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"I believe the odds are now one-in-three that someday we'll look back on this period as an epic mistake, and one of the greatest financial calamities of all time."
– Peter Fisher, former US Federal Reserve Board member, former Blackrock Senior Director, and Professor/Senior Fellow at the Tuck School of Business at Dartmouth University, quoted in the PBS Frontline documentary, "The Power of the Fed."
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Despite the continuing mentions by Federal Reserve Chairman Jerome Powell over the last six months of 'tapering' QE stimulus in an attempt to cool over-heated market conditions, the Federal Reserve has not yet done any tapering. In fact, the Fed increased its balance sheet by another $84 Billion last week, prompting the SPDR S&P 500 ETF (SPY) to set a new all-time high (ATH). We'll likely need to see actual decreases of the Fed Balance Sheet by a significant amount to convince perma-bulls that even though the Fed has boxed itself in a corner, it is serious about fighting inflation.
The degree to which the Fed has pumped up asset prices through constant stimulus has created a financial mania. Future market historians might rank today's stock, bond, and real estate prices right up there with the Dutch Tulip Bulb Bubble in the mid-1600s. You know, the one that lured in Isaac Newton and proved that markets can make even geniuses to look like fools when all the money evaporates.
Breadth Thrust
This week, we saw a breadth thrust in S&P 500 stocks, with more than 80% of them rising above their 10-day averages. Risk appetite has returned as most indicators show risk-on behavior. Industrial metals stocks have now doubled from their low, which has been bad for them, good for stocks.
The Fed has let the Inflation Genie out of the bottle, and higher prices may now be set in stone. While some of it is surely 'transitory' - a term Fed Chairman Powell used for many months to describe the widespread higher prices we seeing – many market segment price increases are not transitory. In recent months, apartment rents have increased the most in the last 20 years, and those are usually 12 to 18-month contracts that are likely to never return to the old levels. Real estate is up by 30% year-over-year, and there have also been hourly wage increases to attract reluctant service and hospitality workers. It would be highly unusual for wages to decline to the old rates, except if a severe recession stikes.
The Fed has put itself into this situation by pushing too much money supply into the system. It would be bizarre for the Fed to hike rates into an economy in which the US debt load is pushing $30 Trillion. Increasing interest rates to mute inflation could also make the cost to repay that debt prohibitive. If rates increase by much, the Treasury will be unable to meet its interest-only repayment of that debt.
Similarly, the Fed cannot hike rates when there are millions of US businesses that meet the definition of zombie companies—that is, their Free Cash Flow is not substantial enough to cover Interest Expenses on their (often adjustable-rate, CCC-rated) debt.
Momentum of Fear Index
The Volatility Index ($VIX) is often referenced as the 'Fear Index' because it provides a read on trader's increasing or decreasing hedging activity using Put-Options on the S&P 500 as the risk of a market decline increases. When the $VIX increases in price, it indicates that there is a high demand for Puts (protection for increasingly bearish sentiment) on shares of the S&P 500.
We take the 'Fear Indicator' to another level by tracking the $VIX's momentum – that is, the pace of its change, whether higher or lower. We find that this reading, which is centered on the $VIX's price momentum rather than its absolute level, to be far more indicative of
Chart 1: Our "Momentum of Fear" indicator tracks the rate of change in the VIX. A more accurate indicator than the VIX itself.
The Federal Reserve as Both Firefighter and Arsonist
Investors have consistently bought the dip in large-cap stocks throughout the 18 months since the bottom of the Covid Crash in late-March 2020. The confidence that investors marshalled to enable them to buy equities on every dip from May 2020 to present – buying in the face of what were initially the worst economic conditions since the Great Depression – was surely inspired by the US Federal Reserve.
It's not an accident that the S&P 500's rally since March 2020 has coincided perfectly with the growth of the Fed's Balance Sheet. Fed Chairman Jerome Powell announced the phenomenal stimulus program on March 23, 2020 - and that's the day that stocks reversed course from a freefall. The Federal Reserve knows what it is doing, and it intends to keep stock prices elevated for as long as possible.
For long-term Fed watchers, you know that "as long as possible" is likely to be until such time as the relentless flow of newly manufactured money drives asset prices to unsustainably expensive levels of overvaluation that threatens to destroy the very economy the Fed had been working so hard to prop up.
The US Federal Reserve is like a responsibly minded lifeguard whose job it is to patrol the local lake each summer. One crowded, sunny day, the lifeguard spots what appears to be a drowning man (the US economy in this analogy) in the middle of the lake. The lifeguard quickly decides he can save the drowning man by heading his little jet-boat to the middle of the lake to pull-in and save the swimmer. Unfortunately, as the lifeguard closes in on the embattled swimmer, he realizes his boat's throttle is stuck wide open. He pulls, pounds, and even kicks the throttle lever to no avail. Then he looks up to see another boat - unaware of his situation - coming to help from the opposite direction. Realizing the two boats will crash head-on, the lifeguard bails out of his craft at the last second.
