ETFOptimize Insights


Quantitative Research & Market Analysis Using the ETFOptimize Strategy Indicators


 

On the Cusp of a Bear market?
Last week stocks saw their worst week in more than two years. Is this the beginning of a bear market? Source: Pexels.com

 

ARE WE ON THE CUSP OF A BEAR MARKET?

 


• Stocks reached extremely overextended prices in late January –  14.2% above their long-term mean – followed by a record-setting, extremely volatile correction.

• Some technical, price indicators are unequivocably suggesting that a lengthy bear market is already in progress.

• But we also examine some of the underlying fundamental drivers of stock prices – which have a more powerful, long-term influence, to see if equity prices will continue upward from here.

 

 

While last week it seems market participants took a breathless respite from the wild recent activity, the week prior - March 18-24, US stocks suffered their worst five sessions in more than two years as blue-chips in the S&P 500 Index (SPY) fell by -5.95%. Surprisingly, that week was not as unusual as it would've been at any other time. That's because, according to the CBOE, the last few months have been the most volatile on record!

With prices going nearly parabolic in January and becoming extremely overextended – based on what FactSet says was the fastest pace of earnings-estimate increases on record, those overextended conditions corrected violently with the most rapid expansion in the CBOE volatility index ($VIX) in history.

 

Three record-setting months
Chart 1:
As a result of the fastest-paced increase in earnings estimates ever recorded, stock prices nearly formed a parabolic pattern in January. That resulted in a violent correction that the CBOE says caused the $VIX index to spike higher in the first quarter at the fastest pace ever recorded.

 

The recent three months of very volatile price action was an abrupt turn of events because prior to this three months of shock-and-awe, stocks had steadily climbed - uneventfully - in a rally that began all the way back in November 2016, with prices never gaining nor losing more than two percent during any week during the span of those 57 weeks.

This steady ascension created a relaxed, easy-going 2017 for investors, with a 14-month, stress-free gain of 26.86% that lulled many into a seemingly benign complacency about the market. However, investor's mellow mood was shattered at the end of January as a nine-week bout of extreme volatility more than made up for the prior year's shortage of excitement.

This week, many investors are asking a very pointed question: is the recent volatility since late-January just a healthy correction following overbought highs – or the beginning of something much more significant?

We will seek to answer that question in this article, first by conducting a 1) technical assessment of the market to determine its near-term price bias – and then by analyzing some 2) overarching economic factors, and reviewing several 3) highly-correlated fundamental stock factors to assess the direction of stock prices in the next few months. Our analysis will answer the question of whether the recent gyrations were just the result of price imbalances - or if caused by a decline in underlying fundamentals, indicate the start of a prolonged, very-overdue bear market.

TECHNICAL ASSESSMENT OF THE MARKET

Technical analysis coincides with the academic theory of an efficient market (EMH), which posits that a security's price reflects all publicly available information about a company. For many technical analysts, a security's price is the most crucial information - price is all you need to know. However, ETFOptimize doesn't see it quite that way. Click this pop-up to learn about the unique way we utilize Technical Analysis in our quantitative ETF-selection systems...

PRICES IN JANUARY – TOO FAR, TOO FAST

In Chart 2 below, you can see that in January the price of S&P 500 (top window) shares began to accelerate sharply higher above their 50-week moving average (dotted-blue line), fueled by investor enthusiasm about global growth and the deep corporate tax cuts enacted by Congress at the end of December. Investors expect the tax cuts to significantly improve corporate bottom lines (Warren Buffett wrote that Berkshire Hathaway's profits rose by $29 billion as a result of the bill).

Analysts estimate that the tax reform could initially add as much as $19 (14%) to S&P 500 earnings in 2018. A commensurate windfall increase in stock prices is the logical result, and when Pres. Trump signed the legislation at the end of December, investors responded in January by pouring funds into risk assets, led by equities. We'll explore the components of earnings growth in another article, but suffice it to say that corporate earnings growth appears to have other drivers beyond legislative stimulus from tax cuts.

Needless to say, analyst's consensus per-share earnings growth estimates for the S&P 500 for 2017-2019 are impressive:

  • 2017: +10%  
    2018: +17.8%  
    2019: +12%  

During the first quarter of 2018, FactSet reported that analysts recently increased earnings estimates for S&P 500 companies by 5.4%. Analysts are always increasing or decreasing growth estimates during the quarter, but over the past five years, quarterly estimate revisions have averaged a decline of -3.9% during the first quarter – so this was an important reversal of that trend.  Even more newsworthy, the Q1 2018 increase was the largest ever since FactSet began tracking the quarterly bottom-up EPS estimate in Q2 2002.

