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After breaking out of their consolidation in early November, stocks have been loitering for four weeks just above the upper-bound of that two-month consolidation that lasted from September to November. There are several good reasons why stocks are not currently surging sharply higher, which is the typical pattern after a breakout from a long, sideways consolidation.
Chart 1 below shows a weekly chart of the S&P 500 with prices just above the upper band of a two-month resistance line that began with the high of 3581 on September 2. Bulls have been unable to piece together a rally for the last four weeks because indices and their constituents are extraordinarily overbought and overvalued. We discussed multiple valuation measures being extremely high in our November 15 ETFOptimize Insights article.
In this chart, you will see multiple, small consolidations (with red and green Resistance/Support lines) over the last two years as stocks would stall to catch their breath and work off overextended conditions following powerful bullish moves. Consolidations are always a healthy development in any market. One of their most significant cause of consolidations is a natural 'reversion-to-the-mean'—which is the most powerful force in investing. In this case, the 'mean' for the S&P 500 is the 125-day Moving Average.
Chart 1: The S&P 500 is staying just above the upper support line of its long, volatile consolidation that began in September and broke through in early November (top-right).
Reversion-to-the-mean occurs for several reasons, but it often occurs when prices have accelerated too-far, too-fast above their long-term average (usually the 125-day EMA). Contrary to amateur traders' conventional wisdom, significant moves in stock prices are rarely a result of various news events. Consolidations are pressure valves that allow overheated conditions to chill out a bit before buyers take over again and the established trend resumes.
Long-Term Support Lines
Chart 2 below shows 25-years of the S&P 500 Index extending back to 1995. We've regularly featured this chart in our analysis content since the early-2000s to show how secular bull markets establish Long-Term Support Lines (LTSLs) during business-cycle expansions. LTSLs appear as a diagonal line (dashed-green lines) that mark the lows investors are willing to accept during bull markets. We can identify LTSLs back to the mid-1800s. LTSLs are a purely-investor-determined phenomenon created by technically-oriented traders.
In the early years of a bull market, technically-based investors draw a line spanning from one intermediate-term low to the next-higher low and then extrapolate that line into the future. This line becomes a way to identify Support. During a business expansion, savvy traders will begin buying anew when indices prices (such as the S&P 500 below) reach that diagonal line. This action creates a new 'V-shaped' low on the chart and marks a further extension of the dashed-green LTSL.
In Chart 2, we see the last three bull markets in the S&P 500 with their LTSLs represented by the dashed-green line:
Chart 2: Stock indices establish Long-Term Support Lines during bullish business-cycle expansions. Breaks below the LTSL usually signals the start of a bear market.
During all those bull markets back to the 1800s, whenever the market pierced its Long-Term Support Lines (LTSLs), and shares subsequently established a new lower-low below the line, it consistently signaled the beginning of a bear market. Only in the last two years of the current bull market that began in 2009 have we seen two instances of stock prices breaking significantly below their LTSL. The recovery back above their Long-Term Support Line resuscitates the bull market and keeps the expansion alive.
LTSL—Last Five Years
Chart 3 below shows a zoom of the LTSL for the last five years with those two severe-but-temporary support breaks (highlighted in yellow). In all the other market corrections instances during normal conditions, share prices would drop to their diagonal LTSL, reverse course (establishing higher lows), and the uptrend would resume. However, in the two recent occurrences below, traders did not follow the age-old strategy of trading the LTSL. Or if they did, they were soon disappointed by prices that continued unexpectedly downward.
Chart 3: The last five years of S&P 500 prices have included two incidences of shares dropping sharply below the LTSL then recovering.
In late-2018 and March 2020, we can see in Chart 3 above that the SPDR S&P 500 ETF (SPY) reached its LTSL, then did something unprecedented—it continued downward (by -10% in 2018 and -27% in March 2020)—before reversing course and climbing back above its Long-Term Support Line. After the March selloff of -34% in the S&P 500, share prices rose higher and resumed their status above their LTSL throughout the summer. On the far right, we can see that SPY dropped back to its LTSL twice again since July (green arrows in September and October 2020) before climbing higher and reaching the current All-Time High a few days ago.
Many analysts wonder what could cause a proven indicator that was accurate for 175 years to break down recently? Why would it begin to fail the standard of consistent signals only in recent years? Why has volatility increased to a new level recently? Here's our analysis:
Why the Rapid Selloffs, Recoveries, and Extreme Volatility in the Last Few Years?
