ETFOptimize Insights

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

At a Critical Inflection Point


Note: This content is for informational purposes only and should NOT be used as the basis for investment decisions or discretionary overrides of the ETFOptimize Premium Strategy recommendations. Subscribers should follow the recommendations of their quantitative models to the the letter, without fail. Any divergence from the strategy recommendations will effectively introduce errors of human judgement, which eliminates all the benefits and outperformance investors receive from a systematic investment approach.



Last week's pullback of -8% for the S&P 500 (SPY) and -11% for the Nasdaq 100 (QQQ) has many investors on edge. This week, those two popular indices have essentially flatlined just above their 50-day moving average. Because these two indexes are so influential on every other stock in the market, the future of investor's fortunes hangs in the balance on that 50-day average.

Investor's heightened nervousness may be justified, particularly after the historic rally from the March lows that saw stocks average a 61% gain in about 5.5 months. That was the fastest rally of such immensity ever recorded—before last week's pullback became a wake-up call for complacent investors to pay attention.

Nevertheless, with every significant market index—including international indices such as the iShares MSCI Emerging Markets ETF (EEM)—pulling back to their 50-day moving average last week, our quantitative indicators are borderline. The medium-term indicators are also marginal, and shorter-term indicators suggest that if those indices break below their 50-day moving average this week, it could develop into a much more severe correction.

We should know soon if the 50-day average will hold as support or if it will be pierced to the downside, releasing those shares to drop further downward—possibly with another significant decline. However, even then, all is not lost. Until the most popular indices (particularly the S&P 500, which represents 80% of all market capitalization) break below their 200-day moving averages, the bull market will essentially remain intact.

The 200-day moving average is currently about -6.9% lower than the 50-day EMA, so dropping to that level would effectively double the loss since the All-Time High (ATH) set on September 2 at 358 for the SPDR S&P 500 ETF (SPY) and 3581 for the S&P 500 Index ($SPX). If the 200-day MA gets pierced, well—then all bets are off. With fundamentals showing high valuations based on declining earnings, and the macroeconomic picture blurry at best, we'll have to assess conditions again should we arrive at that point. However, so far, the 50-day Moving Average is the line-in-the-sand that investors are respecting.

Chart 1 below shows five different indices, representing the most significant market segments, and all are just above their 50-day Moving Averages. These indices defined are, from top to bottom (with applicable ETFs), the S&P 500 Large-Cap Index (SPY), the S&P Mid-Cap Index (IJJ), the S&P Small-Cap Index (SLY), the Invesco S&P 500 Equal Weight Index (RSP), and the Invesco Nasdaq 100 Trust (QQQ):


Indices at 50-day Moving Average
Chart 1: Will the 50-day moving averages currently providing support for major indices continue to hold?



While mega-cap technology stocks led the market and each of these indices higher off the March lows, investors are now turning away from those severely overvalued shares. Examples include Apple (AAPL)—PE of 34, Facebook (FB)—PE of 34, Alphabet (GOOG)—PE of 45, Microsoft (MSFT)—PE of 36, Amazon (AMZN)—PE of 26, and then there is the example of Tesla (TSLA), with a mind-boggling PE in the stratosphere at 1,135 (at last glance).

The apparent driver of the epic rally since the March 23rd low is the approx. $6 trillion injected by the Federal Reserve and Congress in response to the Coronavirus. While Congress appears to have shut off the spigots, Fed Chairman Powell has implied that its resources are virtually unlimited, and it will do what's necessary to support the market. Of course, this was catnip to speculators. "The Powell put is in!" became a common refrain on investment day-trading sites.

However, as we have discussed several times previously, the amount of money the Fed infuses into the market may be unlimited, but that doesn't mean that investors will continue unlimited purchases of the shares of companies at valuation levels no longer making economic sense. We may see a continuation of the bull market. Still, savvy investors will likely change direction by trimming overvalued tech shares from their portfolios and rotating those funds into other, less richly valued sectors and segments that continue to show promise in light of the current economic realities. That may be happening now.

With each of these factors and many more taken into consideration, our quant models took the appropriate action as determined by their algorithmic-decision matrix. Depending on each model's targeted risk level, the more conservative strategies have switched to defensive ETFs. Our more aggressive models are sticking with mildly-aggressive equity ETFs, such as the S&P 500 ETF (SPY) and the iShares US Consumer Goods ETF (IYK). None of the models are currently using 2x-leveraged ETFs, reflecting the current tentative condition in which shares could quickly move in either direction.

Our quantitative models make no predictions; instead, they respond to current conditions and leading indicators—and so far, those conditions have not turned bearish. However, we will continue the Temporary Stop-Loss Policy as described below to mitigate the potential for significantly higher risk for as long as necessary. When these conditions normalize, we will return to the weekly assessment each weekend.

