suggesting that there may be more trouble ahead for long-only investors.


The ETFOptimize TREND INFLECTION INDICATOR

In poker, an inadvertent behavior or mannerism that betrays the player's intentions is called a 'tell' by veteran gamblers. Similarly, the stock market has a number of 'tells' that betray what's occurring beneath the surface and can be used to help determine what the future holds for a particular asset, market sector/segment, or the prices of entire indices. The vast majority of investors are largely unaware of these secret cues, but ETFOptimize sometimes incorporates them into the algorithmic ETF-selection decisions of our quantitative strategies.

One such 'tell' is that a significant expansion in the high-low price range of intra-week price volatility of stocks, indices, and ETFs consistently signals a change in the direction of a trend of that asset. (Note that we use intra-week price volatility rather than far more 'noisy' and potentially misleading shorter-term periods.)

INDICATOR METHODOLOGY

As the trend in the price of an index or asset reaches a critical level, market participants modify their exposure and positioning at various stages of time. Some investors are early to identify that a critical level is nearing and will sell first, while others who don't see the same signal or are not as focused on current events affecting the price, will be slower in their decision process. These escalating purchase and sales decisions can occur because the asset has attained full valuation, as a result of a change in an underlying factor (such as the effect the value of the dollar has on commodity prices), or the asset's price has reached a critical technical level.

More aggressive participants may even be placing short positions on the asset with bets to the downside, while other speculators may be doubling down on their long-only position. When it comes to investing, opportunity is in the eye of the beholder. The result of all of these changes to the positioning and exposure, often by thousands or millions of investors, results in increased intra-week price volatility. This volatility can be measured by an expansion in the range of highs and lows in the price of a stock, index, or ETF as they reach a potentially critical turn-point.

This market 'turbulence,' caused by high-low range expansion, does not have a directional bias.  For example, if the prior trend is upward and significant volatility expansion occurs, our indicator signals a change in the direction downward. If the past pattern is downward and intra-week volatility expands, the signal is for a reversal upward. We normalize the Trend Inflection Indicator using 100 as the signal line. A warning occurs when the indicator moves above the 100-level and the actual signal for the beginning of a new trend occurs when volatility declines and the indicator drops back below 100.  Currently, the Trend Reversal Indicator is in a 'Warning' status for large-capitalization stocks. (Generally speaking, other size market-capitalization indices follow the lead of the large-cap S&P 500, but not always.)

The ETFOptimize Trend Reversal Indicator, shown in the lower window of Chart 4 below, has risen above the critical 100 level for the S&P 500 (large-company) Stock Index ETF (SPY):

 

 
Chart 4: Our Trend Reversal Indicator (TRI) is signaling an imminent trend change for large-cap stocks. Not so for smaller companies.
 

 

Perhaps of importance is the fact that while currently headed sharply higher into 'Warning' territory, our Trend Reversal Indicator has not yet risen above the 100 (warning)-level for mid-cap or small-cap stocks (not shown). 

The bottom-line answer to the question posed in the headline of this article – "Is a Buying Opportunity at Hand?" – must remain, for now, an open-ended question. We will know in the next week or two whether the recent turbulence will be a quickly forgotten footnote in the nine-year rally or the beginning of the end of low-volatility, high-profit investment conditions. One technical rule of thumb to keep in mind: this downtrend will not be safely complete until a new high is established, above the late-January weekly high of 2873 on the S&P 500 index (287 for the S&P 500 ETF, i.e., SPY).

NEXT WEEK: We'll examine key economic indicators to determine the current stage of the expansion and how much more juice is left in this nine-year old bull market.


Visit Our Selection of ETF Investment Strategies






Discover the secrets of modern, successful investing