'ETFOptimize Insights'

Note: Our 'ETFOptimize Insights' articles review the market and the proprietary indicators we use in our models when there has been a substantive change. This content is for informational and educational purposes only, and readers should not use it as the basis for investment decisions or discretionary overrides of the ETFOptimize Premium Strategy recommendations. Subscribers should carefully follow the guidance of their quantitative models without second-guessing them. Profitable investment decisions are often contrarian, and any divergence from your strategy's recommendations will introduce biases and errors of judgment, which eliminates all the benefits and performance advantages of a systematic investment approach.

By September 2021, the SPDR S&P 500 ETF (SPY) had been climbing steadily higher for more than 10 consecutive months. By the close of trading on September 2, SPY attained a fresh, all-time high at $451.74, had set a record for the number of days without a -5% decline going back to 1997, and was about 36% higher than its pre-Covid-Crash high near $330 in mid-February 2020. It was an incredible run for the world's original and most popular ETF (avg. of $28 billion traded daily).

After setting its all-time high a month ago, the S&P 500 began declining – and didn't stop throughout the month. Throughout September, as investor concerns accumulated (more on this in a moment), many dip-buyers became sellers of shares for the first time since the Pandemic hit, and dozens of individual stocks held by the S&P 500 ETF recorded their most significant share-price losses of the last two years. September 2021 was SPY's worst month since March 2020, when the index was falling like a rock in the Covid Crash.

While that last sentence sounds ominous, if we step back a bit and look at the weekly market data from a purely objective perspective (which we do in the first chart below), we can see that not very much has happened at all (so far). The September downturn has certainly not been a huge one. Since its September 2 closing high at 451.74, the S&P 500 ETF (SPY) declined by exactly -5.00% for the first time in nearly a year at the close of trading on September 30. It has been staying near that level since then.

Chart 1a below takes a step back and provides a two-year, weekly chart of the S&P 500 ETF (SPY). When you want fresh insights, it's always a good policy to employ an old trope; "When in doubt, zoom out." By doing so using a weekly chart, we can see that SPY remained above its ever-climbing 10-week (dashed-blue) moving average for most of the last 18 months, only declining to the lower 20-week (dashed-red) moving average three times (yellow highlights). On the far-right, we can see that prices have held between the 10-week and the 20-week moving average for three weeks.

Chart 1a: The 10-week (blue) and 20-week (red) moving averages have consistently supported the S&P 500 since May 2020.

The S&P 500's 20-week (100-day) moving average served as a robust support level for the last three weeks, and this threshold will continue to be a critical level in the coming weeks.

Chart 1b below returns to a 3-month Daily chart of the S&P 500 ETF (SPY) ending on Wednesday, October 6. We're showing this detail to bring attention to the current situation where daily prices have vacillated below, above, below, and back above the 100-day moving average over the past four trading sessions. Seeming to continue this bouncing storyline, the S&P 500 ETF was down sharply on Wednesday morning, with the selling driven by three substantial investor concerns (which we'll discuss next), and prices looked like they could head much lower as the morning progressed.

Chart 1b: Zooming in with a 3-month daily chart, the S&P 500 ETF (SPY) has been alternating above and below the 100-day SMA (red).

By early afternoon on Wednesday, news crossed the wire that mitigated two of the three problematic stories. One was a leak by Sen. Mitch McConnell and the other a public announcement by Vladimir Putin – and traders began buying shares of SPY and its underlying stocks in an afternoon relief rally.

By the close of the day on Wednesday, the price of the S&P 500 ETF (SPY) had spanned 1.63% between its high and low extremes, it had closed back above its 100-day moving average, but shares were only 0.16% higher than Tuesday's closing price. Remaining so close to the 100-day moving average tells me that investors remain conflicted about the market's near-term direction and aren't confident enough to start buying shares with conviction. And there are some good reasons for those concerns...

Playing with FIRE

S&P 500 prices continue to move sideways at the 100-day moving average, with investors unsure of what the future holds – and justifiably so – when we consider some of the potential threats that could directly affect investment markets in the coming weeks.

Those threats are:

1) The Fed is determined to begin 'tapering' its $120 billion per month purchases of Treasury Bonds and MBS before the end of the year.

The Fed's 18-month buying spree ($6.2 Trillion total to date) has caused rampant price dislocations across virtually every major asset class. In retrospect, it looks like the Fed tried to stuff a $1.5 Trillion hole punched in US GDP by the Covid pandemic with more than $6 Trillion in cash – and out-of-control inflation is the result.

When widespread lockdowns first started last year, America's "shop-til-you-drop" culture would not be denied, and many people quickly adapted to working, living life, ordering restaurant delivery, grocery delivery, and shopping online. Online e-commerce went through the roof. A few months after the crash, the US Real GDP Per-Capita had already recovered back to its prior level, which, at the time, was difficult to believe considering the impact of Covid.