This article will present several critical indicators, including macroeconomic, fundamental, and technical signals, to inform investors why our quantitative models are taking their approaches. Overall, that approach is a conservative bias to the upside, with several positions mitigating a selloff's potential. The market is at a critical binary inflection point, but the direction ahead is not clear. Let's see what we can determine from the insights provided in some of our key indicators…


A Historic Decline of GDP

We recently had several clients ask if we find that GDP changes are a reliable factor in our systematic investment models. Let’s address that question for a moment…

Since the economy was already sliding into a recession in the 1st Quarter of 2020 (we called the market top on February 20), the Coronavirus pandemic and the resulting closure of businesses sparked a dramatic acceleration of the economic contraction in late-February and early March. The result was three months of dystopian strangeness with the economy dropping off a cliff—those troubles reflected in US Gross Domestic Product (GDP), declining some -32.9% in the second quarter, according to the Commerce Department.

To put that number in perspective, the economic shock in April, May, and June was more than three times as severe as the previous record quarterly declineof -10% in 1958—and nearly four times worse than the most difficult quarter of the Great Recession in 2007-2009.

Chart 2 below shows US Gross Domestic Product (GDP) since 1990 in the top window, accompanied by its 12-month Rate of Change (ROC) in the second pane, compared to the 12-month ROC of the S&P 500 in the bottom window. We can see that GDP dropped in Q2 with a vertical plummet at a 12-month Rate of Change (ROC,12) of -8.64%. The opposite occurred with the S&P 500, a RISE in the 12-month Rate of Change (ROC,12)!


GDP Rate of Change
Chart 2: Monthly growth of GDP in the top window, 12-month ROC of GDP in the middle, and the 12-month ROC of the S&P 500 at the bottom.


The stark difference in these two critical economic activity measures—GDP and the S&P 500—going in opposite directions over the last year is highly unusual. While many factors drive changes in stock-price levels, ultimately, corporate earnings are the primary driver, and corporate profits are a fundamental component of GDP. Historically, GDP and the stock market have been connected and correlated.

Chart 3 below shows that in the last 25 years, the S&P 500 has skyrocketed ahead of GDP. With the 25-year performance last tied with GDP performance in 2009, today, the S&P 500 has grown at 5.4-times the GDP growth rate, with an 806% gain for $SPX versus an increase of 150% for GDP in 25 years.


GDP vs SP500, 25 Years
Chart 3: In the last 25 years, the S&P 500 (black) has outpaced GDP growth (green) by a factor of about 5.4 to 1.


One reason for this out-performance is that the S&P 500 and most other major indices are market-capitalization-weighted, meaning the largest, fastest-growing equities receive the most significant weight bias, skewing the index to the upside. The criterion of market-capitalization weighting is an example of the quantitative-selection standards applied in most popular market indices—without investors realizing it.

The S&P 500 also exhibits survivorship bias. Companies that significantly decline or file bankruptcy are removed from the index, while successful companies stay and prosper. For these reasons, GDP changes are not positively correlated with stock prices, and we cannot use the pace of GDP growth as a viable signal for our quantitative ETF strategies.

However, there is a smorgasbord of other macroeconomic factors our research over the last 22 years has found to be highly indicative for times of increasing market risk. Composites built from those factors provide excellent overall signals to weigh a contracting economy's influence on stock prices. The next section illustrates a few of these indicators, and then we will delve into the technical signals mentioned earlier.


Latest GDP Estimate

On September 16, the Federal Reserve Bank of Atlanta released its "nowcast" of GDP growth for the third quarter of 2020:


"The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2020 is 31.7 percent on September 16, up from 30.8 percent on September 10."

The 'GDPNow' estimate for real GDP growth is a running estimate and is not an official forecast by the Atlanta Fed. Keeping that in mind, we can see that a 31.7% rate of growth in Q3-2020 is the mirror opposite of the -32.9% GDP decline in Q2-2020. If this realtime estimate turns out to be accurate, then we actually could see a 'V-shaped recovery' as has been extensively discussed by bullish investors.


Which Macroeconomic Factors Work Best?

Our research has found that market-based indicators are substantially preferable to other types of signals, particularly those that rely on a subjective interpretation. Interpretive indicators might include qualitative surveys of a particular group, such as corporate executives (purchasing plans, hiring intentions, etc.) or investor sentiment surveys (bullish or bearish).

