Robustly Bullish Indicators Date: Sunday, October 11, 2020 Posted by: ETFOptimize Research Category: Indicator Analysis 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. Investors have faced unprecedented volatility in the last three years, with skyrocketing swings in stock prices. These sharp moves began with the quick correction of -10% in early 2018 following overenthusiasm related to the corporate tax cut enacted in late-December 2017. Then there was another -19.5% selloff of the S&P 500 ETF (SPY) in late 2018, followed by a very robust rally of 44% through 2019, which put the market into an over-extended condition by early 2020. In February 2020, our indicators signaled that a recession was beginning, and many of our models switched to defensive ETFs. Then, as almost always accompanies over-extended conditions, stocks reverted to their mean. However, this time, it exacerbated the selloff, with prices speeding sharply lower when the COVID-19 Pandemic hit the US’s shores in late February. In 2020, investors saw the wildest of these swings, with the fastest selloff in history, as SPY plummeted -34% in only four weeks. In late March, sparked by a Fed-and-Congress-fueled, $6-trillion infusion into the economy, stocks rose, and just kept rising. By the end of August, the S&P 500 ETF (SPY) had gained 61% in only five months. As expected, following a gain of this magnitude, in early September, the S&P 500 consolidated to burn off some of the excess gains. However, the downturn was short-lived, and prices climbed again on September 21, gaining about 6.5% to the present (October 11, 2020). Chart 1 below shows weekly prices for the S&P 500 ETF (SPY) with a pattern of increasingly more massive price swings in both directions. The question on most investor’s minds today is whether this swing pattern will continue with an even more enormous selloff into 2021—or if this the end of the dangerous pattern of ever-larger swings. Chart 1: For the last three years, the S&P 500 ETF (SPY) has experienced ever-increasing swings in its price. What’s next? As shown in Chart 1 above, the S&P 500 (SPY) had declined for four weeks through September with a corrective pullback of about -7%, which burnt off some overextended conditions that were present after the powerful five-month, 61% gain that began on March 26. Subsequently, stocks have closed steadily higher in the two weeks since September 21, and last week produced a muscular increase, with a one-week gain of 3.9% for the S&P 500 ETF (SPY). Based on collective signals from the (now 50) different data series we use in our quantitative investment strategies, the answer to the question above is that notwithstanding likely significant volatility, stocks appear poised to continue higher, and the climb upward could be quite robust. Because of the number and robustness of the bullish signals this past weekend, several of our rules-based models selected several 2x-leveraged ETFs for purchase on Monday (Oct 13), reflecting the bullishness shown by the different indicators used in each model. That’s the first time the models have selected leveraged positions this year. This article will cover several of those crucial indicators as examples of the overall message – of a potentially bullish near term – we see from the (now 50) proprietary indicators we employ in our systems. Indicator 1: Volatility and Risk in the S&P 500 A valuable indicator for the future of S&P 500 prices is the CBOE Volatility Index ($VIX). According to Investopedia.com: “Created by the Chicago Board Options Exchange (CBOE), the Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the S&P 500 index options’ price inputs, it provides a measure of market risk and investors’ sentiments. Investors, research analysts, and portfolio managers look to VIX values to measure market risk, fear, and stress before they make investment decisions.” Options that hedge a decline of the S&P 500, measured by the Volatility Index ($VIX), are a popular tool used by traders to hedge against volatility and declining prices in the S&P 500. The price of the $VIX reflects demand from buyers relative to the motivation of sellers. When $VIX rises, it means there is increased trader demand for options that hedge against perceived increased risk for the S&P 500. Chart 2 below shows that moves above the 20-level in the Volatility Index ($VIX) correlates with price declines in the S&P 500. Red-shaded areas show these increased-risk periods. However, notice that $VIX is exceptionally volatile, with sharp rises and drops within brief periods, causing unpredictable whipsaws and making this indicator less than perfect for our needs as quantitative investors (not short-term traders). Chart 2: Quantitative investors often use levels above 20 on the $VIX to signal increased risk. Red-shaded areas show readings above 20. Whipsaws of stock volatility are the bane of rules-based investors because of their unpredictability and a vicious propensity to force investors to reverse decisions. Whipsaws are not just frustrating; they are costly. Applying a Moving Average to volatile indicators can smooth out many whipsaws. Still, when we use Moving Averages, those signals become slightly lagging indicators of market moves. In the top pane of Chart 2 above, we identify (using red and green percentage measures) several times when $VIX prices swung by considerable amounts in very short timeframes. For example, in late-2008 (left side of the upper window), $VIX spiked higher by 319.1% (dotted-green) and reached a high of about 80 as the Financial Crisis caused worldwide panic. At the time of this spike in late-2008, Lehman Brothers had collapsed, mortgage companies and other real estate-based lenders were being gobbled up to save them (with the Treasury Department and Fed playing matchmaker). Markets melted down as institutional investors (mutual, hedge, and pension funds) dumped everything. However, by early 2010, $VIX had slowly declined and lost almost -80%, moving below 20 as risks associated with the Financial Crisis subsided. This year (2020), the Volatility Index spiked 448% to near 70, then declined and bottomed in early August near 22. The Volatility Index has since moved higher and is presently at a level of 25. Since March 2020, $VIX has not once closed below 20, suggesting that investors remain concerned about the potential for a second crash. Therefore, if an investor used this single indicator ($VIX) for timing market exposure at a level of 20, they would have been in cash since the first quarter of 2020 and have missed the bullish upturn. ETFOptimize doesn’t use $VIX or any other individual indicator to inform our market-exposure signals. Instead, we use a fulsome composite built from a selction of more than 50 different data series to attain the most accurate risk-timing for each model we operate. Each of our models uses market-exposure indicator sets with a low correlation with our other models. When used together—as they are when combined in our Ultimate Combo-6 Strategy—it provides minimal drawdowns with an average of only -8% per year. Still, the Volatility Index ($VIX) remains above a level of 20 today because investors have concerns about all the potential uncertainty ahead. At a level of 25, the $VIX indicator is showing that the implied volatility for the S&P 500 in the next 30 days is about plus or minus 2.40% per day. That is an exceptional amount of volatility compared to the long-term average, in which the S&P 500 typically stays in a daily range of about 1% to -1%. The level of 2.40% is exceptionally high, except during brief, risky periods, and $VIX has never remained this elevated for this long in its history. That uncertainty emanates not just from Coronavirus threats to the economy but from a contested presidential election potentially marred by violence. Investors seek a steady economic environment and certainty, and they are fearful of getting the opposite. Momentum of Fear Indicator The intensity of changes in an indicator can provide more effective signals than the indicator itself. For example, if the Unemployment Rate slowly rises from 4% to 7% over three years—an average monthly increase of only 0.083%—investors may not pay much attention to that slow, subtle change. However, if a 3% increase in the Unemployment Rate occurs in a single month, it would cause sharply increased concern by investors about the economy’s health, and there would likely be a substantial market reaction. This principle applies to many critical indicators, and we find this approach is useful for both slow-moving indicators and rapidly whipsawing indicators. Indicators in the middle, with timely signals, can use their original settings without change or normalization. Our research shows that second-derivative measures, particularly longer-term Rate-of-Change measures on core indicators, offer more accurate and timely signals than the original indicators themselves. Concerning the Volatility Index ($VIX), the second-derivative Rate of Change provides increased accuracy with far fewer whipsaws. Chart 3 below plots our “Momentum of Fear’ Indicator (MoFI)—calculated from the Rate of Change of the $VIX—in the bottom window, with the S&P 500 Index ($SPX) in the top pane. The red-shaded areas show when the MoFI moved above the zero level, with a heightened rate of change for the