That's when the Fed should have begun its 'tapering,' but the central bank was determined not to let a good crisis go to waste and took the opportunity to try to induce inflation into the system by continued stimulation. Since the 2008 GFC, the Fed has made no secret about its desire to see 2-3% inflation return to the US economy. But a $23 Trillion economy doesn't start and stop on a dime, and this year the Fed found itself trying to explain why inflation is now at 5% and not coming down after they claimed it was "transitory" for most of a year.

I believe this is the first time in history that a central bank has seriously tried to create a specific inflation rate. I guess nobody warned them that you are playing with FIRE when attempting to manipulate inflation in the massive US economy. The rampant increase in the money supply has overwhelmed supplies, sales are off the charts from pent-up demand, inventories are short, and supply backlogs are limiting the ability of manufacturers to replace that inventory. Too much money chasing too few goods is a recipe for even higher inflation - transitory or not.

Stocks, bonds, and real estate (to name three asset classes) are trading at all-time high valuations by many measures. The S&P 500 quickly recovered its losses from the Covid crash and is up well above its pre-crash high – with a PE ratio of 34 – more than double S&P 500's long-term, average PE ratio. Real estate is up 30% in the last year based on a combination of the lowest mortgage rates ever offered – and far too much money in the system.

There is likely only one direction for prices to go when the Fed withdraws its artificial price support, and that direction is down. Reducing the stimulus is a move that should have happened more than a year ago – before the $120 billion per month of asset buying became the norm and before record-breaking valuations became an entrenched status quo. Now that home prices have increased by 30%, people naturally don't want their property value to return to its prior level. Who can blame them?

Overvaluation as Decline-Severity Indicator

Most experienced investors know that significant overvaluation never causes a market downturn, so we can't use overvaluation as a market timing signal. The famous quote by economist John Maynard Keynes comes to mind; “The stock market can remain irrational far longer than you can remain solvent.”

However, most investors aren't aware of the extent to which overvaluation directly correlates to the severity of the inevitable selloff when a contraction begins. Historically, to control inflation or otherwise cool an overheated economy, the Fed would often switch abruptly from a dovish, easy-money policy to a hawkish tightening by raising interest rates – with predictable consequences. However, since 2000, the Fed seemed to have learned that lesson and began the tightening process very subtly in the last few cycles.

This cycle is different because the Fed has overwhelmed the system with money supply, and the response will be far more abrupt. Jerome Powell will likely talk an easy-does-it game, but the reality will be an end to the stimulus over 2-3 months, and interest rates could begin to increase within six months. The only solution to the out-of-control economy may be to force a 'mild' recession (although that phrase will never cross a Fed member's lips). Never mind that the Fed has about as much control over the degree of contraction as it has over the degree of inflation. It wouldn't be the first time that the Federal Reserve effectively terminated the business cycle.

Chart 2: The US Money Supply has gone through the roof since 2020. That status is about to abruptly change.

The abruptness of the Fed's plan will shock investors, and reductions could begin as soon as next month. When valuations are at an extreme and tightening begins, that's when stocks often abruptly decline – frequently to their long-term average valuation unless the Fed mitigates that decline. For perspective, the S&P 500 would have to drop by more than half (-56%) to mean-revert to its long-term average valuation. That may not happen, but if this scenario plays out, don't be surprised. The Fed has few options to maintain prices to the upside, but there are possibilities. The economy is in uncharted territory, so it's impossible to speculate on outcomes.

The Federal Reserve – historically both firefighter and arsonist – may have committed its most tragic policy error in history by boxing itself into the current no-win position. We'll know more about timing after the Fed's early-November meeting but expect the possibility of an exceptionally rapid elimination of stimulus, followed soon after that by interest rate increases. If inflation approaches 10% or more in the coming months, that timetable will grow increasingly truncated.

On a positive note, 2022 will provide an incredible opportunity for savvy investors to profit from market volatility using a proven systematic investment strategy. Will the Fed's tightening cycle, combined with highly overvalued conditions, be enough to derail the economy and spur a recession? That's unknown at this point. There are too many variables in play.

However, a quantitative, rules-based investment strategy using diversified ETFs is the optimum way to maximize investment returns during challenging times. You are in the right place, so stay tuned and don't stray from your strategy's recommendations!

2) Global energy prices are shooting sharply higher by the day, and we still have more than 2.5 months until the winter solstice. Temperatures have not yet begun to decline to winter levels, but pandemic-related supply constraints are already causing all-time high prices in the critical energy sector of Europe and Asia. Natural gas prices surged 500% above average in the UK, and China has instituted rolling blackouts across the country to conserve energy going into the winter. Coal – yes, coal – prices are up 400-500% across Europe. India will run out of coal within four days – and winter isn't even here yet.