The two boats crash with an enormous impact, their fuel tanks are ruptured, and they instantly explode into a inferno on top of the water. Now there are two destroyed and sinking boats, five shellshocked and drowning swimmers engulfed by an immense, fuel-fed fire burning all around them, all in the middle of the previously calm lake. Mortally injured in the crash, as the lifeguard takes his last gasp of air and goes down for the final time, his last thought is, "I was just trying to be the good guy!"
The point: The Federal Reserve has long imagined itself as the "good guy" saving the American economy. However, it doesn't see the risks associated with its "good-guy" policies until it is too late. The result of its interference in free markets has always been that the US Federal Reserve drove stock prices into economic busts. These severe economic downturns are invariably caused by too-rapid-tightening of interest rates. Since the first iteration of the US central bank created under Alexander Hamilton as Secretary of the Treasury in the 1790s, there is a clear, repeating pattern of miscalculation by the Federal Reserve that has resulted in a recession 100% of the time. Based on history, the Fed is both firefighter and arsonist combined.
In the last 230 years, the Fed's too-easy monetary policy has repeatedly led to extreme over-valuation of assets and an overheated economy, which the Fed responds to with an abrupt tightening cycle, almost always triggering a recession. US economy is a gigantic, complex machine with far too many moving parts and too much inertia to change directions as abruptly as human political forces may desire. If the Fed is successful in mitigating a economic recession, the inertia in the other direction can reach a point when it overwhelms the economy's capacity.
That's just what has happened in the last 18 months. The Fed succeceded in stopping the stock-market selloff in its tracks in March 2020, largely because the market responds far quicker than a $20 Trillion economy. However, this inertia didn't play a role when the Covid Crisis hit the US in early 2020 – the result of millions of businesses across all sectors of the economy forced to simultaneously shut down.
However, the combination of Federal Reserve's creation of $3.5 Trillion at the push of a button, combined with Congressionally sponsored transfers of wealth from the government's debt capacity to US citizen's bank accounts has overwhelmed the US economy with liquidity. Some estimates are that while there was a $1.5 trillion economic hole created by the Covid shutdowns in 2020, the government has filled that hole with five times as much liquidity. All combined, the Fed reserve and Congress has created nearly $16 Trillion in new money supply that flowed into the US economy in the last 18 months, as shown by the M1 Money Supply series.
Chart 3: The M1 Money Supply has gone through the roof since the Covid Pandemic began, blowing out all previous perspective.
Unfortunately, while all that new money the Fed is distributing into the economy as a stimulative measure, the Velocity (activity) of that money supply continues to fall.
Chart 4: The Velocity of M1 Money Supply, i.e., the average number of hands a dollar goes through, has collapsed.
This dynamic is the result of an unbridled Federal Reserve pushing hundreds of billions of dollars into the financial system every month since March 2020 is inflation. As always, the Fed stayed with its zero-interest, increasing-money-supply policy for FAR too long. Just last week, the Fed increased its Balance Sheet by purchasing $8.17 billion of Treasury Bonds and MBS, increasing the Balance Sheet to $8,962,474,000 (nearly $9 Trillion). This phenomenal expansion of the Fed's Balance Sheet resulted in the majority of this liquidity flowing into the stock market to support prices.
History shows us that overextended stocks (today near all-time highs) are highly succeptable to reverting to their mean (down) when a significant perceived risk develops. While overvaluation doesn't – by itself – create market crashes, the level of asset overvaluation at the peak has a direct effect on the length and severity of the subsequent, recessionary collapses.
The more over-extended an equity or ETF, the easier it is to derail its upward trend – and virtually any surprise shock will suffice as the pilot light for disaster.
Today's Threats to the Bull Market
Most investors can rattle off multiple risks that worry investors today – take your pick from a long list:
• Extreme Inflation, or… Extreme Deflation,
• Federal Reserve 'Tapers' Too Aggressively,
• A Collapse of Overvalued Stock Prices,
• A Collapse of Overvalued Bond Prices,
• A Collapse of Overvalued Real-Estate Prices
• A Collapse of Commodity Prices After Climbing 112% in 18 months,
• The Evolution of a New Super-Bug Variant driven by individuals who refuse to be vaccinated for the Covid Virus. A recent Bloomberg survey of investors showed that this was their #1 concern about the future, so-stated by 63% of respondents.
…and many more challenges to the longest bull market in history. However, bull markets love to confuse and frustrate the maximum number of investors as they continues to climb a wall of worry.
