ETFOptimize Insights

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


Earnings Analysis


This Bear is ABout to Draw Blood


• Traders have ridden the Bear Market Bounce off the March 23rd lows to an epic 30% gain.

• Many speculators are only now piling into the market, just in time for its collapse.

• The classic third stage of a bear market is a renewed, grinding selloff that will take the market to new lows, driven by epically corrosive macroeconomic and stock fundamental news


Maximum Investors Now Sucked Into Classic Bear Trap

In the last few weeks, we have received several contacts from our clients, in addition to a few subscription cancellations, from those frustrated that our models have held very conservative ETFs – and in many cases cash-proxy ETFs – that have essentially held steady for the past month-plus. However, our designers are proud of our model's performance, because they are responding as designed, avoiding periods of high risk and relying on cold, hard, quantitative facts for their decisions – rather than the fetid human emotion upon which most individual investors rely.

After a historically quick -34% selloff, the market has ripped higher by about 30% off the March 23rd low (it would require a 52% gain to get back to even). The current rally has now sucked in the maximum number of speculative investors – i.e., mostly inexperienced gamblers who rely on their 'instinct' for their decisions. 'Buy high and sell low,' is the approach dictated by human emotions – until these people lose so much money they finally throw up their hands and turn their savings over to a mutual fund manager who doesn't do much better than amateurs (avg. 20+ year mutual fund return is 2.6%). Of course, the alternative is using a rules-based, quantitative investment approach – and following that guidance to the letter.

Investors who are following our models with discipline should keep in mind that the current powerful bounce is stage two of a classic bear market. Stocks are following the game plan this writer has seen so many times prior, since first buying equities in the 1974 bear market lows. Stage three of a bear market is a continuation of the long-term downtrend at a slower, brutal, grinding pace that foreshadows the financial catastrophe that lies ahead.

The third stage of a bear market gets underway when shares have gained so much in phase two that the maximum number of gamblers capitulate to the pressure of missing (what must be) an epic bull rally. A rally that must – just must be getting underway and will go to all-time highs – this is classic FOMO. It's unfortunate.

Chart 1 below shows a six-month chart of the S&P 500 Index with Fibonacci retracement levels marked on the right side. As you can see, shares reached the 61.8% level on Wednesday. We believe this is where the market will begin to collapse as dire reports of economic hardship flood the airwaves and investment website pages. It is going to get very, very ugly.


Bear Market Bounce
Chart 1: We have seen an epic bear-market bounce since March 23, matching the top bear-market bounce during the Great Depression.

At the time of this article – just 60 days since the virus first victim, more than 1.1 million Americans have been diagnosed with COVID-19, aka 'the Coronavirus,' more than 62,000 have perished from a disease that causes its victims to suffocate to death. More than 2,000 Americans will die from this virus in the next 24 hours, and another 2,000 the next day, and another 2,000 the next...

Moreover, with the pandemic causing the shutdown of businesses across the world, US GDP is expected to drop by -30% in the second quarter. Do investors think that the market is going to return to prior highs – as if we all just had a 'snow day' – without consideration of these fundamental facts? For many, the answer is apparently 'yes.' However, these are the marginal traders who see the equity market the way they see Las Vegas – a chance to 'score' bigtime!

As usual, these gamblers have been lured in near the top, while savvy, experienced pros prepare to take their money from the other side of the trade. Rather than going long in anticipation of a V-shaped recovery and refreshed bull market, in the coming weeks our models may purchase defensive or inverse positions to take advantage of the coming third-wave downturn of the current bear market. Each model's algorithms will determine if the weight of the evidence is sufficient to make new purchases.


Ugly Fundamental Facts Counter the Rally

Since the pandemic hit America and shutdowns began in late February, more than 30 million American workers have filed for Unemployment Insurance. It required a decade for the US to recover to full employment after hitting 10% unemployment during the 2008-2009 Financial Crisis. With analysts forecasting 25% - 30% unemployment by the end of the 2nd quarter (June 30), it could require decades for the US and world economies to recover from the economic effects of the current pandemic. With the Unemployment Rate already estimated to be at 16% and skyrocketing higher by millions each week, the current events are of such magnitude that it will likely change our world in many ways for the rest of our lives.

Typically, consumption accounts for about 70% of GDP in the United States – the highest rate of consumption driving GDP of any developed nation on earth. Moreover, in 2019, consumption accounted for an astounding 90% of the gross domestic product (GDP) of the US economy. Today, with consumption cut by 70% or more (and potentially going much lower), it will likely take many years for consumers to repair their balance sheets and make up for the loss of income during this period. It will take many years for consumption to rebound back to 2019 levels.

