• Last week's powerful bull rally saw the S&P 500 gaining 6.15% in just four days. Is it a trap that will lure in bulls to their decimation - or the start a significant rally?
• All but one of the NINE ETFs we hold in our ULTIMATE 6-Model Combo Strategy are in positive territory, with an average gain of 6.70%, led by FCG with a 17.64% gain.
• Across our models, the only position that's down is SDS, the 2x-leveraged inverse S&P 500 ETF, but it's off by only -4.40% after losing ground in last week's rally.
• On Monday (March 21), the ETFs we hold surged sharply higher, but the S&P 500 (SPY) and its inverse (SDS) were flat, with investors unsure which way things are headed.
I often study the detailed annual statistics of the last 100+ years for the US stock and bond markets. It's an activity I'm sure many ETFOptimize readers also pursue when looking for fun and excitement during carefree Springtime weekends (smirking with sarcasm).
So, if you're like me, you noticed that a consistent, recurring theme throughout the last 10 decades is that the most potent, short-term (1 or 2-week) rallies – during any given year – almost always occurred during long corrections or bear markets. Investors and traders become far more reactionary during downtrending markets. An investor's most carefully conceived, highly developed strategy gets thrown out the window at a moment's notice when the loss of money – or the fear of missing out on a reversal higher – is involved.
That may be what happened last week – a likely bear-market, rebound-rally from oversold conditions, which I predicted in the market-analysis content published for ETFOptimize subscribers last Monday morning (March 14). To quote from last week's Quick Look Report (now publicly available):
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"Stocks will invariably have reactionary bounces higher, giving bulls a glimmer of hope, and there will probably be two, three, or four-consecutive-day rallies in the coming weeks and months. Bear-market rallies have historically featured the sharpest, most extreme, short-term stock gains. Still, those quick moves higher often occur just long enough to entice bullish investors back into their long positions, setting them up to be punched in the mouth.
Considering that the market regularly delivers hair-pulling conundrums, seemingly designed to produce maximum frustration and break investors' brains, we’ll likely see a short-term rally soon.” |
I just added that bold-red highlight to the "four-consecutive-day rallies" phrase in the quote from last week's article. Lo and behold, that four-consecutive-day rally was delivered – just as anticipated – in the final four days of last week. On Tuesday, the S&P 500 ETF (SPY) opened the day at 418.47, climbed sharply higher that day as well as the subsequent three sessions, closing Friday at 444.52 — a gain of 6.24% for the four-day surge, or an average of about 1.56% per day during those four market sessions.
Sunday, March 27 Position Performance
- ULTIMATE 6-Model Combo Strategy
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The table to the right shows the holdings in our ULTIMATE 6-Model Combo Strategy, with one short position that lost -4.42%, one cash-proxy ETF that stayed flat, and seven other positons that are all profitable and have earned gains between 5.35% and 22.29% in the last 2-3 weeks.
The Nasdaq 100 ETF (QQQ) experienced more extreme moves, as it commonly does, which is an appeal of the QQQ ETF. Falling -21.14% from its late-December 2021 closing high at 402.98 to the early-March closing low at 317.78, the technology-laden Nasdaq index then bounced 10.14% higher in 4 days, directly to its 50-day MA.
Chart 1 below shows a 2-year chart of the three primary indices in the US stock market: the S&P 500 (SPY), the Nasdaq 100 (QQQ), and the Russell 2000 (IWM). These three indices represent the most well-known stock benchmarks - the largest-capitalized, 500 publicly traded US companies within the S&P 500 Index (SPY), the 100 largest technology and internet-based businesses (QQQ), and the most-traded 2,000 small-capitalization companies (IWM).
The chart below shows that last week was a big one for all three indices. The S&P 500 ETF (SPY) gained 6.15%, the Nasdaq 100 surged 8.35%, and the Russell 2000 ETF (IWM) climbed by 5.36% – represented by the surges in their charts for each on the far-right. With that 6% gain, the S&P 500 recovered about half its -12% year-to-date loss last week.