But first, I'd like to bring up one risk, in particular, that could cause prices to revert sharply lower and a bear market to get underway. Moreover, this risk would be a total surprise because it has never occurred before, and it could explode very quickly, catching the world off-guard. Perhaps most dangerous of all, there is nothing the Federal Reserve can do about it! The problem can't be resolved by throwing billions or trillions of dollars at it.
TODAY's MOST DANGEROUS THREAT to AMERICAN PROSPERITY
A new article identifying this risk will be published in the next few days… so please stay tuned. If you are a registered subscriber, we'll send you an email notification when the content is posted to the site. However, right now, let's examine the other risks, shown by ETFOptimize indicators, that are likely to have the most significant impact on the market over the next few weeks.
Critical Indicators Providing Market Insights and Signals
Today's ETFOptimize Insights Report will provide an overview of some of the most critical data sets and charts that stood out when we reviewed the signals from our indicators this weekend. Please keep in mind that we don't review our indicators to inform discretionary decisions on whether to buy or sell, or what to buy or sell. Those decisions are automated, operated by six computer servers that each weekend process billions of bits of macroeconomic, company, and market data used by our indicators, rules, and algorithms in about two seconds – thank you, applied physics!
The reason we don't make descretionary decisions is that even though our team has an enormous amount of experience in the investment world (40 years for myself alone), many studies have shown that professionals are just as prone to making poor decisions as are rank beginners, and I can personally vouch for those conclusions. We are all human, and millions of years of evolution have deeply ingrained the same 'fight-or-flight' and 'greed-or-fear' emotions in the psyche of each of us – whether we have 40 years or 40 days of investing experience.
When it comes to matters of money, there are very few of us who can open our brokerage website at noon on a Tuesday, realize our portfolio has experienced a -30% loss that morning, and not panic – accompanied by drastic errors. The number of people in the world who are named Warren Buffett, or who are Warren-Buffett-like in character – not flinching in the face of such a paper loss - can be counted on one hand. Investors who are not emotionally affected by the market's extreme swings of profit and loss have an enormous advantage over every other investor.
Therefore, to unemotionally address financial decisions, over the last 23 years our firm has developed more than 50 highly accurate indicator sets - developed during quiet, concentrated hours of calmness, insight, applied experience, and cold logic – that when combined into diversified composites can provide exceptionally accurate investment signals. We believe the indicators we're presenting below are likely to be crucial drivers of the market in the coming week, and perhaps for several months ahead.
I say "likely" and select my words carefully because I have enough experience to know that it is the mark of an amateur to be overly confident when making investment predictions. The word 'likely' implies probabilities, and that's the best anyone can do in the world of stocks and bonds. The indicators I'm going to show, based on past similar situations, provide a higher probability of 'outcome A' over 'outcome B.' That's all – there is a greater likelihood of one outcome over another, and when multiple indicators are combined into diversified sets, resulting in a clear expected direction, it's best to pay attention.
Please keep in mind that each of our models use a different set of indicators to drive its decisions. Therefore, the indicators presented below will not be perfectly in synch. In fact, they are designed to NOT be synchronized – they provide different takes on different data sets and achieve signal diversification to accompany position-selection diversification. As Warren Buffett – one of the most successful investors of all time, with a net worth approaching $100 billion – has said (I paraphrase), "In investing, diversification is the only free lunch."
By making diversification one of the primary drivers in the construction of our models, we're hoping to provide clients with abundant free lunches through significantly enhanced performance. We find that the only factor - other than diversification - that plays a more significant role in enabling our investment strategies to produce consistently profitable, long-term returns is avoidance of loss. Obviously, diversification plays a critical role in loss avoidance, so the two concepts work synergistically.
Critical Indicators Affecting Stock Prices for the Next Few Weeks
As you review the following indicators – which grabbed our attention as we analyzed them this weekend – remember that each of these indicators are combined with other indicators to make 5- to 15-node composite indicators, with statistically significant differences between the indicator composites used in each of our strategies. The permuations of ways 50 indicators can be combined into a 10-indicator (average) set is more than 10.2 billion, so we don't anticipate running out of potential combinations to test anytime soon.
Each of our models uses a weight-of-the-evidence approach with indicators that result in a binary '1' or '0' reading, which can be interpreted as 'Risk-On' or 'Risk-Off,' 'Aggressive/Defensive.'