Volatility Index ($VIX). Chart 3: The ETFOptimize ‘Momentum of Fear’ Indicator has declined back below zero, providing a bullish, “coast is clear” signal. You can see that our ‘Momentum of Fear’ Indicator has signaled since late-September that it is safe to return to the market. Notice that this indicator avoids frustrating whipsaws and provides accurate signals of imminent market declines. S&P 500 Breadth Indicators are Robustly Bullish Breadth measures provide an overall picture of the health of an index, such as the S&P 500. When an index is rising, its breadth indicators are also climbing, and there is significant participation in the advance, then the price increase is more likely to be sustained. The same principle applies in the opposite direction with a falling stock index. Alternatively, when an index’s price and its breadth indicators diverge, it may be a warning of a reversal. Chart 4 below shows the SPDR S&P 500 Large-Cap ETF (SPY) in the top window, and the lower panes provide three different measures of weekly breadth for S&P 500 stocks over the last three years. These measures include: 1) the S&P 500 Advance-Decline Percent, 2) the New Highs-New Lows Percent, and 3) the Percentage of S&P 500 stocks with prices above their 200-day Moving Average. An OVERALL BULLISH signal occurs when two of the three indicators are on Bullish Signals, and vice versa for Bearish Signals. For a Bullish signal on the Advance-Decline Percent (window #1), there must be a margin of 30% more S&P 500 stocks that advanced last week minus the number of shares that declined. For a Bullish signal on the New Highs-New Lows Percent (window #2), there must be 10% more stocks making new highs than those making new lows. Window #3 in Chart 4 below shows a measure of the percentage of individual S&P 500 companies with share prices above their 200-day moving average. A reading over 70 is bullish on this chart. And when an indicator reaches a signal, that signal remains in place until an opposite sign changes it. Chart 4 below shows that all three S&P 500 Breadth Indicators are on Bullish Signals, with the S&P 500 New Highs-New Lows Percent (window #1) and S&P 500 Stocks Above Their 200-day EMA (window #3) both recording new bullish signals at the end of last week. Chart 4: All three breadth indicators for the S&P 500 are now signaling that market internals are bullish. With the Advance-Decline Percent Indicator (window #1 above) previously reaching a Bullish Signal in early June, all three breadth measures signify that stocks are on the rise; we should see higher prices in the coming weeks. Conclusion There are many more indicators from the categories of Macroeconomic Risk (MRI), Technical Risk (TRI), and Breadth Risk (BRI) that are bullish, which we could have featured in this article. However, let’s also note that several Fundamental Risk Indicators (FRI) based on S&P 500 Earnings and other measures have remained bearish since before the February-March selloff. However, investors always discount prices into the future. They are looking past the current period of devastating corporate earnings declines to a time when the world has a vaccine, and the economy can return to more normal conditions. This week will mark the start of third-quarter earnings reports, and expectations are for an incredible improvement over the second quarter’s report, which recorded the damage done from a closure of the US and the world economy that accompanied the first wave of the COVID-19 Pandemic. These vastly improved earnings reports should go far to elevate stock prices once again—or at least keep them levitated at this level for a while longer until we can see the light at the end of the pandemic tunnel. However, while most of our indicators are bullish, and there is ample participation in the last two weeks’ upturn, uncertainty remains high. Not just from the Pandemic, but in the US, we are facing great uncertainty about the upcoming election on November 3. Stop-Loss Policy In Place Because of the heightened uncertainty, we will continue to maintain our intra-week stop-loss policy, which will monitor each ETF held in our models at the close of every trading day. Should ETFs break one of the quantitative Sell Rules that would otherwise apply on the weekend, we will send subscribers to that model, an email notice advising about the pending sale. If this happens, close the ETF the next morning, an hour or two after the open, when ETF prices are stable. We document that trade in the weekend’s update. If you have questions about any aspect of this article, please contact us via a Support Ticket. We’ll be glad to clarify our meaning to the fullest extent possible.