Warning: Pushing on a String Date: Sunday, July 18, 2021 Posted by: Christopher Michaels Category: Market Analysis 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. Over the weekend, we learned that on Monday, July 19, nearly all of our quantitative Premium Strategies made position changes that added defensive ETFs to each model's holdings. In some cases, half the shares held in a single Equity ETF will be sold and the funds used to buy a new defensive ETF. Our systematic strategies that usually hold a single Equity ETF are selling half that position and investing it in a Defensive or cash-proxy ETF. For example, our NASDAQ Persistent Profits (1 ETF) Strategy, which usually owns the Nasdaq 100 ETF (QQQ) during bullish times and the iShares 20+ Year Treasury Bond (TLT) when risks rise, recommended that users sell half the shares of QQQ and diversify those funds into a different defensive ETF that is closer to a cash-proxy ETF than TLT. The effect of this transaction will be to make the model less bullish by adding a hedge—the models are not switching to 100% bearish positioning—at least not yet. Specifically, after this update, QQQ will effectively be a 1/2 or 50% bullish position, rather than having 100% bullish exposure. On the other hand, there is not much that is currently working beyond the S&P 500 ETF. After Monday, other models positioned to accept more risk for a higher return (such as our Equity+ Strategy) will be 100% invested in defensive ETFs, such as the Utilities Sector ETF (XLU) and Consumer Staples Sector ETF (XLP), which are the current market-leading sectors. Chart 1 below shows US Sector Performance for last week (week of July 11), with four out of five (80%) of the Defensive Sectors (Staples, HealthCare, Utilities, and Real Estate) on the right side of the chart in positive territory while five out of six (83%) of the Growth Sectors (Discretionary, Communication Services, Technology, Industrials, Materials, and Energy) on the left side of the chart losing money last week. The strongest sector last week was Utilities – certainly not an indication of investors anticipating strong economic growth. Chart 1: Growth Sectors on the left side of this chart lost money last week, while the Defensive Sectors on the right side were overall profitable. Despite the increase in defensive holdings, several of our models retained exposure in two Equity ETFs that profit during 'Risk-On' market environments. These are the SPDR S&P 500 ETF (SPY) and the NASDAQ 100 ETF (QQQ) – accounting for 30% and 10%, respectively, of our Ultimate Combo Strategy, which combines all six of our models. We wondered why the models didn't move to 100% defensive positions and continued to retain exposure to more risky instruments such as Equity ETFs. To answer these questions, we conducted research into the indicators and algorithms used in our models, to try to determine why our quantitative investment models made their defensive choices this week. This article will review our findings... The S&P 500 Remains in a Steady Uptrend For the last year, the SPDR S&P 500 ETF (SPY) has continued to set regular new highs month after month, with investors frequently seeing the world's most popular ETF (SPY) rally higher after tagging its 50-day moving average, a level that has consistently served as support for a buy-the-dip response. This steady ascension higher has led the S&P 500 to also reach an all-time high in its valuation, topping even the 'Roaring 20s' and 'Dot-Com Bubble' extreme market peaks in 1929 and 2000. (*Note: We don't include the Financial Crisis peak valuation in late-2008 because it was the result of a 1-time fluke in prices and earnings.) Chart 2 below shows the SPDR S&P 500 ETF (SPY), which holds America's largest and most successful public companies. SPY was the first American ETF created in 1993. The S&P 500 represents about 80% of all available stock-market capitalization (price times the number of shares outstanding). From the chart below, we can see that each time SPY dropped to touch its 50-day moving average (blue line, with touches of the 50-dma marked by yellow circles), it was seen as a 'buy-the-dip' opportunity for investors. We are taught that markets don't just go straight up, but instead they move in a series of impulse moves and corrective reactions as the overall trend continues. However, the last 16 months has very much been an exception to that rule of market trends. Since the Covid Crash selloff in March 2020, the S&P 500 has been the one index that seems to be on rails headed higher, with nary a -5% pullback since last October. Chart 2: Since the Covid Crash in March 2020, the S&P 500 has experienced a smooth, consistent run higher, with its 50-day moving average serving as support. The only exceptions to the general rule of investors buying on dips were the two shallow (about -4%) drops below the 50-dma last September and October, 2020 (marked with red circles). Nevertheless, these two declines to SPY's 100-day moving average were also rewarded by a strong rally to new all-time highs in short order. At the open on Monday, July 19, SPY dropped to 422, which is immediately above its 50-dma. Will the ETF rally from here as it has so many times in the last 16 months, or will it continue declining to a lower level as it did last September and October? While various portions of the market have experienced a mixed bag of performance as investors rotated from one sector/segment to another following the Covid Crash, the S&P 500 has progressed higher throughout the last 16 months, on a remarkably steady trajectory. One factor involved in that performance is a result of the S&P 500 being a broad and diversified index of 500 of America's most successful publicly traded companies, while most other ETFs are based on less broad market segments. By design, the cap-weighted index construction itself provides intentional diversification that smooths the undulating performance of the various market segments from which it is composed. Another reason is that a significant portion of the Federal Reserve's steady monetary largess is flowing into the S&P 500 index through direct purchases of the various ETFs representing the S&P 500 index. These ETFs include the aforementioned SPDR ETF (SPY), as well as SPY's competitors, including the Vanguard S&P 500 ETF (VOO), the iShares Core S&P 500 ETF (IVV), among others. For an ETF to fulfill their original purpose (i.e., a financial product that enables ownership of an entire index of dozens, hundreds, or thousands of stocks in one transaction), when an investor purchases an S&P 500-based ETF, in most cases, he/she is indirectly buying shares (on a cap-weighted basis) in each of the 500 companies from which the S&P 500 Index is composed. That's because most passive, index-based ETFs (such as SPY) make outright purchases of a representative number of shares of each stock from which an index is composed (or less often, a statistically representative subset of stocks from the index). Derivatives and other, more exotic financial tools aren't usually employed in creating an ETF unless that ETF's tracking objective also tends toward the more exotic, such as 2x or 3x leveraged long and inverse ETFs. Now that the Federal Reserve has established that it intends to continue using QE to manipulate markets higher whenever it deems necessary, many savvy investment managers have decided that they can play this new game, too. With the Fed releasing updated data about the size of its balance sheet every Wednesday, and both quantitative and discretionary money managers taking their market-exposure cues from that report, will stocks continue to climb in coordination with Fed stimulus? Well, not so fast, Bubba... Fed Driving Bizarre Market Distortions There are a plethora of factors recently weighing on stock prices, including the following issues: • Sharply rising hospitalizations and deaths related to the more-contagious and higher mortality Delta Covid variant. Cases are up 66%, hospitalizations have increased 31%, and deaths (which usually lags the first two statistics) are up 17%; • Half the country is refusing to get a vaccine shot as a result of partisan politics and misinformation; • Worries there will be additional, unexpected lockdowns, after investors had largely discounted the Covid Pandemic being over; • Worries about post-Covid re-opening plays and their potential for driving enormous economic growth; • Supply-chain backlogs will continue to put upward pressure on this likely temporary inflation; • Inflation last month reached 5.7%, the highest increase in prices in about 18 years; • Market breadth measures, particularly for small and mid-cap stocks, show increasing deterioration, which is a bearish signal. • Valuations have reached nose-bleed levels, the highest in history for many measures;| • Seasonality analysis shows that the worst month for stocks is September, closely followed by August, both just ahead. To counteract these concerns, the Federal Reserve has pledged to remain dovish in its monetary policy, keeping rates near zero and continuing the steady infusion of Quantitative Easing (QE) until strong economic growth resumes. Historically, a steady infusion of QE has spurred bull rallies in the S&P 500, and since March 2020, that historical relationship has continued. Nevertheless, that relationship may soon be broken. Chart 3 below shows the Federal Reserve Balance Sheet more than doubling from the use of QE in the last few years. After immediately jumping to $7 trillion last July, the Fed assumed a steady rate of Treasury purchases at a rate of about $120 billion per month. Chart 3: The Federal Reserve has more than doubled the size of its balance sheet since the Covid Pandemic. Because of the steady increases in the Fed Balance Sheet, the amount of money in the economy has skyrocketed, reaching nearly $20 trillion today from $4 trillion in early 2020. M1 Money Stock is a measure that reflects the amount of money in the economy. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (3) other liquid deposits, consisting of OCDs and savings deposits (including money market deposit accounts). Chart 4 below shows a chart of M1 Money Stock since 1980, sharply increasing by more than 500% to nearly $20 trillion in the last 18 months alone. Chart 4: The amount of money in the US economy is best reflected by M1 Money Stock, which has surged sharply higher in the wake of massive stimulus. Since Quantitative Easing (QE) began as an 'experiment' in 2008-2009, the trope that investors have followed religiously is "Don't Fight the Fed." The US Federal Reserve has been a primary mover in the US investment market since the institution was first created, and investors who have followed that advice have been well rewarded. However, as hedge-fund mogul Jeremy Grantham has said, "A policy of not fighting the Fed will be applicable until it isn't." Who knows what will trigger a break in the relationship between QE and stock returns? Well, we may be seeing that disconnect getting underway already. While Money Supply has increased parabolicly in the last 16 months, the Velocity of M1 Money Stock has plummetted by about -80%. M1 Velocity is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is decreasing, then fewer transactions are occurring between individuals in an economy. Chart 5 below shows a chart of the Velocity of M1 Money Stock since 1960. We can see that this indicator peaked at 10.68 transactions in the 4th quarter of 2007, just before the world was hit by the Global Financial Crisis. M1 Velocity declined by about half from 2007 to the 4th quarter of 2019. However, when the Covid Pandemic hit in February-March 2020 and governments mandated lockdowns, the number of transactions in the economy dropped by more than -80%, recently stalling at 1.2 transactions from 5.5 transactions per unit of currency in late 2019. Chart 5: The Velocity of M1 Money Stock has dropped by -80% since the Covid Pandemic got underway (yellow shading). Finally, we have one chart that may summarize conditions in the economy more than any other presented above. Overnight Reverse Repurchase Agreements – the 'Repo' market – is a measure of the amount of Treasury Securities sold by the Federal Reserve. While Quantitative Easing is all about stimulating the economy through the Fed's purchase of Treasuries, the Repo market is the opposite – the Fed's sales of Treasury securities to banks. The Repo market is a measure of 'excess reserves' in the financial system, and a spiking number of agreements implies that banks cannot find enough credit-worthy borrowers who want to take on additional debt. Repo's reflect an increasing number of banks that are giving the 'hot potato' of money back to the Federal Reserve, effectively saying, "We can't use it and don't want it—you deal with it." Chart 6 below shows that the measure of overnight Repo sales recently spiked to near-$1 trillion, which is the highest level in history. Chart 6: Overnight Reverse Repurchase Agreements is a measure of overstimulation, with banks temporarily giving QE back to the Fed. Conclusion The profound distortions and manipulation of equity share prices from Federal Reserve activity has created a bull market for stocks during a time when the US economy might have been experiencing a crisis greater than the Great Depression. Credit for this out-of-place bull market that ignores contraction in macroeconomic indicators and stock fundamentals goes to the Federal Reserve's Quantitative Easing policy. However, 13 years after Fed Chairman Ben Bernanke created the "experiment" he called Quantitative Easing, we may finally be seeing limits to the effectiveness of this policy. While the Fed is 'printing' $120 billion each month in dollar credits that are used to purchase Treasuries and MBS from banks, the rate of Overnight Reverse Repurchase Agreements, or 'Repo market' is showing that banks are now saying, "No more!" to continuing efforts at stimulation. The Repo Market is showing that banks have ample deposits – so much that they cannot lend it out fast enough and all that easy money is languishing in their accounts. They are teling the Fed that they would rather have the security provided by Treasuries earning a modicum of interest (about 1.19% as of Monday, July 19) than cash being pummelled by the 5% inflation registered last month. Banks are telling the Fed that it is now 'pushing on a string,' and they cannot lend out all the cash the Fed is pushing. We may be seeing the beginning of the end of QE experiment – Fed policy or not.