The Nasdaq 100 (QQQ) and Russell 2000 (IWM) are faring far less well than the S&P 500 (SPY), and that's important. While the S&P 500's gains are reliant on just two dozen of the largest companies, and all the rest of the market is stuck in the cellar.
Chart 1: Last week, the S&P 500 ETF (SPY), Nasdaq 100 ETF (QQQ), and Russell 2000 ETF(IWM) surged back above falling 50-DMAs.
The red line in each window in Chart 1 above represents that ETF's 50-day Simple Moving Average (SMA). All three ETFs re-attained that level last week. Also, the S&P 500 ETF (SPY) re-attained its 200-day moving average, a long-term average that is often considered by amateur investors as the threshold between bullish and bearish conditions. We consider the 100-day Moving Average to be a more accurate long-term average (mean) between bullish and bearish conditions, but that's a story for another day.
When prices move too far from the long-term mean of a price-series, you can count the days, hours, or minutes until it reverses course and returns to it's long-term mean. No investor has ever beaten the undeniable probability of mean reversion. Mean reversion is an important driver of value-investor's returns, and a crucial aspect of all successful investing.
Many investors use the 200-day moving average as a crucial (sometimes their only) signal that bullish conditions have turned bearish and they should sell. They use it as a Sell Signal. However, the 200-day (40-week) moving average works better as an identifier of the environment we are in than it does as a sell signal. Moving averages have an inherent lag which makes them poor stand-alone indicators, and they should never be used for sell signals.
Large-cap stocks are usually perceived to be better able to weather the challenging conditions ahead, and investors bid their prices higher while neglecting the less-stable small-cap stocks. When this situation develops in late-stage bull markets, it's often characterized as the "Generals leading the Soldier into battle."
Where Has the Bull Market Gone?
Last week I posted one of our longer Quick Look Reports, warning that investors should be prepared for a sharp, counter-trend rally and reminding readers not to abandon their quantitative strategy's choices because they caught a case of FOMO from a short-term market rally. It's easy for investors to get swept up in powerful bear-market rallies and try to jump in because, well... Fear of Missing Out.
As always, I urge you to stick with the process of the Premium Strategy you've selected for your needs (or switch to another), always taking the longer-term view of your investments. We want to help you avoid market exposure during periods of heightened risk. That's one of the objectives of our data-driven strategies, and they will make the appropriate, difficult decisions, relieving you of unnecessary stress on the path towards achieving our long-term investment goals.
What are the Primary Factors Increasing Market Risk Today?
There are a plethora of challenges facing the economy and the market today, including:
1) Historically High Inflation – At a 40-year high at 7.9%, inflation will affect both corporate profits and consumer's propensity to spend money;
2) Hawkish Federal Reserve – With its Quantitative Easing program, the Fed has been a stimulative driver of higher market prices for the last 13 years (since 2008), but now it is switching to being a contractionary weight on market prices, motivated by inflation-control mandates written into law, the Fed must eliminate its stimulative measures (money printing through QE), and increase interest rates to slow the economy.
Now reducing the liquidity in the economy instead of increasing it, the Fed will be a weight on market prices going forward. Keep in mind that the Fed has one perfect historical record: a recession has ensued every single time it starts an interest-rate increase cycle;
3) Potential Spread of New Covid-19 Variants – While many are pretending it's gone, the unpredictability of Covid is still with us. Remember that the virus started in a small, relatively poor Chinese province – and that the poorer half of the world still remains unvaccinated. Any one of those unvaccinated countries could be where the next variant mutates and thrives. We can't totally dismiss Covid yet, but getting vaccinated with the safe and effective Covid-19 Vaccines is your best bet for living a full, healthy life;
4) Margin Debt Meltdown – Margin Debt is now at more than $1 Trillion outstanding. That's more than double the amount of margin used at the lows in March 2020.
5) The Russian Invasion of Ukraine Escalates Into a Larger War – While seemingly nobody wants it, many are asking what Vladimir Putin's ultimate goal is for invading Ukraine and destroying any goodwill his country may still have in the world – forever. What's the end game?
