• 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 leading macroeconomic indicators, which consistently signal recessions before they begin, are still showing a constructive environment for equities.

• 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%. Moreover, for technical reasons, investors should expect further deterioration of stock prices in the coming month – perhaps as much as another -10% in additional losses on the S&P 500.

Over the last two months - as stocks churned in a volatile, relentlessly downward trajectory through October and November, headlines in the financial news media have focused intense negative attention on the decline of the technology sector in general and FANG stocks (Facebook, Amazon, Netflix, Google) in particular. Also, small-capitalization stocks (Russell 2000), the oil sector, and – well – the stock market as a whole is likely to see a continuation of the downturn.

We’ve also seen a great deal of ink devoted to the widespread notion that the Federal Reserve is to blame for the selloff. The primary complaint is that the Fed is pursuing a rate-hiking policy that is too aggressive, causing the "buy the dip" approach that has worked since 2009 to no longer work.

It doesn't matter who is to blame – or even whether any entity is to blame. What matters is what the market is telling us is ahead for stocks – regardless of whether that story seems rational or irrational to you – and then positioning our portfolios appropriately for those conditions.

At this time, the indicators we use are telling us that there has been no underlying, macroeconomic or fundamental reason for the selloff. It is 100% technical in nature and is related to the completion of a significant market cycle. Upon completion of this leg of the technical cycle (perhaps in another month and another -10% – give or take), investors should expect a powerful and robust six-month bull rally to return stocks to their September 2018 highs and beyond.

If you miss out on this imminent, powerful rally because you are sold on a bearish story about the economy and the stock market from articles you have read online – we can practically guarantee you'll be kicking yourself for a long time to come.

So how do we know that a powerful rally is ahead, and how can we know when it is getting underway? By using proven leading and coincident macroeconomic and fundamental indicators – each carefully crafted into a refined, quantitative investment strategy. Quantitative strategies – when constructed properly – remove investor bias, emotions about matters of money, and the behavioral errors that have caused investors to rack up a long-term annualized return of just 2.7%.*

*According to performance-tracking an analysis firm Dalbar, Inc.

Macroeconomic Indicators Tell a Bullish 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 of -20% or more, you must have a recession. Therefore, if we keep our 'eyes' peeled for recessions, we can at least avoid the very worst potential losses.

So how best to identify imminent recessions? By using proven macroeconomic indicators, with the indicators shown in this article being examples of some of the best available...

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 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 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).

The Buying Opportunity Indicator (BOI) provides accurate signals when conditions are ripe for a rebound rally, scoring 44 of 44 winning signals since 2009.

 

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 issued last weekend – and could have been implemented at the market open last week (November 20).

Buying Opportunity Indicator (BOI)Zoom:  Recent 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.

However, we must keep in mind that well it is a highly-accurate indicator, the Buying Opportunity Indicator℠  is often early. Therefore, we will look to additional indicators for more timely ETF purchase signals. The BOI is telling us that the time is ripe for the market to make a significant run higher – but not just yet. Your shopping list ready!

Conclusion

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.

However, to complete the current technical cycle, stocks will likely continue downward over the next few weeks and may demonstrate volatile whipsaws. And when that cycle is complete in about a month, technical conditions are set up for a powerful bull market rally to ensue.

Moreover, 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 marketplace to persuade them to override a proven quantitative systems. ETFOptimize provides the most sophisticated, accurate, and robust quantitative strategies available today.

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 raging bull rally begin at the start of the New 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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*According to Dalbar, Inc., an independent expert in the evaluation of investor practices and performance.