ETFOptimize Insights

Data-driven Analysis of Critical Market Indicators that Determine Strategy Timing and Selection


Earnings Analysis
Is it time for the Bulls to resume leadership?


Critical Indicator Gives Bullish Signal


• Investment advisors became consistently more negative as a relatively minor downturn played out in October and November.  But does the downturn really signal an end to the 9.5-year bull market?

• Proven macroeconomic indicators, which consistently signal recessions well before they begin, are still showing robust, constructive conditions.

• A 20% improvement in the relationship between stocks and earnings has created the best valuation conditions in years.

• Our Buying Opportunity Indicator℠ gave a signal to purchase S&P 500 based ETFs and correlated individual stocks on November 20.



The End is Nigh!  The End is Nigh!

The S&P 500 saw an all-time closing high of 2930.75 on September 20 and dropped to a closing low of 2632.56 in the holiday-shortened week that ended last Wednesday, November 21 – which is a decline of just -10.17%. At this point, the current market pullback barely qualifies as a correction, which is commonly defined as a decline of more than -10%.

Over the last few weeks - as stocks churned slowly but relentlessly downward through October and into November, headlines in the financial news media have focused intense negative attention on the decline of the technology sector and FANG stocks in particular, small-capitalization stocks, the oil sector, and, well, the market as a whole.

In the last month, we’ve seen a great deal of ink devoted to the widespread opinion that the Federal Reserve is pursuing a rate-hiking policy that is too aggressive, causing the "buy the dip" approach that has worked since 2009 to come to an abrupt end. But is this authentic – or just an expression of investor frustration? After all, things were so easy before!

Macroeconomic Indicators Tell A Different Story

Since 1950, 85% of all bear markets have been correlated with US economic recessions. And for the 15% that were not correlated, it's questionable if they truly qualified as a bear market. For example, in 2011 the S&P 500 went down to within a hair's breadth of a -20% decline from its high. Some folks measure it as a bear market, while others don't. But was there a recession? No, there was not – and there was not a bear market either. It was a very severe correction.

So let's just say, for the sake of argument, that to have a legitimate bear market you must to have a recession. After all, there has never been a recession without a bear market to accompany it. If we keep our eyes peeled for recessions, we can at least avoid the very worst potential losses.

How best to identify imminent recessions? By using proven macroeconomic indicators. The ones shown below are examples...


Unemployment Still Falling

Continuing Unemployment Claims are still declining, and there is likely to be a significant upturn in layoffs and growing unemployment lines whenever a US recession is approaching. Companies will begin to see a decline in demand for their products/services and will quickly cut hiring. Layoffs will follow. An upturn in unemployment provides several months of lead time before a recession begins. (Click image to enlarge.)

Unemployment: Continuing Unemployment Caims continue to fall, with no sign of recession in sight.

A rise in the unemployment rate usually corresponds with the decline in the stock market – since both are leading indicators. However, unemployment statistics are currently providing a contrarian divergence to the two-month downturn in stocks. That clearly creates an opportunity.


Industrial Production-Manufacturing Still Climbing

Additionally, there is no sign of a decline in Industrial Production for Manufacturing, which usually begins with a steep downturn as recessions approach. (Click image to enlarge.)

Industrial Production: Manufacturing
Industrial Production for manufacturing continues to rise briskly after a low in late-2015. Click image to enlarge.


Loan Delinquency Rates Continue to Improve

Loan delinquency rates continue to improve (fall), and they usually start climbing as much as a year or two before recessions begin. (Click image to enlarge.)

Loan Delinquency Rates
Loan Delinquency Rates continue to improve (decline). Click image to enlarge.

Yield Curve Not Inverted Yet

An inversion of the yield curve is a common harbinger of recessions, and it occurs when the Fed is putting pressure on the short end of the curve (two-year Treasuries) to provide some cushion for lowering rates in the future, while the long end is pressured downward by increasing demand for bonds as a defensive measure. Today there is no sign of an inversion – yet – something that usually (on average) occurs many months before a recession gets underway.

Yield Curve:  An inverted yield curve is a reliable harbinger of recessions. It is getting closer – but not there yet. Click image to enlarge.

A Relative Improvement of 20% for Valuation

Even as stock prices were steadily falling over the past two months, corporate earnings have continued to climb at a brisk clip. For example, since they were last at a plateau in the summer of 2016 at $86.44 per share, S&P 500 earnings have skyrocketed higher by 42.1% to reach $122.48 per share today.


Valuation: Even as stock prices were floundering sideways this year, earnings have continued to climb at a brisk pace, thereby improving valuations by almost 20%.


