Optimized Insights

Data-driven Market Analysis Using the ETFOptimize Strategy Indicators





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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 1987 and 1998, frightening but of little lasting economic 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.


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.)


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.

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