There have been two highly anomalous patterns in the previous two years, with the SPDR S&P 500 ETF (SPY) dropping far below its LTSL before forming a 'V' bottom and resuming its uptrend above the green LTSL? It's our opinion that three relatively new forces have been at play to keep prices elevated:
Reason #1) the US Federal Reserve Bank (Fed) has pursued its Quantitative Easing (QE) program since late 2008, starting with $909 billion and then pumping more than $6.3 trillion of nearly interest-free funds into the banking system during the current economic cycle that began in 2009. Anytime there is a significant selloff in stocks, the Federal Reserve jumps into action with more Quantitative Easing.
Beginning with Alan Greenspan, enhancing the 'Wealth Effect' through stock-market manipulation has been an unwritten Federal Reserve objective, on top of its two written-into-law goals: 1) Maximizing Employment and 2) Controlling Inflation.
Chart 4 below shows that in 2020 alone, the Fed balance sheet has increased 73%, growing to $7.216 Trillion from $4.173 Trillion. Want a reason why the market has remained elevated in the face of a global pandemic that caused the devastation of businesses across the world? You're lookin' at it:
Chart
4: The Fed balance sheet has increased by 73%, growing to $7.216 from $4.173 trillion in 2020 alone.
Since the 1980s, rumors about a secretive, government-run 'Plunge-Protection Team' have floated around the investing world. Still, up until the current economic cycle, when the Fed announced an honest-to-god 'Plunge-Protection' policy existed in the form of QE, everyone with a brain thought PPT was just a nonsense conspiracy theory. Today? Welllll.... not so much. QE turns out to be the real 'Plunge-Protection Team.'
Chart 5: Options trading has increased dramatically in the last 15 years.
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Reason #2) A massive increase in leveraged Options Trading may be another reason for these highly unusual trading patterns. Younger, less risk-averse Millennial and Gen-X investors have embraced Options Trading like there's no tomorrow.
Millennials and Gen-Xers have witnessed the onset of Climate Change, the potential for a Social Security bankruptcy, an opioid crisis, massive economic despair, government dysfunction, a global pandemic, and three significant market crashes during their short lifetimes. Who would blame these youthful, intrepid investors for thinking there may be 'no tomorrow' and investing like that's the case?
Chart 5 shows stock options volume as a percent of shares growing by nearly 100% since 2006. In March 2020, there was first a -40% decline followed by a breathtaking, parabolic increase occurring in late-March 2020. In large part, this dramatic increase in options selling and subsequent buying is what sent the market straight down in late February and then straight upward in late March.
Yet, why would the enormous popularity of Options Trading be a source of the extreme volatility we've seen recently? Because A) options on equities or indices are far more affordable than the equities or indices themselves, this allows option investors to buy more exposure for their dollar and enhance their gains per dollar.
B) Options Traders can also easily leverage their positions by merely signaling a desire to trade on margin with any transaction. For Options Traders, getting leverage sometimes only requires ticking a checkbox on any trade to obtain margin facilitated by the options broker that can multiply their returns many times over.
In the stock-market world, getting a margin account is a challenging and time-consuming endeavor. Investors must jump through seemingly endless rings of fire—including putting up offsetting collateral they own—to guarantee a margin account from their broker that leverages their portfolio balance to reap dramatically higher returns.
If you are tempted to dive into leveraged options trades, remember that the potential for significant gains also means there is an offsetting potential for substantial losses. There are no free lunches.
And finally, Reason #3) the enormous increase in passive index-based investing through ETFs has dramatically changed the stock market's fundamental structure. In August 2019, the volume for passive investments topped the volume of active investments for the first time. Index-oriented ETFs increasingly move the market from supply or demand for their constituent, underlying stocks.
In a bull market, the increase in share prices of the constituent stocks increases the ETF price, which in turn creates more demand for the shares and advances their prices. In a bull market, it is a virtuous, vicious cycle. However, in a bear market, the opposite occurs, and the market can sell off faster than investors can react—as took place last March.
For example, whenever participants pile on trades in individual FANG stocks, it triggers an increase in the price of ETFs that hold those shares, including the SPDR S&P 500 ETF (SPY) and the Invesco NASDAQ 100 Trust (QQQ), to name a couple of the largest ETFs that hold FANG stocks.