But, as a result of investor's enthusiasm over tax reform combined with organic earnings growth, the price of stocks (represented below by the S&P 500 index in the top window) moved too far, too fast above its long-term, 50-week mean. In a near-parabolic move, prices extended 14.2% above that crucial level in January, which is the first time prices have reached that far above their mean in more than seven years. As in physics, every action requires a reaction, and as a result of this outsized upward move, during the week of January 28, stock prices began to reverse course and tumble downwards to correct the out-of-balance price conditions.

The lower window in Chart 2 below shows the percentage spread that prices attained above or below their 50-week EMA, a moving average that serves as the long-term mean of the market. After stretching 14.2% above their 50-week moving average, stocks performed a classic 'reversion-to- the-mean' move and spent the last eight weeks dropping back to their 50-week moving average.

Prices move too far, too fast in January
Chart 2: Prices reached extremely overbought conditions in January – extending 14.2% above their long-term 50-week EMA. In the lower window, PPO (50-week) measures the amount prices have moved in either direction above or below the 50-week, long-term mean. January's peak was the highest in seven years.


This law-of-physics response to overextended prices resulted in an intense two-week selloff that began on January 28 and continued through today.  The volatility that followed created a first-quarter that – according to the CBOE – had the highest increase in the Volatility Index in history.

There was an initial -10% drop, an erratic, one-month, 6.7% rally, then yet another, more significant slide that began on March 12 and continued through last Thursday (March 29). As the holiday weekend approached, stock prices settled just above their 200-day moving average, which appears to be at least a temporary station where investors can take a breather, gather their thoughts (and money), and prepare over the long Easter weekend for what's to come.

Volatility combined with portfolio losses often prompts investors to worry whether a correction could be the beginning of a longer-term bear market. After all, it has been nine years since the last bear market ended following the Financial Crisis – with most investors aware that the average economic expansion only lasts 4.5 years. If the current bull market continues until August 22 this year, it will be the longest expansion in history.

Furthermore, high volatility is a classic sign of a significant change to the trend of the market, and as we profiled in our February 14 Insights report, volatility reached the trend-changing level in February. The record-setting volatility (according to the CBOE) in the first quarter of 2018 may signify an inflection point in the long-term upward trend of the market that has been in place since March 2009. Now that volatility indicator doesn't necessarily mean you should plan for a -50% bear market. A significant increase in volatility, over a certain level, could be a signal that a more benign correction or a moderate downturn could be ahead.

Let's see what some of the indicators we use in our strategies are telling us…

TECHNICAL RISK INDICATORS

ETFOptimizeuses a set of multiple technical indicators to create a portion of our ranking systems composed of rules-based components (binary output). Other technical analysis tools such as moving-average crossovers apply in the majority of our data-series analysis as a signal for a binary change. Each of these indicators is designed to show either risk-on or risk-off conditions. Then the results of those components are appropriately weighted and individual results compiled for the final output. This output is configured as a percentage between zero and 100 which can give us the current status of the market's regime; i.e., whether the market is in expansion or contraction and an indication of the strength of those trends.

MARKET BREADTH

Our systems analyze breadth indicators of the market such as the New Highs/New Lows Ratio, Advance-Decline Percent Ratio, Percent-Above 200-day Indicator, High Beta vs. Low Beta Stock Ratio, Accumulation-Distribution Ratio, and others. Breadth ratios are valuable because they can measure the internal condition and performance of various segments of the stocks in an index, which we can't see in the price of an index alone. For example, sometimes stock leadership from a handful of companies or a particular sector (such as the technology sector most recently) can be forceful and will lift an entire index along with it. However, this unbalanced condition cannot last forever, and when the vast majority of stocks in an index are showing weakness, eventually the index will turn downward (usually rapidly). For this reason, breadth is often an excellent leading indicator of market turns.

BREADTH - ADVANCE-DECLINE PERCENT: 

In Chart 3 below, we see that on March 23, one of our breadth indicators, the Advance-Decline Percent ratio dipped below -30% (which indicates weakness) for the S&P 500, S&P Mid-Cap 400 and Nasdaq 100. That's the second time in two months that breadth has given a bearish signal. That's the  second bearish thrust signal this year, following the first one in early February.