Chart 3 below shows an example of a binary, Risk-On/Risk-Off system (red lines), with the S&P 500 ETF (blue) in the background. Notice the correlation between times when the indicator is at the top with a reading of 1 (low-risk), the S&P 500 is bullish and climbing. When the indicator drops down to 0 (increased-risk), the S&P 500 is falling. This one indicator may be a decent way to manage a two-ETF investment strategy, switching to the S&P 500 ETF (SPY) when the reading is 1 (low risk) and moving to a Defensive ETF, such as the 20-Year Treasury Bond ETF (TLT) when the indicator has dropped to 0 (increased risk). This indicator (based on a variation of Initial Unemployment Claims) appears to be an accurate long-term method for systematically identifying times to be invested and times to be defensive.
Combined into diversified, multi-indicator composites, they can also generate progressive, variable signals that can have, say, five different levels of exposure to the market.
Here is how the two examples above are put into action: a binary risk-on/risk-off model (such as our S&P 500 Conservative (1 ETF) Strategy) might use a 10-indicator composite for risk assessment and ETF selection, with the indicator composite considered to be bullish if it has a reading of 70% and above and bearish at 69% and below.
Another strategy with a 10-indicator composite might have an output with five levels of bearishness to bullishness; measured at 2, 4, 6, 8, and 10, with each level signaling a different level of exposure to market forces by using a different ETF. This type of indicator drives our S&P 500 Bull/Bear (1 ETF) Strategy, which invests using SSO (2x leveraged S&P 500 ETF) when the reading is 9 or 10, SPY (standard, 1x S&P 500 ETF) when the reading is 7 or 8, SHY (a short-term, cash-proxy Treasury ETF that is used in sideways markets) when the reading is 5 or 6, SH (inverse S&P 500 ETF) when the reading is 3 or 4, and SDS (2x-inverse S&P 500 ETF) when the reading is 0 or 1.
Our Premium Strategies use these signals to generate the appropriate market exposure levels – i.e., reduce exposure during periods of high risk and increase exposure when market risk is low. These indicator composites are also used as the basis for our multi-ETF model's Ranking Systems, selecting the optimum ETF at the optimum time for virtually any type of market condition; bullish, bearish, or sideways.
Sub-Strategies Combined Into Our ULTIMATE 6-Model Combo Strategy®
We then combine the diversified market-risk signals from our six systematic sub-strategies to construct the steadiest systematic portfolio we have found. While it's possible we haven't been exposed to every possible quantitative portfolio that's out there, we are pleased with the results of our six-model combo strategy since 2007 (our firm launched on the internet with the first e-commerce quantitative strategy in 1998).
Our Premium Strategies are NOT intended to beat the market every week, month, or even every year. In our experience, constantly grasping to outperform an arbitrary, volatile return number (such as the S&P 500's performance) is a recipe for disaster. The objective of beating a volatile number requires that investors assume too much risk to achieve thier goal. Investment decisions based on 'beating the market' usually results in timing errors, whipsaws, and significant losses when risk accumulates but your portfolio's holdings assume a continuation of past profitable positioning. Human brains are poorly designed for the challenge of investing, with any decision related to money prompting subconsious emotions that regularly sabotage our results. Moreover, this statement applies to professional money managers nearly as much as it does to first-year investors, with 90% of mutual fund managers underperforming the market.
The best alternative to counter this overriding challenge is to remove the human factor from real-time decision-making. Quantitative investment strategies are designed during periods of calm and introspection, when careful analysis can be done and sophisticated algorithms written and backtested. Algorithmic investment models can analyze billions of bits of data in less than a second, while a similar analysis by a human could take weeks.
For this reason, many academic studies have shown that real-time comparisons of quantitative to discretionary approaches (across all industries, not just investing) nearly always favors the quant – and not by an insignificant amount. However, the weakest link in any systematic investment approach is you – the person who implements the computer's recommendations. If you second-guess those recommendations or add another step (such as waiting for a dip), you have essentially destroyed all the benefits that accrue to a rules-based investment approach.
Moreover, our models are designed to accomodate long-term savings goals for such big expenses as a home, college tuition, retirement, and other significant life-objectives. With these goals in mind, rather than doing 'market timing,' which many people criticize, our models are doing risk assessment and equity exposure reduction during periods of heightened risk.
The result is a surprisingly effective and steady production of profits each year, averaging a CAGR of about 30%, with an avg. Max Drawdown of just -8%.
Chart 3 below shows the equity-curve chart of our Ultimate 6-Model Combo Strategy since July 2007. Notice how steady the performance has been since before the GFC got underway in late 2007.
Chart 3: The real-time performance of our Ultimate 6-Model Strategy shows a very consistent upward growth of 30%, combined with an avg. max drawdown.
Collectively, the six models that comprise our Ultimate combination strategy have produced 92 of 92 consecutive profitable years, beating the S&P 500 in 93% of those years. However, if we removed our Defensive (2 ETF) Strategy (which naturally underperforms the S&P 500) from that line-up, the record would improve substantially.