Another type of indicator we eschew is a series that can be—and regularly is—manipulated, such as Treasury Bond Yields. While the market plays a significant role in establishing Treasury rates in the very short-term, the US Federal Reserve has always manipulated US Treasury Bond interest rates to warm or cool the economy. In the last few years, the Fed has also instituted increasingly innovative and aggressive ways to manipulate the economy, including 'Yield Curve Control,' in which the Fed attempts to maneuver longer-term rates—and especially during the current recession, massive amounts of Quantitative Easing (QE), which involves the outright purchase of an increasingly wide variety of assets in an attempt to control critical prices.

For this reason, we don't employ classic investment indicators such as identifying an Inverted Yield Curve from the difference between the 10-Year Treasury Yield and the 2-Year Treasury Yield to signal a coming economic contraction. Instead, we use uncompromised, market-based signals that are not manipulated by anything other than economic forces and the 'invisible hand' of animal spirits.

An example of one of these market-based indicators is our Corporate AAA vs. BBB Yield Differential measure.

Corporate AAA-BBB Yield Differential

We find that one highly accurate, market-based Yield series is the Corporate AAA/BBB Yield spread. We dub this series $MRS02 (for 'Macroeconomic Risk Signal') in our Quantitive Signal System. Corporate Bonds issued by private corporations trade on the open market. Therefore, they provide an accurate comparison of different yields as determined in real-time by actual bond investors—not the potentially skewed ideas of the current plug-n-play Federal Reserve Chairman.

Unfortunately, Fed Chairmen and Federal Reserve Boards are composed of human beings—who are just as prone to the biases, emotional dispositions, preconceived ideas, and passionate economic aspirations as a 16-year-old investor buying his first shares of stock. Nobody is free of the human behavioral errors that haunt us all—from seasoned veterans to investing virgins, and everyone in between.

Corporate AAA Yields are the highest-quality bonds issued by higher-quality companies with healthy balance sheets, as determined by rating firms such as Moody's, representing the safest bonds. AAA Bonds usually pay the lowest yield (currently 1.58%) because of their lower inherent risk.

Meanwhile, companies far lower on the risk-assessment scale issue Corporate BBB Bonds are issued by companies far lower on the quality-assessment scale. These bonds pay a higher yield (currently 1.77%). However, BBB Bonds are still rated higher than so-called 'junk bonds' (Corporate CCC or lower), issued by companies having poor financials or high levels of debt relative to the company's ability to service that debt. These lowest-rated bonds pay substantially higher yields (currently 11.77%) than their high-quality brethren to compensate investors for the much greater risk of default incurred when owning these debt instruments. However, we find the AAA-BBB Yield Differential is more accurate for our purposes than the AAA-CCC spread.

Chart 4 below shows the 20-year history of our Macroeconomic Risk Score 2 ($MRS02) Signals and the underlying Corporate AAA and Corporate BBB Yield series that establish those signals.

Working up from the bottom window, the independent AAA (gold) and BBB (light-blue) Yield since 2000 is displayed. The next-to-bottom pane shows the 'Corp BBB-AAA Spread' in green, representing the difference between the two yield series — i.e., the higher BBB Yield minus the lower AAA Yield.

The middle window in red shows the SIGNALS derived from the 'Corp BBB-AAA Yield Differential,' using our proprietary assessment measure. This series is binary, with the higher readings indicating 'Risk-ON,' while '0' signals indicate increased risk, suggesting its time to avoid exposure to the market; 'Risk-OFF.' Finally, the top graph shows the SPDR S&P 500 ETF (SPY) in blue. You can compare the $MRS02_BBB_AAA_Signals in red to changes in the S&P 500 in the blue top graph. Notice that a 'Risk-OFF' status aligns with price declines or volatility in the market:


$MRS02 - Corp AAA vs Corp BBB Signal
Chart 4: This chart shows our $MRS02 Signal, derived from the Corporate AAA-BBB Yield Differential; derived from the lower two windows.



It may not be easy to see how the $MRS02 Signals align with the S&P 500 from the narrow charts above, so we're providing a more detailed view in the next chart.

Chart 5 below shows how the $MRS02 Signals align with the S&P 500 when more detail is available. Here, the two series (our $MRS02 Signal and the S&P 500 ETF, SPY) overlay one another in a single window. In this view, you can see how our $MRS02 indicator's signals provide an accurate assessment of real-time market risk whenever the spread between the two series increases by an amount that's significant enough to trigger our proprietary signal.



Chart 5: Showing the $MRS02 Signals (red) over the S&P 500 ETF (SPY), notice the accuracy of this macroeconomic indicator at times when rates signaled trouble.