Is Putin just toying with Ukraine to lure the West into instigating a global battle that will forever earn Putin a place in the history books? To start dropping tactical nuclear weapons and launching missiles at other countries, "to defend Mother Russia's Empire" based on a false provocation manufactured in the brain of an aging dictator? If not something like that, it's unclear how Putin wins from the current situation when he seems to care about nothing but his legacy in history.
6) The Price of Oil Doesn't Come Down – When the US canceled all imports of oil from Russia, it canceled 8 miilion barrels of oil per day. All those barrels are not easily replaced. Saudi Arabia isn't interested in reducing the price of their product by producing more barrels, and Iran and other countries are either reluctant or complicated by other issues.
It seems a correct moral decision that the US and Europe should cancel purchases of Russian oil to impose as much economic pressure as possible, but this is going to increase prices for gas/oil/fuel throughout the world – and overall prices in general for US citizens. Oil is in so many ancillary products, such as ubiqitous plastic packaging, clothing, shampoos, computers, cars, and innumerable additional products
7) Company Valuations Remain at Nose-Bleed Levels – Despite the market volatility and decline this year, stock valuation remains at or near all-time high levels. Coming into 2022, the Shiller PE Ratio, which examines inflation-adjusted earnings over the past ten years to moderate out recessions, stood at 40 – more than double the long-term average of 16.9 (dating back more than 150 years). Every time in history the S&P 500 surpassed a Shiller PE of 30, it went on to lose more than -20% of its value.
The Two Most Critical Risk Factors for Investors
Of all those factors, there are two more that are the most significant near-term factors affecting our market selections this week: 1) Increasing pressure on Credit Markets, and 2) Breadth Indicators remain bearish. We'll address both of these risk factors below.
1) Credit Markets Are Under Pressure
Last week, Fed Chairman Jerome Powell announced, in his press conference following the Fed meeting on Tuesday and Wednesday, that the Fed was now getting serious about its efforts to reduce inflation. The Fed raised the Federal Funds rate by 25 basis points (0.25%) instead of 0.50%, which many expected.
On Wednesday, the Fed reported that its Balance Sheet increased by $43.56 Billion, taking it to a new, all-time high at $8.95 Trillion. As a result, the stock market saw this as a positive for stocks, and the Fed was clearly not being serious about fighting inflation. As a result, stocks surged last week with one of the most powerful rallies in years.
However, yesterday (Monday, March 21), Chairman Powell said that the Fed is prepared to act aggressively to slow the rate of inflation. Essentially, Powell said – "I really, really mean what I said last week!"
As a result, in the last 24 hours, the US 2-year Treasury Yield went up 10%. In the last week it went up +22%. The ROC (rate of change) of does matter, especially when concentrated in short-periods of market time.
Monday, March 21, 2022
2-Year Treasury Yield: 2.14%
5-Year Treasury Yield: 2.33%
10-Year Treasury Yield: 2.32%
20-Year Treasury Yield: 2.67%
Table 2: Interest rates climbed sharply and headed towards inversion. These levels were updated after the close on Monday, March 21, after Fed Chairman J. Powell issued a bearish press release. |
Today, the 5-Year Treasury and 10-Year Treasury have reached inverted levels at 2.33% for the 5-Year Treasury and 2.32% for the 10-Year Treasury.
The 2-Year and 10-Year Treasuries Yields, the most commonly referenced pair, are now only 18 basis points from becoming inverted (2.14% vs. 2.32%). Finally, the 10-Year and 20-Year T-Bonds are just 35 basis points apart. Which pair is most important? All of them! An inverted yield curve is upon us, and all these pairs may be inverted by the end of this week.
Chart 3: The S&P 500 is in the top window, the 10-year/3month relationship in 2nd window, and the 10yr/2yr in the bottom pane.