 Bearish breadth indicator – advance decline percent
Chart 3: The Advance-Decline Percent Indicator shows another bearish breadth thrust on March 23, the second in two months.

 

Note: The S&P Small-Cap 600 has held up better than large-caps and mid-caps through the correction and did not experience a bearish breadth thrust.

Also, despite the bearish signal from the Advance-Decline Percent ratio, each of our other breadth indicators is – perhaps surprisingly – providing bullish signals. Overall, the reading from a composite of all breadth indicators is still positive – i.e., bullish – but only barely so.

THESE THREE TECHNICAL INDICATORS ARE SIGNALING INCREASED RISK

Chart 3 below shows three examples of the technical analysis-based risk indicators referred to earlier, which we use in some of our ranking systems. This chart shows the S&P 500 ETF (SPY) in the top window, our Market Risk Indicator (MRI) in the second window, the Price Momentum Oscillator (PMO) in the third window, and the Stochastics Oscillator in the bottom window. All our signaling that bearish conditions began about two weeks ago.

 

 Technical indicators are negative for stocks
Chart 3: Each of the three technical indicators shown above turned bearish around March 13. Continue reading to learn why our strategies aren't in cash.

 

We can see from the top window that the weekly price of the S&P 500 dropped below its 20-week moving average (dotted-blue line), which serves as the intermediate-term mean of the market. However, closing prices are still above the 50-week moving average (not shown). If prices drop below that long-term, 50-week EMA, then hold on to your shirt because that's when things could get very ominous. (The 50-week EMA currently stands at 2571.75 on the S&P 500 index.)

Each of the three lower indicator windows shows that the technical indicators turned negative about two weeks ago, on March 12 and March 14 (denoted by red-shaded areas) and are signaling that risk has significantly increased. Specifically, with the middle window showing Price Momentum Oscillator (PMO) rolling over in February, the momentum of the S&P 500 ETF now appears to be entering a secular decline. Our adaptive-rotation ETF systems that depend strictly on these type of technical-price readings have moved into cash (or cash-proxy ETF) positions as a protection against potential losses.

For our systems that depend on a more comprehensive set of components, that is not the case. The reason for is that most of our ranking systems include economic indicators that at present are still bullish - as well as stock-fundamentals components, such as the Blended S&P Earnings Estimates trend (shown below), which also remain constructive. Let's review some of those indicators…


ECONOMIC INDICATORS

Our rules-based ranking systems take a subtle and sophisticated approach to interpret the market's current regime, which provides us with a determination of the appropriate group of ETFs from which to choose. If the Market Regime Score is very high, the system will select from the more aggressive group of ETFs that accompanies that strategy. For example, if the rank of the market regime is above 70%, some of our equity portfolios are designed to select from 2x-leveraged long positions. If market-condition ranking is below 30%, that signifies that risk is high and depending on the strategy, it is appropriate to move into a cash proxy or even a 2x-leveraged inverse ETF if that option is included in the strategy's design.

Next, the strategy will use its ranking system to select the most profitable ETF to own for both current conditions and the most likely forward conditions. Each of the 28 different data-series we used throughout our ranking system and Buy/Sell rules has a particular weighting, and each is part of eight composite components that also have their own overall composite weighting formula. 

Let's review an example of an Economic component in the ETFOptimize strategies...

CIVILIAN UNEMPLOYMENT

One of the economic components we use in our quantitative analysis and ranking systems is the monthly measure of unemployment. The current civilian unemployment rate has held steady at 4.1% since last October – six months without a change. Previous lows in post-war unemployment reached 3.40% in 1969, 3.70% in 1957, and the record low of 2.50% that lasted for a single month in 1953.

When unemployment reaches a low and then reverses course and begins rising, over the last 25-years, unemployment has been an excellent coincident indicator of increasing risk and market declines (prior to 1990, the indicator was more ambiguous). The unemployment rate is usually not a leading indicator but is an accurate coincident indicator, so when leading indicators have already turned negative, this indicator provides us with near-100% assurance that it's time to take defensive measures.