We can see from the chart's far-right, showing the present day that the $MRS02 Signal is currently near the top in the ON or '1' position, i.e., Bullish. Remember that this indicator is but one of nearly a dozen Macroeconomic Indicators used to inform our composites. Moreover, each model uses a different combination of multiple composites to determine its appropriate exposure to market forces, depending on the point in the spectrum from conservative to aggressive investing for which they were designed.


Risk Indicator Types

We use as many as 38 different Risk Indicators in a variety of composite configurations – from multiple areas of investment analysis; forming the following categories of indicators: Macroeconomic Risk Score ($MRS), Fundamental Risk Score ($FRS), Market Internal Risk Score ($IRS), Sentiment Risk Score ($SRS), and the Technical Risk Score ($TRS). These composites can provide quantitative models with unparalleled robustness. By using a unique combination of indicators in a diversified set of models—it's possible to attain uncorrelated position selection and uncorrelated risk mitigation that results in a phenomenal performance.

Chart 6, below: When we combine six of our best, uncorrelated, stand-alone models into a single, diversified 6-9 ETF model (i.e., Ultimate Combo-6 Strategy). This configuration produces an investment system that generates profits every single year since inception, an Annual Return of 30%, an average annual Max Drawdown of just -7%, and an average Alpha over its benchmark (S&P 500 ETF - SPY)—of 25.72% per year. With those statistics, it's not surprising that the strategy attains a sky-high Risk-Adjusted Return of 3.08.

Since its introduction a few months ago, our Ultimate Combo-6 Strategy was only available as an annual subscription. However, by popular demand, we recently made this model available via a monthly subscription at a price that's less than subscribing to all six models individually.


Ultimate Combo-6 Strategy

KEY: The red line shows the ULTIMATE COMBO STRATEGY performance since inception (07/01/2007).
The blue line is the benchmark buy-and-hold of the S&P 500 ETF (SPY).

Chart 6: A combination of six uncorrelated quantitative strategies provides exceptionally steady gains with limited drawdowns in our Ultimate Combo-6 Strategy.


Keep in mind that while this model has only been offered to the public since June, the six strategies contributing to it's selections have been operating as far back as 2000 for one of the models. The trades were made in real-time. We only recently made the combination of all the models available when the capability recently became available to us.


Poor Participation at the Recent High

Chart 7 below shows that in the last 20 years, each time the S&P 500 reached an All-Time High (ATH) that was 10% or more above its 200-day moving average, 80% to 95% of S&P 500 constituents were also above their 200-day moving average. But NOT TODAY — with the S&P 500 reaching nearly 16% above its 200 DMA at the end of August, only between 60% – 70% of S&P 500 companies were above their 200 DMA. Today that figure is at only 61.6%.


Chart 7: Fewer stocks in the S&P 500 are participating in the rally to highs since the March low than any time in the last 20 years.



The implication is that a relatively small number of companies dominated the S&P 500 and NASDAQ this year—particularly mega-cap 'technology'-based consumer-products companies such as Facebook (FB), Apple (AAPL), Alphabet (GOOG), Amazon (AMZN), Tesla (TSLA), Netflix (NFLX), and a handful of others, while the average S&P 500 and NASDAQ company produced much lower performance.



The coming week or two will be crucial in determining the direction of the stock market over the coming weeks and perhaps months. If major indices, such as the S&P 500 Index (SPY) and the Nasdaq 100 Index (QQQ) can retain their status above their 50-day Moving Average support level, then it's likely that the bull market will continue in the weeks ahead and these indices will soon begin to climb. However, if those indices pierce their 50-day moving average, we can expect a continuing decline—perhaps one that gathers momentum and becomes a significant selloff.


To learn more about the advantages of ETFs over individual stocks and mutual funds, please see this article in our Introduction Section, titled "Why ETFs are Today's Investment of Choice." To learn more about the advantages of quantitative investing, please see our article titled "The Benefits of Systematic ETF Investing."




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One example of a Premium Strategy that were proud of is our Adaptive Equity+ (2 ETF) Strategy, which has an Annual Return since Inception of about 40%, an Annual Return in the last three years of 64%, and a 2019 Annual Return of 76%. Moreover, its Maximum Drawdown is just -7%, and it has a Risk-Adjusted Return (Sharpe ratio) of 2.58. So the model's performance is improving each year.

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Adaptive Equity+ (2 ETF) Strategy
Adaptive Equity+ (2 ETF) Strategy
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The ETFOptimize strategies operate using our proprietary, quantitative financial-analysis programming that has been continuously upgraded and refined over the last 25 years, accompanied by the highest-quality, point-in-time investment and economic databases. As ETFs have become increasingly popular over the last 20 years, we've embrace these products, which offer investors instant-diversification – eliminating the individual company risk inherent in stocks.

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