Chart 2: Natural gas prices in Europe have gone through the roof.

Many European countries had already begun cutting carbon-based energy sources in their switch to renewables, implementations which the pandemic derailed. The resulting shortages and extreme price increases in carbon-based energy sources threaten not just to slow the global recovery but may be responsible for thousands of excruciating deaths in Europe because many lower-income families won't be able to afford the cost to heat their homes, and sadly, some families will freeze to death.

In the early afternoon, Russian President Vladimir Putin announced that his country – known to be an energy superpower – was ready to step in and stabilize the skyrocketing energy prices. So kind of him. If Vladimir Putin has Europe by the short-hairs this winter, things could become even worse...

The one bright point for U.S. readers is that, because the United States has become energy self-sufficient in the last 25 years, this continent will probably not be directly affected by the energy crisis in Europe. However, constraints on the existing supply chain issues may be exacerbated, particularly concerning China's many products and components.

3) The most urgent danger to the US stock market may be the partisan fight developing in Washington over another increase to the Debt Ceiling. Politicians have known this thorny issue was coming for many months, but we are now just 11 days from defaulting on the debts that the government owes — created by legislation that both Republicans and Democrats previously authorized, such as the $900 billion pandemic relief bill signed into law by former President Trump. See this article in the Wall Street Journal explaining "How the U.S. Debt Ceiling Works and Why It Matters."

The last time there was a partisan fight like this over the Debt Ceiling was in 2011, and the stock market had a meltdown of -19.98% brought on by similar brinksmanship by the opposing party while Joe Biden was in the White House. Of course, Biden was V.P. to President Obama at the time, and Senator McConnell was on the other side, pushing the envelope and getting his conservative demands met to cut entitlements and domestic spending automatically. Perhaps Biden and McConnell learned something the last time this situation happened, and they won't go there again? (Haha - I know, but I try to have a sense of humor about it.)

Chart 3: In 2011, we had a similar Debt Ceiling standoff featuring nearly the same cast, costing investors almost -20%.

The thing is, we all can say, "Yeah, this is the game they play, and they will push it to the last minute, but it will get done, and the US will not default on its obligations."

Yes, that may be true – but these days, I think maybe we just don't know what's going to happen. We've seen so many shocking events occur in the last few years, and many politicians appear to have a nihilistic "tear it down" mentality; it seems like almost anything can happen. On the other hand, maybe this isn't much different from 2011. I clearly remember the apocalyptic vibe during the summer that year as the deadline drew ever closer. Investors finally hit the sell button – crashing the market by precisely -19.98% (just short of a bear market). That's when the politicians decided to stop playing games.

Surely neither party will want to be responsible for driving the American economy off the cliff just to score political points. Will they? These days, the answer to that question is more unclear than at any other point in my life (40 years in the investment industry).

However, there's not much that would surprise me these days, and I would say that McConnell might cause a default if for no other reason than to show Dems who's the boss – and not be accused again by Donald Trump of "choking." When emotions are high, people can make regrettable decisions.

Isn't it time to be rid of a 100-year-old legacy of WWI that every 2-3 years causes uncertainty for the markets? So do something! Call or write your representatives now! Call (202) 224-3121 to be connected by the US Capital switchboard and reach your Senator and Representative.

At midday on Wednesday, Sen. McConnell offered Dems a short-term extension (to December) to get the Debt Ceiling increased temporarily. That means we'll get to revisit the whole Debt-Ceiling thing again, with a possible market correction, just in time for Christmas. Stocks may take off if Dems accept the deal on Thursday.

Based on the midday announcements from Putin and McConnell, investors relaxed a bit, and the S&P 500 rose back above its 100-day moving average. Not far above that level, investors were still unwilling to commit 100% on Wednesday, but we'll see what happens next with the Debt Ceiling offer.

It remains to be seen whether these concerns will work out positively or negatively for investors, and only time will tell. That said, it's not a good sign that JPMorgan-Chase CEO Jamie Dimon has ordered his executives to begin preparing for a Debt Ceiling default by doing a review of all contracts.

While the 100-day (20-week) moving average has been a reliable, secondary support level since the Covid Crash, that doesn't mean that stocks can't decline below it. The S&P 500 has stayed elevated without a correction longer than average. According to Yardini Research, Inc., during the last 38 years, there have been 37 corrections, defined as a decline between -10% to -19.99%. Investors generally define losses of more than -20% as Bear Markets, but IMO, the Covid Crash was an anomalous correction. It came and went so fast and was tied to a recession that may have lasted a month, so that can't count as a Bear Market, can it?

It doesn't matter what we call them; the ETFOptimize models attempt to mitigate any downturn that appears to have a probability of being over -10%. Our models were very successful in doing that in the Covid Crash, limiting the loss to an average of -8%, based on our ULTIMATE Strategy, which combines all six of our current models.