Chart 1 below shows five-years of data for the S&P 500 (blue) in the top window, Retail Sales (green) in the second pane, Housing Starts (red) in the third window, and Vehicle Sales (purple) in the bottom pane. As would be expected, each of these data series has dropped off a cliff with the onset of COVID-19. Housing starts (middle window, red) have dropped 25%, Vehicle sales (purple) have dropped 31%. Retail Sales (green), shown in the second window, only displays the 7% loss in February. Since then, the industry's sales have declined by 60% and 70% of prior sales levels. These data series are expected to show far worse damage in the coming months.


Chart 1: Retail Sales (green) in second window, Housing Starts (red) in the third window, and Vehicle Sales (purple) in the bottom window.



A Decade of Job Growth Wiped Out in Five Weeks

Assuming a recession began in Q1 of 2020 (i.e., taking December’s non-farm payrolls report as the last data point), the US created around 20.5 million jobs over the longest expansion in history. Going by the NBER’s official start date, this expansion began in June of 2009.

Over the past five weeks, America has effectively seen the entirety of the job gains from the last decade-plus wiped off the board. The red dot in Chart 1 below shows what is now a significant net loss over these 11 years.

Ten years of job creation wiped out in five weeks
Chart 1: The job gains accumulated over the last decade-plus have been wiped out in five short weeks – with more to come.


Hours Worked at Small Business Plummeting

According to Homebase, a time-tracking website used by more than 100,000 local small businesses tracking more than 1 million hourly employees, the number of hours worked is down by about -60% after hitting a low of -75% on April 12. These figures use an average for the month of January as a baseline to capture the effect of COVID-19 on small businesses.

According to the company, Homebase’s customers in the US consist mostly of restaurant, food & beverage, retail, and services and are largely individual owned/operator managed. That makes this data particularly well-suited to this situation, given the pain is concentrated in the services sector, and particularly in food & beverage.


Chart 2: Hours worked at small businesses is down -60%. Source:



Macroeconomic Risk Indicators

We use composites of as many as 38 different data sets to inform and drive the decisions of our quantitative models. These signals come from Macroeconomics, Stock Fundamentals, Sentiment, and Technical Indicators to form variable ranking systems that determine each model's exposure to market risk and the optimum ETF to take advantage of current conditions. The systems do not attempt to formulate forecasts of future developments, but instead use 'nowcasting' to identify present conditions and times of increased risk.

In this article, we will examine two Macroeconomic Indicators (Unemployment and Corporate Bonds) and one Stock Fundamentals Indicator (S&P 500 Eearnings) that are each showing high-risk conditions at this time.


Unemployment Indicator

Many investors aren't aware that going back to the mid-20th century when the government began collecting employment records, increases in the Unemployment Rate have coincided closely with severe stock market selloffs – i.e., 'bear markets.' Having their fingers on the pulse of the economy, business owners begin shedding workers in the early days of an economic downturn. Investors are also early and anticipate the future by about six months. These two different groups (which often overlap) For this reason, the Unemployment Indicator is a highly accurate signal of recession-associated market downturns, which are usually much more severe than other market pullbacks, totaling -30% or more in declines.

The one drawback to this data set's accuracy is that it is usually a lagging indicator, but it can confirm that a downturn is of the more severe variety after other indicators have already signaled to reduce risk exposure, and that is what it is indicating at this time.

Chart 3 below shows the S&P 500 ETF (SPY) in the top window, Initial Unemployment Claims in the second pane, the Unemployment Rate in the third window, and our Unemployment Signal in the bottom pane. This indicator is currently on zero, indicating a high-risk condition.

2000-Present Unemployment Signal

Chart 3:
The Unemployment Signal (bottom window) is currently on zero, indicating a high-risk condition associated with a bear market.



Corporate Earnings Signal

While the $4.4 trillion pushed into the economy by Congress ($2.3 trillion) and the Federal Reserve ($2.1 trillion) has served to inject liquidity, stop the market selloff, and temporarily prompt a bear-market rally, it is far short of the damage done, and won't come close to addressing the damage that will occur in the coming months and years from the loss of income. US corporations are a few weeks into the 1st Quarter 2020 earnings season reporting, and dire realities accompany those reports.