Chart 4 below shows the Civilian Unemployment Rate in the top window and the S&P 500 index in the lower window. You can see from the red-shaded areas (where unemployment trend changes occurred) that market tops coincide with lows in unemployment. Currently, unemployment has been at 4.1% for about six months, so this is a bit concerning. Either this is the bottom and unemployment will soon begin rising (warning!), or it is a temporary plateau on the way toward lower unemployment levels.

 

 Unemployment and Equities – the turn will be an ominous signal
Chart 4: The Unemployment Rate appears to have leveled at about 4.1% for the last six months. When it turns higher for two months, it is a high-probability sell signal.

 

Our systems require two months of rising unemployment to generate a lower score for this component, which would then begin weighing on the overall market regime determination. One month of increasing unemployment is insignificant and could merely be noise. Two consecutive months is still a gray area, but if other indicators our providing similar negative signals, a rising unemployment rate is a clear sign of increasing risk and the likely end of the bull market. The reason for this is that an increase in unemployment means that corporations are cutting back on hires – and may even be firing/laying off employees. That's an unambiguous sign of economic contraction.

We believe unemployment could still go either way. There are only a few concerning economic signals currently in place, so if expansion continues, we could see additional labor supply coming off the sidelines and converting from part-time jobs to full-time jobs. Assuming the fledgling wage inflation continues, more workers will be attracted to the job market who wouldn't have reentered if not for the prospect of higher pay.

On the other hand, if demand for workers continues to rise and there are fewer people than estimated who can return to the workforce from the sidelines, then there will be significant upward pressure on wages as employers are forced to compete for the remaining available job seekers. Wage increases are the number one cause of rising inflation, a force which will be battled by the Federal Reserve with interest-rate increases if it gets too high, and then you have another equity response heading in the opposite direction - that is, downward.

Regardless of what happens between now and then, when there are two months of rising unemployment, it will be a definite precursor of increasing market risk and therefore, demands we provide this economic component with considerable attention in the coming months.


STOCK FUNDAMENTALS

The ETFOptimize adaptive-rotation ETF strategies also use a variety of stock-fundamental factors to comprise our Market-Regime scores – as well as in our Ranking Systems and Buy/Sell rules.

S&P 500 BLENDED EARNINGS ESTIMATES

A sample of one of the stock fundamentals data series we include in our systems is the Blended Current Year & Next Year S&P 500 Earnings Estimates (Blended CNY). The S&P 500 index is the most widely used benchmark for stocks, and S&P 500 earnings estimates are the most commonly utilized stock estimates in the world.

We use a unique, blended composite of the Current Year earnings estimates combined with Next Year earnings estimates, a combination which is called 'Blended CNY.' This blending uses quarterly earnings figures, and as each quarter of the year transpires, this series will use more of the Next Year's estimate and less of the Current Year's estimate. The result is an earnings indicator that is very closely correlated with the movements of the price of the S&P 500 index.

Chart 5 below shows the S&P 500 Blended Current year & Next Year Earnings Estimates (Blended CNY). Notice that when the Blended CNY is rising, stock prices are also climbing. When the blended CNY is declining, the S&P 500 is usually heading downward along with it. At those times when earnings and price separate from one another, invariably stock prices soon play catch up (rarely the other way around).

It's easy to see why Blended CNY is used in our systems when you recognize its value as a coincident indicator is high.

 

Chart 5: The blue line is the S&P 500. The red line represents a blended composite of Current-and-Next-Year ( Blended CNY) earnings estimates for the S&P 500. As each year progresses, the indicator uses less of the current year's estimates and more of the next year's estimates, providing for a very accurate real-time gauge of stock prices.

 

Notice the current conditions on the far right-hand side of Chart 5, above. The S&P 500 is shown in blue and Blended CNY is in red, and the two data series are creating a pattern that demands attention!

What's most concerning about the image is that after first forming a parabolic pattern in January, Blended CNY earnings (red) have stopped rising and appear to be rounding off and topping.  What comes next for earnings is going to be critical for the performance of stocks going forward.

If equity analysts all drank the same Kool-Aid and hiked their estimates far too much to start 2018, they may all be bringing those estimates back down to earth in April when they report first-quarter 2018 earnings. If that's the case, market participants, particularly institutional investors who bought based on much higher earnings estimates, will be paring back their equity holdings.