With an increase in upward momentum, there's an incentive for many investors to purchase those ETFs. The rise in demand for the ETFs causes each of the stocks also to receive an increase in demand. This action hikes their prices up even more. However, this knock-on effect dramatically increases the volatility of those shares in the same direction—either higher or lower. It is genuinely a self-feeding cycle that has caused significant volatility in the market.
When we consider all three of these relatively new factors, modern-day investing has become a self-feeding cycle that can dramatically exacerbate price changes—i.e., increased volatility. Unbeknownst to them, individual stock and ETF investors have effectively become hand-in-glove trading partners. Rather than the horse pulling the wagon, during many significant rallies or selloffs, the wagon is pulling the horse, which exacerbates the market's volatility and endangers investors.
Share Prices at Technical Extremes
There's a good reason why stock prices have stalled in the last four weeks: Prices are at historical extremes. Two weeks ago, we shared Chart 7 below for the first time. The extreme reading it shows justifies that we check in again to see where things stand this week. The middle pane shows our Breadth Indicator $BI01: the Percent of S&P 500 Issues Above their 200-Day Moving Average, with a Danger-signal drawn at the 80% level. The sweet spot in this chart is 60% to 80%. Over 80%, things get sketchy.
The bottom window provides a view of our Technical Indicator $TI09: the Percent the S&P 500 ETF (SPY) is Above its 200-day Moving Average with extreme levels indicated when it reaches 10% and above (today it's near 13% above). These two indicators identify extreme, relative price readings—market-based indicators that show when stocks have moved too-far, too-fast, and become prone to sharp selloffs.
The top window displays the S&P 500 ETF (SPY) with dashed red lines indicating downturns that came on the tail of overextended readings in one or both of the two Extreme-Price Indicators.
Chart 7: The S&P 500 ETF (SPY) remains at extreme price levels that continue to climb higher. How much higher can prices go?
Chart 8 below shows a zoom into the last six months of Chart 7 above. Here we can see where stock prices recently became overextended (around November 9). Today, that status is even higher, into extreme readings in the nose-bleed territory.
Chart 8: A six-month zoom into Chart 4 shows the S&P 500 ETF (SPY) reaching ever-higher levels of price extremes.
Overhead Resistance
Chart 9 below shows the S&P 500 now abutting overhead resistance that stretches back to the February 2020 high. An overhead resistance line such as this will often catalyze a correction and provide some problems for investors to overcome with time. Considering the overheated prices combined with this overhead resistance, the most likely direction is either downward or sideways.
Chart 9: The S&P 500 has reached overhead resistance. When combined with the overextended conditions addressed above, we could see a downturn.
Ask Yourself...
Is it likely that the S&P 500, representing more than 80% of all US stock-market capitalization, will continue rising significantly higher when share prices are already so far above their long-term averages? If ever there was a time for reversion-to-the-mean, it seems it would be now. When it's nearly impossible to identify investment opportunities that aren't near their all-time highs, that's usually a precursor of a significant selloff. Any day now, investors will start thinking about taking profits.
However, extreme prices and stretched valuations make for rotten trade signals. Remember the old trope, "The market can stay irrational far longer than you can remain liquid." Extreme prices are more like a weight tied to the market's feet, but by itself, overextended valuations can't cause shares to trade lower. However, when stocks and ETFs begin to sell off, the over-extended levels become a catalyst for even more significant losses. The worst market crashes in history have come after periods of extremely overextended prices (think of the roaring '20s followed by a -90% market crash and the Great Depression).
Nevertheless, we have to keep reminding ourselves that we're not living in history. It's a whole new investment environment today, in which the word 'unprecedented' should be the word of the year. With investors perceiving a constant 'Fed Put' under the market—whether there is or not—prices may not decline much in the near-term—at least until something occurs to overwhelm that 'Fed Put.' That 'something' may include the Fed itself, stating that there will be no further QE to extend prices to ever-increasing stratospheric levels. (Side note: The 'Fed Put' is the reason that value investing has not worked for decades.)
