Note: Our 'ETFOptimize Insights' articles review the proprietary indicators we use in our models when there has been a key change. 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 that investors receive from a systematic investment approach.
After being positioned for either direction during election week, our models put a toe back in the equity water this week, based entirely on our quantitative indicators' borderline readings that now have a slightly bullish bias. However, at this week's assessment our models remained tentative, with 50% of our two Equity-based models remaining in cash-proxy or defensive ETFs. Another good tell is that our Ultimate Combo-6 Strategy, which combines the ETF holdings of all of our current models, has nearly half of its assets in cash or cash-proxy ETFs, and there is a good reason for this. Stocks are slightly more likely to move higher, but for now, the market remains in a sideways consolidation.
Until a breakout of the current consolidation occurs, investors remain at risk of a rapid drop of prices back to the bottom of the consolidation channel to around 325 (-8%). However, this support zone is significant, and the amount of money an investor can lose is clearly defined. That's not to say that prices won't decline below 325, but with a well-defined Support Zone, it will provide time for a revised assessment.
Chart 1 below shows that the S&P 500 ETF (SPY) has been in a volatile, sideways consolidation for the last two months, after reaching an all-time closing high of 356.27 on September 2. Last Friday, the S&P closed down from that high by about -1.7%, making for an abysmal showing for the market the last two months.
Then on Monday, many thought the sharply higher open, with Dow Industrials up by a breathtaking 1,144.50 points or 4.04% and SPY higher by 3.94% marked robust breakout of stocks from the two-month consolidation zone. Well, at least the first batch of traders, probably composed of amateurs who put in bullish, electronic market orders before the open, thought it would be a breakout.
However, professional traders and high-frequency traders (HFT) jumped on those amateurs with shorts, and drove prices down sharply in the first few minutes. Human investors quickly got cold feet and began selling, triggering increased volume, and SPY dropped back into its consolidation zone, closing at near its low for the day at 354.56.
Chart 1: The S&P 500 has experienced a sideways consolidation for the last two months. Hopefully, we will see a breakout this week.
Tuesday's action confirmed that Monday wasn't a mistake, by staying within the consolidation's upper limit at 354.04 (-0.15%). It's likely we shall soon learn if the 'Biden Rally' that began on Election day has legs and will break out of the consolidation—or if stocks will drop back to the bottom of the two-month-plus consolidation funk.
It's clear to investors that a Biden/Blue-Wave sweep of government didn't happen, and the US will have a divided government. With a Republican Senate apparently remaining in Mitch McConnell's hands, there are profound implications for investors. (Note: There is still a run-off election in Georgia for the election of that state's two Senators, but Republicans are strongly favored to win.) Investors began unwinding their positions last week in industries that were Democratic favorites, such as Infrastructure and Renewables.
The likelihood of a multi-trillion-dollar pandemic stimulus is probably off the table, which caused Treasury yields to plummet last week. Meanwhile, technology stocks have returned to lead the market higher—just as they did earlier in the year, and that sector lodged a 9.7% gain last week. In a way, big bets on a handful of mega-cap technology stocks present “a very, very, very bearish view of the future—that nothing [else] is going to grow,” said Richard Bernstein, chief executive and chief investment officer of Richard Bernstein Advisors.
A divided government means gridlock, something that has always been favorable for stocks. Investors prefer a level playing field that allows companies to fight for market dominance based on the quality of their products and services. However, we must keep in mind that today's dominant forces are the global and the US economy's direction (more below), the COVID-19 pandemic, and whether there will be government stimulus.
It's possible that little will get done beyond what Executive Orders can accomplish, considering that Mitch McConnell had eight years of practice in blocking legislation during President Obama's term. However, this time around, government gridlock may not be the windfall for the market that prior gridlocks created. Economic growth may be hard to come by in the face of a pandemic and the most profound decline of GDP in recorded history.
Breadth Still Remains Bullish After Recent Close Calls
Several key measures indicate we'll see a continuation of the bull rally in the coming weeks. On the other hand, several indicators also harken for a decline. We'll cover a few of those indicators—from both Bullish and Bearish influences—in this article. One of the bullish indicators is S&P 500 Breadth.
Chart 2 below shows the S&P 500 Index for 2020 in the top window and four critical Breadth Indicators in the lower four panes. These include, in windows numbered on the left side1) the Advance-Decline Percent, 2) the High-Low Percent Index, 3) the Percentage of stocks above their 200-day MA, and 4) the Bullish-Percent Index, which shows the percentage of S&P 500 stocks on a Buy Signal. This system requires three of the four indicators having coincident signals for an Overall Breadth Signal.
Chart 2: Multiple S&P 500 Breadth Indicators remain on a bullish confirmation signal since March, but there was a close call from two indicators recently.
Notice that the Advance-Decline Percentage (pane #1) came very close to a Bearish signal in late-October. Also, we barely dodged another Bearish signal from the Bullish Percent Index in the 4th (bottom) window in September. But an inch is as good as a mile with Breadth Indicators, and Overall Breadth has remained bullish since early-June.