An inverted yield curve does not cause a problem for stocks. Rather, an inverted yield curve is a measure of pressures in the credit markets that reflect macroeconomic challenges or opportunity. Usually this occurs when the Federal Reserve is pressuring short-term rates higher (as we know it's now beginning to do with the 0.25% Fed Funds increase last Tuesday), while demand for longer-term Treasury Bonds are falling.
This dynamic of increasing short-term rates and declining long-term rates indicates that the economy is under extreme pressure when the rates cross one another. It occurs when the Federal Reserve is increasing the shortest-term rates – while the economy is weakening and money is moving into lower-risk, short-term assets.
The reason the Yield Curve is an excellent indicator for stock exposure is that stocks are one of the highest risk assets and when investors move money into lower-risk assets and away from stocks, it's a high-probability indicator that stock prices are likely to decline.
Chart 2 below shows how all four yield levels are rising sharply and reaching a confluence. Normally, longer-term bonds must pay a higher yield because they are held far longer and incur higher risk from a variety of sources, such as credit risk or interest rate risk.
Only when yields begin to decline can we move money into bond ETFs from Cash-Proxy ETFs (such as BIL, the short-term, 3-month Treasury Bond). Declining yields means that investors are buying bonds and bidding up prices for those bonds, giving us an opportunity to profit.
Chart 2: Treasury Bond Yields are reaching a confluence at slightly more than 2%. The 5-year and 10-year yields are inverted.
Many investors are aware that an inverted yield curve is a negative for the market, but are not sure when. The truth is that it's not when yields invert that the risk arrives. While inverted yield curves are a very accurate harbinger of recessions, the actual risk of an economic decline and a market selloff arrives when an inverted yield curve starts to unwind. That usually occurs when market pressures reverse from bullish to bearish, the Fed stops tightening, and is forced to begin stimulating to keep the economy from falling off a cliff.
However, what we've never seen in history is a situation in which the Fed needed to stimulate during a time of a 40-year high in inflation, which we have now. If the Federal Reserve doesn't conquer inflation as it slows the economy in the coming months, it may be forced to abandon its 13 years of hand-holding stock investors, and the market may need to learn how to function without the training wheels provided by the Federal Reserve's QE (money creation) program.
That means the Fed may be forced to intentionally allow investment markets to fall (or crash)– in an effort to cool the economy. However, that may be the only way the Fed can defeat the overheated conditions it created itself.
By overstimulating with far too much money for far too long – from the Covid Crash in March 2020 until just a few months ago (November 2021) – we now have year-over-year CPI inflation running at 7.9% annualized, 1.7 available job openings for every job seeker, wages rising (which locks in the inflation cycle), housing prices rising at a pace that's locking out first-time buyers, and income inequality fueling political partisanship and driving a wedge into US society.
If you could eliminate all those problems by crashing the market for six-nine months, would you – should you – do it? That may be the conversation that a core group of Federal Reserve Board members are having in private over the coming days and weeks. We are truly in unprecedented times...
Yield Spreads and Market Breadth
In Part 2 and Part 3 of this article, we will continue to monitor and review Yield Spread developments in credit markets, as well as identify and discuss several of the very critical Breadth Indicators that we combine into a weight of the evidence Breadth Composite we use as a vital determinant of market exposure and ETF selection. Market Breadth provides us with a look inside the stock market, accessing critical measures of market forces that consistently lead price movements.
These two components of investment data reflect developments in both the equity market and its much larger cousin, the bond market. Yield Spreads in the Bond market can then be combined with Breadth Measures in the Equity market to provide us the crucial, composite variable of Investor Sentiment – the primary determinant of near-term and intermediate-term prices.
In the long term, Macroeconomic conditions steer Fundamentals, which in turn drive Prices over periods of several months to several years. These components – supplemented by Technicals as an additional measure to confirm the data from the other groups – comprise our 50+ component data series assessed each weekend to form our quantitative, data-driven investment approaches.
On the Other Hand...
Corporate Profits are still rising. In one of the future parts of this article series, we will also address Corporate Profits and why this crucial component of Fundamentals group is one of the most significant aspects affecting whether stock and ETF prices will rise or fall in the coming months.
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