The Fed MUST KNOW what it is doing to market valuations. Surely the Federal Reserve Board isn't living in a bubble where they don't have access to the fact that valuations are close to setting all-time records (soon surpassing the extremes of the dot-com bubble), and that they are blowing yet another enormous asset bubble. Eventually, all bubbles must pop; they can't live forever. And the larger a bubble is blown, the more significant the mess when it finally does burst. Ostensibly, the 'Fed Put' has caused the devastating -50% and -60% market crashes in the last 20 years.
The Fed Put
The phrase "Don't fight the Fed" began with the "Greenspan Put" (Alan Greenspan, former Fed Chairman from 1987 to 2006) in the late-1980s, implying that investors shouldn't sell or short stocks when the Fed is actively pushing asset prices higher. Jim Cramer, a host on CNBC, has called the current 'Powell Put' like a "slot machine that always pays out." He added, "You can't lose in this market."
The Fed Put is like free insurance for aggressive risk-taking. It creates a moral hazard that drives speculation in a high-risk game of 'chicken.' Let's take a moment to summarize the Fed Put:
The 'Greenspan Put' began in the late-1980s to fight the 1987 market crash, the 'Bernanke Put' in the 2000s for the Financial Crisis, and the 'Yellen Put' in the 2010s. The 'Powell Put,' which is the version of the Fed Put we have today, has been the most aggressive of them all. After all, the current economic downturn is perhaps the worst in history. Yet stocks are trading at all-time highs.
Yet, ask yourself—have all of these 'Fed Puts' stopped significant market declines? No; some of the worst market crashes in history occurred in the last 33 years when all this Fed manipulation of investment markets began. Ostensibly, a solid case can be made to lay the blame and the credit for the devastating market crashes—and their recoveries.
When things become too over-extended from Fed-induced speculation, and then there is an unforeseen change of conditions, nothing can stop the devastating crash that's inevitable. It's like putting your hand up, screaming threats, and making a mean face to stop a tornado that's headed for your house. We can't stop the forces of nature or the movements of a $20-Trillion economy when it's determined to take a power-nap.
For this reason, more than ever, investors need a systematic investment approach that employs proven indicators to identify times of heightened risk and then take the appropriate defensive action promptly. An algorithmic investment model provides a process that offers consistency, removes the return-destroying effects of significant downturns, mitigates risk, and enhances returns. Most of all, it allows investors to avoid emotionally based, reactive decisions that have resulted in the average investor underperforming the rate of inflation (2.3%) over the long term.
Chart 10 below shows a live example of a diversified, quantitative investment model that accomplishes all of these objectives over the last 13 years.
Its easy to see from the lower window showing drawdowns how systematic risk mitigation can reduce losses—and significantly enhance returns. By eliminating the gut-wrenching losses that cause investors to capitulate after a significant downturn, sell everything, and lock in those losses near the lows, quantitative investing can provide something invaluable: peace of mind.
Conclusion
This article identifies the drivers of significantly increased market volatility in recent years. It also establishes why higher prices would likely have significant headwinds—i.e., because stocks are already at excessively stretched levels. A correction may occur, but during this unprecedented time when there is a relatively new driver of prices running at 1,000 mph (the Fed), they could just as easily move higher.
Suppose the S&P 500 share prices fall below 3550 (360 on SPY), then the last four weeks would be considered a failed breakout from the previous consolidation. It's also possible that share prices will rise from here. After all, our systematic models have an overall bullish bias—primarily from mostly bullish technical indicators. Macroeconomic and fundamental indicators remain at bearish levels.
We are still in a bull market until we're not—until lower-lows appear on weekly charts (there's too much noise in daily prices for use). Prices can continue climbing long after extremes appear. As an example, this situation is precisely what occurred in 1997-2000. At that time, the Dot-Com bull market kept prices climbing for another three years after Fed Chairman Alan Greenspan said there was "irrational exuberance" in the market. Despite extreme valuations and stretched prices, the 'greater fool' theory remains a stubborn thing.
In the coming week or so, we should learn the answer to the question of the market's intermediate-term direction. In the meantime, investors should ignore macroeconomic and fundamental indicators, many of which are now broken by the Fed and other exogenous forces, and instead focus on innovative technical indicators, such as the ones we feature here in our ETFOptimize Insights posts. That's what our quantitative models are doing, and so far, they have performed well.
Coming...
In our next ETFOptimize Insights article later this week, we will discuss a macroeconomic indicator with a record of 100% accuracy in predicting recessions and recoveries since the 1940s. Stay tuned...