"Of companies reporting, 28% have missed consensus EPS by more than a standard deviation of analyst estimates, a rate that would represent the largest share in the 22 years for which we have data," Goldman Sach analyst David Kostin wrote recently.

"Only 36% of stocks have reported EPS beating analyst estimates, the smallest share since 2008," said Kostin. In a typical quarter, about 75% of all publicly traded companies beat their earnings estimates. Goldman's full-year, top-down estimate for S&P 500 earnings is just $110 (down 35% from $170/share only a few weeks ago). That means that if the S&P were to make it back to 3,000, the multiple would be more than 27 (the long-term average is 16) - in the middle of the worst economic downturn in a century.

Our quantitative systems use an S&P 500 earnings composite that employs trailing-12-months (TTM) earnings, Current Year's Earnings Estimates (CY), and Next Year's Estimates (NY) in an algorithm that steadily increases weighing on actual earnings and decreases weighting on forecasts as we each progress through each quarter of a year. We call this series the SP500 Progressive Blend Earnings Composite (PBEC).

Charts 4 below displays our raw S&P 500 PBEC Indicator from July 1, 2000 to present in the middle pane in green. The binary signals from this indicator are shown in the bottom pane in red. On March 16, the gauge dropped to zero, indicating a high-risk condition.

2000-Present Earnings Signal

Chart 4: Our S&P 500 Progressive Blend Earnings Composite (PBEC) shows that the signal dropped to zero (risk-off) on March 16.



Corporate Bond Interest Rate Signal

The divergence between the highest-quality, AAA-corporate bond interest rates and much-lower-quality BBB-corporate bond interest rates provides an excellent macroeconomic indicator that we use in our signal composites. Many investors turn to the Treasury Yield Curve for a similar signal, but Treasury Bond interest rates are actively manipulated by Federal Reserve policy, making them less reliable indicators of actual macroeconomic conditions.

Historically, Corporate Bond interest rates are only affected by market forces. However, with the Federal Reserve now stating its intention to purchase Corporate Bonds and Bond-secured ETFs to prop up the market, we will have to see if there is a manipulative effect. If so, we may have to drop this indicator from our lineup. In the meantime, it remains an accurate signal that we can combine with many others to determine an approach to the current level of risk.

Chart 5 below shows the S&P 500 in the top window, the Corporate AAA Bond interest rate (purple) and Corporate BBB Bond interest rate (orange) in the second pane, the divergence between the two in the third window (green), and our signal from this divergence in the bottom pane (red). As you can see on the far right of the bottom pane, this indicator has dropped to zero and is signaling a high-risk market environment.


Corporate AAA - BBB Bond Differential

Chart 5: The Corp AAA/Corp BBB Bond Interest Rate divergence has historically provided excellent risk signals for stocks. It is currently signaling increased risk.


During times of increased economic uncertainty and recessions, the spread between high-grade (AAA) Corporate Bond and low grade (BBB) Corporate Bond yields typically diverges. Chart 5 above illustrates this phenomenon well; Corporate Bond spreads do indeed rise during recessions. Recessions usually contribute to higher rates of business failures and defaults, thus leading to lower-quality bond (BBB) buyers demanding higher interest rates to compensate for the risk they are taking when investing in a particular bond. On the other hand, the high-quality bonds (AAA) maintain a steady, lower interest rate because of the demand for the debt of high-quality companies, and the difference between the rates for the two qualities of bonds provides an accurate quantitative market signal.

We can see in the second window that interest rates on lower-quality bonds (BBB) has recently spiked sharply higher (far right), while high-quality investment-grade (AAA) Corporate Bonds interest rates have declined. This Corporate Bond interest rate divergence creates an excellent signal of related challenges to the equities market since equities and bonds exist on a spectrum of potential instruments available to investors.



This article offers a sample of the many macroeconomic and stock-fundamental indicators that are showing a consensus signal that the market is at a very high-risk crossroads. Our models have stood aside as the market experienced a highly volatile, classic bear-market bounce.

Our models assess that stocks are about to turn downward now, and will begin stage three of a classic bear market – i.e., a slow, grinding downtrend that goes on to set new lows. Quantitative investment model users should always follow the recommendations of their rules-based models – without the slightest deviation.

Quantitative models may not profit from short-term market bounces such as we have seen recently, but they will help you avoid losses when those relatively brief swings go the wrong way – as this one is highly likely to do in the coming weeks.


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*According to Dalbar, Inc., an independent expert in the evaluation of investor practices and performance.

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