On the other hand, if those estimates prove accurate and do not get revised downward, then they will likely resume their recent upward climb from his new, higher level - at about the same trajectory as before. The first-quarter 2018 may go down in history as one of the most dramatic jumps higher for earnings, followed by a resumption of business as usual by America's publicly traded corporations. In that scenario, it's likely that stock prices will continue higher from here – at least until later in the year when interest rates and unemployment may signal malign problems.

For subscribers to any of the ETFOptimize Investment Strategy products, your strategy will assess these parameters and more than two dozen others each week to provide you with effort-free recommendations of the most profitable ETFs to hold for the current conditions.

We hope you don't get the wrong impression about the purpose of our ETFOptimize Insights Market Reportsof which this article is one. While these reports dive into the details of many indicators that are components of our investment strategies, we don't use this economic and market analysis as the basis for any of our strategy's investment decisions.

The purpose of our Insights market reports is to provide both strategy subscribers and the public with some of the substance that is behind the decisions of the strategies. Rather than merely consist of black-box systems that you know nothing about, our Insights reports are intended to deconstruct a few of the indicators each week and provide you with a sound basis for our strategy's choices.  As a side benefit, we are providing a publicly-available, data-driven analysis of the market.

For readers who do not yet have an ETFOptimize strategy subscription, please read this brief note:

Summary

Based on all the indicators in a strategy – including many more additional market gauges not shown in this article, each of our quantitative systems create a Market Regime Score for any given point in time. Based on the Regime Score, the system can then pick from the correct group of ETFs, categorized by direction of the trend (which determines whether to use a long or defensive/inverse ETF) and degree of aggressiveness (which determines whether to use a standard or leveraged ETF). Then the system can then select the highest-ranked ETF from those groups.

You can see from Chart 6 below that the current Market Regime Score is 59.67%. While not bearish, this system lingers just on the constructive side of neutral and has been slowly and slightly losing momentum since recovering full strength in mid-2016. At this point, underlying economic factors and fundamentals such as earnings growth are supporting the market - and that's a good thing. If the fundamentals are solid, then our systems stay fully invested. However, at some point, contributing economic and fundamental components such as the unemployment rate (shown above in Chart 4), inflation, or others will turn, and the market's direction will reverse.

 

 

ETFOptimize Market Regime Score
Chart 6: Currently the market regime score for this system shows a reading of 59.67%. This reading is just on the positive side of the neutral zone. A precarious position.

 



CONCLUSION

The title of this article; "Are We On the Cusp of a Bear Market?" was chosen because it seems so many investors are concerned about this issue. However, the samples of indicator analysis provided in this article support the likelihood of a continuation of bullish conditions.

While technical indicators are bearish, it is likely the result of the technical damage done during the correction of January's extremely overextended prices – followed by what was perhaps the most rapidly-volatile quarter ever recorded (according to the CBOE). However, because of this damage, technical (price) indicators are still suggesting that there is more downward market action ahead.

However, underlying economic indicators and stock-fundamental indicators remain bullish. Maybe they have dropped slightly from the readings at the end of last year, but they are still signaling that investors should maintain a constructive bias toward equities and stay with long their ETF holdings. For those with more conservative views, our indicators are not advising short or defensive positions. If anything, cash or cash-proxy ETF such as the iShares 1-3 year treasury bond ETF (SHY) may be appropriate, as is currently being recommended by our S&P 500-Aggressive Strategy.

If more downward market action is ahead, many investors will find it difficult to continue to hold long (and sometimes even leveraged-long) ETFs or equities. At times like this, an investor must maintain confidence in the underlying-condition indicators and strategy recommendations and resist reacting to temporary price volatility and paper losses. For many people, this is impossible to do. But successful investors have learned that this is a vital part of achieving their financial goals.

It appears that the air in risk assets is getting thinner and thinner, but there is likely a more extended top than January's peak still ahead of us. Our quantitative systems will downgrade risk aggressively when excesses have reached a maximum and begin to roll over. This event will occur when the Market Regime Score, shown in Chart 6 above, finally drops below 30%. When that happens, some of our strategies will move into cash or defensive positions, while more aggressive strategies will purchase leveraged, inverse ETFs to profit from the downturn.

Bottom line: While underlying conditions remain favorable for equities, in the near term investors are likely to see more volatile declines. The time remaining in this long bull market grows shorter with each passing session.

If you have any questions or comments about this issue of ETFOptimize Insights, please contact us with a Support Ticket.

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