As small as it was, last week's selloff (-2.18%) was the most significant weekly decline since the Covid Crash, and stocks showed some of the most considerable volatility investors have seen in a year. While seasoned veterans snicker at a -2% weekly decline, it's no wonder that new investors are a little flustered. After all, since last November, stocks recorded their longest stretch without a -5% decline since 1997. Then September came, and all the new investors who joined our ranks last year faced the worst month they've ever seen. Maybe it's time to go back to betting on football?

10 Million New Investors and Their Options

When the Covid lockdowns during 2020 left many people sitting at home and bored to tears, US investment brokerages recorded millions of new clients who were excited to have something to do during the pandemic. 2020 saw the most prolific increase of investors during any year in history, with US brokerages reporting more than 10 million new customers. While it's commendable to invest for the future when there's an opportunity, the bulk of those 10 million new brokerage customers used their money less like investors and more like gamblers making opportunistic use of the reliable investment-system infrastructure.

By that, I mean the use of Options rather than purchasing common stocks or ETFs – equities that represent ownership in publicly traded companies. Options are derivative financial instruments based on the value of an underlying security, such as stocks or ETFs. An options contract offers the buyer the opportunity (not the requirement) to buy or sell—depending on the type of contract they hold—the underlying asset at or before a specified point in the future (the expiration date) and at a specified price (called the strike price). Options buyers pay a premium that is just a fraction of the underlying stock's or ETF's price, say 2%, which allows them to leverage control of significant amounts of equity.

Because the investor is not required to own the underlying asset, options are a more directional bet on equity. Options can also effectively hedge an existing investment, which is how most investors use them. Farmers were the reason that options were created - to hedge the possibility that bad weather would wipe out a crop in any given year, but what options offer to modern-day investors is an opportunity to leverage their money significantly.

As Chart 4 below shows, tracking of options volume suggests that a considerable percentage of those 10-million new investors were speculators using Call Options (a bet, often leveraged, on higher prices) to play the S&P 500, technology, and healthcare's robust and steady rally since the pandemic low. Options volumes spiked to triple the previous average.

Chart 4: In 2020 and 2021, options volume spiked to three times the previous average level.

Chart 5 below shows more surprising evidence. For the first time, the average daily notational value of options was greater than that of stocks in the last year!

That's a genuinely unique fact that reflects the enthusiasm of 10 million young options investors, many of whom embrace the sophisticated investment strategy known as 'YOLO.'

Chart 5: Average daily notational value of options recently exceeded stocks for the first time ever.

According to FINRA, in 2021, the amount of leverage used by speculators reached nearly $1 Trillion – a significant all-time high.

Chart 6 below shows the history of margin debt since 1997. It's easy to see the abrupt spike higher following the Covid Crash.

Chart 6: Margin debt recently surged to nearly $1 Trillion. When that leverage comes unwound, it could spell big trouble for equities.

The Changes Implicated Are Staggering

The point of showing the above charts is to reveal how much the market environment has changed in the last 18 months. The millions of active investors who have been participating in the market for many years were joined over the previous 18 months by a new group of 10 million (primarily) young people. They are right at home in front of a screen, and many were masters of the high-tension sports-betting world that shut down during the pandemic closures. Most are intelligent, and they did not waste the unique opportunity presented by $120 billion per month of artificial government support for the market.

Various reports suggest that many of these new 'investors' were online gambling addicts who turned to options trading when the sports betting they loved shut down in 2020, and they turned to the next best adrenaline rush they could get that was still functioning - i.e., stock-market options trading. Many applied to get – and many did get – as much leverage as the industry would extend to them, which turned out to be nearly $1 Trillion.

Now that football season is underway, the NFL and sports betting websites are back to running full-steam. Will this vast, 10-million-strong group of young Turks abandon the options market, return to sports betting, and pull out all that liquidity and leverage? The easy-money days are likely over, and what's ahead will require some real skill and experience to identify the highest probability of winning investments. That's where ETFOptimize comes in...

In Part 2 of this article, we will go through some of the most compelling indicators we have identified this week. However, we want to show a proven indicator related to this article's discussion about options investors, graphically displaying a potentially crucial market-based data point.

CBOE Options Equity Put/Call Ratio

The CBOE Options Equity Put/Call Ratio has long been an accurate indicator for trend changes in the S&P 500 ETF (SPY). Recently that indicator has been rising off the most extreme, most bullish reading it has ever recorded. If it continues moving higher, it means that options traders have switched to Puts (bets on equity declines) and are eschewing Calls (bets on higher prices). We will soon know if this indicator signal is robust or if it was just experiencing some volatility. It hasn't yet moved enough to produce a clear signal.