Typically, Overall Breadth Signals are proven early indicators of market moves since we are looking inside the market (in this case, the S&P 500), but this year the rally off the March lows was a low-breadth rally. The uptrend was driven by a relatively small group of very large-market-cap technology companies, such as Apple, Facebook, Netflix, Amazon, and similar equities that had an outsized influence on the S&P 500 ETF (SPY) and the Nasdaq 100 (QQQ). While stocks took off on March 26, we didn't see an Overall Breadth Indicator until early June. This narrowness of Breadth caused some of our models to remain out of the market for far too long.
S&P 500 Progressive Blend Earnings Composite (PBEC)
Earnings are the 'mother's milk' of the stock market, so the saying goes, but this market baby might be getting a little thirsty. Our Earnings Composite is still signaling that the trouble with profits since the CODID-crash hasn't abated. For accuracy, rather than using a single earnings component in our fundamental signals, we combine three different S&P 500 earnings measures.
All of these readings are then built into a Composite Indicator that uses a progressively more considerable amount of Next Fiscal Year EPS Mean (NextFYEPS Mean), Current Fiscal Year EPS Mean (CurFYEPSMean), the S&P 500 Trailing Twelve Months (TTM) As-Reported EPS. We call this combination the Progressive Blend Earnings Composite (PBEC).
Chart 2 below shows our S&P 500 Earnings Composite for the last 10 years, with the S&P 500 ETF (SPY) in the top window (#1), the PBEC SIGNALS in the second pane (#2), the PBEC Raw data (#3), the S&P 500 Next FY EPS Mean (NextFYEPSMean at #4), the Current Fiscal Year EPS Mean (CurFYEPSMean at #5), and the S&P 500 Trailing Twelve Months (TTM) As-Reported EPS in the bottom window (#6).
Chart 3: This chart shows signals from our S&P 500 Progressive Blend Earnings Composite (PBEC) Signal in window #2.
Chart 3 above shows that our PBEC Signal (#2) remains on zero, a 'Risk-Off' signal. On the right side of each chart, we can see from Next Year's EPS forecast (#4 in red) and Current Year's EPS forecast (#5 in green) that analysts are optimistic. However, the chart for Actual, Trailing Twelve Months EPS (window #6 in orange) is still declining since the S&P 500 earnings collapse began with the pandemic in the first quarter.
Deciding which one of these charts you believe is most reflective of actual conditions is relatively moot because we combine all three in a sophisticated algorithm. The Progressive Blend Earnings Composite (PBEC) indicator remains bearish, with a Risk-Off signal, but on the verge of crossing its signal line.
Corporate Bond Yield Differential (AAA-BBB)
The divergence between the highest-quality, AAA-Corporate Bond interest rates and much-lower-quality BBB-Corporate Bond (just above 'Junk' bonds) interest rates provide an excellent macroeconomic indicator 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.
However, while market forces have historically driven Corporate Bond interest rates, the Federal Reserve is now stating its intention to purchase Corporate Bonds and Bond-secured ETFs to prop up the market. We will have to watch closely 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 other market-based indicators to identify the current level of market risk and select the most appropriate ETF.
Chart 4 below shows the S&P 500 in the background with a dark-blue line and the divergence between the Corporate AAA Bond interest rate and the Corporate BBB Bond interest rate with a red line. The light-blue line provides the Signal Line we use to determine turnpoints in this indicator. Drops below the blue Signal Line indicate increased risk. We can see that the indicator dropped sharply at the beginning of the COVID crash—providing a very accurate slightly early/coincident signal, and it has surged sharply higher since bottoming in March, continuing to deliver a precise harbinger for our models.
Chart 4: Corporate AAA-BBB Bond Yield Differential is a very accurate, market-based economic indicator.
Chart 5 below shows the S&P 500 in the background with a dark-blue line, with binary signals from the chart above, indicating when the Corporate AAA Bond interest rate and Corporate BBB Bond interest rate differential crosses below the Signal Line. On this chart, drops to '0' indicate increased risk, while increases to '1' indicate decreased risk and more bullish economic conditions.
Chart 5: Corporate AAA-BBB Bond Yield Differential Signals, 2000-2020.
Chart 6 below is a zoom into the last five years of the 20-year chart above, providing more detail on the signals. We see from this chart just how accurate the Corporate AAA Bond / Corporate BBB Bond Interest Rate Differential can be used in identifying periods of increased risk. Again, drops to '0' indicate increased risk ('Risk Off'), while increases to '1' indicate decreased risk and more bullish economic conditions ('Risk On'). This indicator is currently on a bullish, Risk-On signal.
Chart 6: A zoom into the Corporate AAA-BBB Bond Yield Signals show just how accurate this indicator as a real-time, coincident indicator.
Conclusion
The indicators shown above are examples of the dozens of indicators that drive the risk-exposure and ETF-selection of our quantitative models. Those indicators offer mixed signals right now, which explains why our models have one foot in aggressive positions and one in cash-proxies or defensive ETFs. The sum of the indicators shows a slightly-above-zero signal—or only somewhat bullish current conditions.
We will see a definitive signal soon—either Bullish or Bearish. Sideways consolidations do not last forever, as there is too much money in investment markets, with too many powerful interested parties, for conditions to stay unprofitable for very long.
Quantitative models usually require persistence for at least a week to produce a signal, with a weight-of-the-evidence approach to their decisions. During periods that are as volatile as we have seen in 2020, signals sometimes slightly lag the market's turnpoints. However, quantitative indicators continue to provide—by far—the most robust approach to investing success by removing the deleterious effects of human emotion.