Still and all, the price of the S&P 500 has increased by just 21.27% from 2172 in the summer of 2016 to 2633 last Wednesday. This creates an effective improvement in the cost of S&P 500 shares, relative to earnings, of about 20%.

We are seeing evidence suggesting that institutional investors are buying massive amounts of equity ETFs – probably because they have also identified this favorable change in S&P 500 relative valuation. This underlying support for equities creates a significant likelihood for a bullish rally in the days and weeks ahead.

For example, over the last four weeks (since October 24), total domestic and world equity funds (mutual funds and ETFs) have seen inflows of $12.5 billion, with US fund inflows comprising $9.1 billion of that amount. On the other hand, there has been more than -$21.6 billion come out of bond funds over the same time period. (Source: Investment Company Institute)

Clearly, since the end of October institutional investors are placing money in aggressive equity funds that will profit from a rally – rather than defensive bond funds, as preparation for further declines. These data points speak volumes and should carry a profound message for savvy individual investors.

ETFOptimize Buying Opportunity Indicator℠

Today we would like to introduce investors to our "Buying Opportunity Indicator℠" – a new addition to the key indicators our firm uses as components of our quantitative investment strategies.

Our Buying Opportunity Indicator℠ uses a composite of market fundamentals (changes to S&P 500 revenues and earnings, changes in analyst estimates, and a real-time proprietary indicator) and a sophisticated, price-based technical composite (Ratio of New Highs/New Lows, High-Beta/Low-Beta Ratio, Rate-of-Change for the S&P 500 in 10 different time frames, MACD, and Stochastics). This chart shows the indicator signals going back to the beginning of the bull market in 2009 (when our proprietary indicator began being tracked in real-time).

Notice how the signals, denoted by the green vertical lines, correspond with excellent opportunities to purchase shares of the S&P 500 (upper window).

Prospective Next Year's EPS Estimate (PIT)
Buying Opportunity Indicator (BOI):Provides accurate signals that conditions are ripe for a rebound rally, Scoring 44 or 44 winning signals.


Three-Year Zoom

The next chart provides a zoom into the last three years of the chart above. You can see that the Buying Opportunity Indicator℠ gave an excellent, timely signal in February 2016 that gained 218%, a signal in March of this year that garnered 9.44% to September's high, and a signal was just given last weekend – which might have been implemented at the market open last week (November 20).

Blended EPS Combination
BOI Zoom:  Focus on the last three years of activity of the Buying Opportunity Indicator shows that it provides accurate – if early – entry signals.


We know already that last week was down, with the S&P 500 losing $80.81 (-2.96%) from the open on Monday to the close on Wednesday. The previous signal, shown in March 2018, was also early. So how to eliminate these early signals and improve the timing?

The method we use to eliminate early signals is the use of a secondary indicator to determine the long-term market regime – identifying when underlying conditions are bullish and appropriate for S&P 500-based purchases. At this time, most regime indicators we use are saying that short-term conditions remain bearish, and we should hold off on large new purchases until short-term prices move upward again. That could occur quite soon. In fact, S&P 500 futures are sharply higher in the premarket hours.

The result of this composite is an indicator that provides very high probability signals of profitable buying opportunities. Since 2009, the indicator has seen 14 of 14 winning signals, although the signal given in May 2011 might have been too short a holding time (three weeks) for many investors.

Going forward, we apply the Buying Opportunity Indicator℠ to new purchases of S&P 500-based ETFs, such as the SPDR S&P 500 ETF (SPY), the Invesco S&P 500 Equal Weight ETF (RSP), and the ProShares Ultra S&P 500 ETF (SSO) and highly-correlated individual-stock components of the S&P 500.


Investors should keep in mind the first paragraph of this article – that the current market pullback barely meets the standard definition of a "correction" (a decline of more than -10% from a prior high), and it’s certainly not a bear market (a drop of more than -20% from the previous high) – which is what some advisors are suggesting.

We're not saying it’s out of the question for stocks to continue downward in the short term or demonstrate volatile whipsaws in the coming weeks and months. They certainly could.

However, with US economic conditions still highly favorable and no sign yet of a Wolf at the door, we advise our clients to stick with the signals from their quantitative systems and never allow the intense emotions that swirl around the market to persuade them to override their proven quantitative systems.

With valuations having come down rather significantly, earnings still briskly climbing higher, all economic signals showing a green light, and our Buying Opportunity Indicator℠ recently giving a GO for new purchases, we think there is substantial likelihood investors will see a bull rally into the end of this year.

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


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