ETFOptimize Insights

Data-driven Analysis of the Critical Market Indicators
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ETFOptimize Insights
Note: Our articles cannot cover all offsetting aspects of each model, nor can they provide the spectrum of aggressive/conservative differences between each model. Clients should always follow their model's published systematic decisions to the letter. Doing otherwise negates all the advantages of a systematic, ETFOptimize Premium Strategy. Copyright © 1998–2022, Optimized Investments, Inc., dba Contact us for reprint permission.

Powerful Rally or a Bull Trap ?
Part 2

– See Part 1 –

Note: Our articles cannot cover all offsetting aspects of each of our quantitative models, nor can they provide the spectrum of differences between each model. Clients should always follow their model's published systematic decisions to the letter. Doing otherwise negates all the advantages of a systematic investment approach.Copyright © 1998–2022, Optimized Investments, Inc., dba Contact us for re-use permission.


We posted an ETFOptimize Insights market report for Premium Strategy subscribers last Monday morning, titled "Powerful Rally or Bull Trap? (Part 1)." Today, we post the second part of this article, focusing on the recent inversion of the Yield Curve.

This multi-part article reviews why our models have switched to a bullish status in the face of the recent two-week rally. Because of this change to the status of the market, primarily based on



Monday, April 4 Position Performance

- ULTIMATE 6-Model Combo Strategy
(Yellow-highlighted column)

Table 1: We're adding four new positions on Monday to existing ETFs.

Table 1 to the right shows the holdings in our ULTIMATE 6-Model (5-10 ETF) Combo Strategy, which combines the holdings from all six of our current individual systematic strategies (more coming soon). We are purchased four new ETFs today (Monday, April 4).

To make room for the new long positions, we're selling shares of the First Trust Natural Gas ETF (FCG) at a profit of 29.4%, the Utilities Select Sector SPDR Fund (XLU) at a profit of 12.9%. We'll trim some shares from the Invesco DB Base Metals Fund (DBB) at a gain of 14.1%, the iShares US Energy ETF ((IYE) for a profit of 13%, and the Invesco Optimum Yield Diversified Commodity Strategy (PDBC) for a profit of 3.3%. Our remaining ETF positions have an average gain of 8.27%, with a high of 14.10%.

On Monday, another ETF we sold was a substantial (40%) position in the SPDR Barclays 1-3 Month T-Bill ETF (BIL). We used BIL as a cash-proxy ETF, and it contributed 100% to the S&P 500 Conservative (1 ETF) Strategy and 100% to the Nasdaq Persistent Profits (1 ETF) Strategy.

These two models typically hold TLT to profit during bearish periods, but at this unusual time, with bond yields rising, we have been forced to instead hold the cash-proxy ETF, BIL.


Support and Resistance Level is Currently Bullish

Chart 1 below: First, let's look at the current S&P 500 Support/Resistance level. One of the fundamental tenets of technical analysis is that broken support becomes the first level of resistance, and vice-versa, broken resistance becomes the first level of support.


Chart 1: The level of 450 on SPY (4500 on the $SPX index) has been Support and Resistance since last September.


Since September 2021, the S&P 500 has vacillated above and below a critical Support/Resistance level at 450 (4500 for the SP500 Index). This turbulence began as the US Federal Reserve began to communicate its plans for starting a rate-increase cycle in March 2022.

Notably, SPY surged above the 450 level last week and stayed above this on Monday (April 4). Because the S&P 500 is now above this Key Support Level, above its 200-day moving average, and our Breadth Composite has moved into Bullish territory, we have to conclude – at least for now –that stocks will continue higher and the bull market will continue.

Therefore, our quantitative models sold defensive positions in the cash-proxy ETF (BIL) and the Utilities Select Sector SPDR Fund (XLU). However, we also took a profit of 29.4% in the First Trust Natural Gas ETF (FCG), but that decision in built into the algorithms to take profits at a certain percentage if gained within a specific time.


Credit Markets Under Increasing Pressure

While there are still many challenges, equities have a well-deserved reputation for climbing walls of worry. Most of the real headwinds for stocks are in the future, not here today. Conditions have switched back to bullish for now, but eventually, the Fed's tightening cycle will cause stocks to sell off and perhaps even crash. However, based on history, we may have between 11 months and 23 months (an average of 17 months) before a downturn begins, based on the history of yield-curve inversions and recessions.

On March 16th, Fed Chairman Jerome Powell announced that the Federal Open Market Committee (FOMC) had raised the Federal Funds Rate by 25 basis points (0.25%). This may have contributed to the subsequent 11.5% rally in the S&P 500 because it wasn't the larger, 50 basis point (0.50%) increase that many expected.

The Fed also reported the same day that it had increased its Balance Sheet by $43.56 Billion, taking it to a new, all-time high of $8.962 Trillion. The stock market saw the combination of the least-possible rate hike and an increase in the Fed balance sheet as a positive for stocks, perhaps signaling that the Fed is less serious about fighting inflation than advertised.

As a result, stocks surged in the last two weeks in one of the most powerful two-week rallies in years, gaining an average of about 1% per day. Also, the S&P 500 ETF (SPY) and other popular indices such as the NASDAQ 100 (QQQ) pulled back at the end of last week, setting up an excellent entry point for our new recommendations on Monday (April 4).

Interest rates will eventually become a drag on stocks when the Fed goes too far (as it always does). It's an inconvenient truth that the US Federal Reserve has never entered an interest-rate-increase cycle that didn't ultimately result in an economic contraction (recession).

Between now and when the market chokes on the Fed's interest-rate increases later this year, there is an opportunity to make significant profits. Historically, some of the best market returns have occurred at the anticipated end of bullish periods in similar situations. Perhaps investors see the current situation as their last chance to profit for a while and crank up their activity before the significant decline begins.

However, investors can likely expect much more turbulence than we saw in 2020 and 2021, when the S&P 500 went more than a year without a decline of -5%.

In a year like this, when the market is more volatile and one of the dips is likely to morph into a full-on selloff at some point, is when a carefully crafted, systematic investment approach can be your best friend. Without our sophisticated data-analysis tools, it is challenging for investors to know when to ride out a dip and when to sell to avoid significant losses.


Current Treasury Yields

Last week was a noteworthy one for investors for multiple reasons. The development that grabbed headlines across the financial world was that the 2-Year and 10-Year US Treasury Bond Yield Curves inverted.



Monday, March 21, 2022

3-Month Treasury Yield: 0.66%
2-Year Treasury Yield: 2.43%
5-Year Treasury Yield: 2.56%
10-Year Treasury Yield: 2.42%
20-Year Treasury Yield: 2.64%

Table 2: Interest rates climbed sharply and many inverted. Inversion is when shorter-term bonds have higher rates than long-term bonds. These levels were updated after the market close on Monday, April 4.


The US 2-year Treasury Yield climbed to 2.43% on Monday, April 4, while the 10-Year Treasury Yield climbed slightly to 2.42%. With the short-term rate above the long-term rate, this inversion has confirmed a classic 2-Year/10-Year Inversion of the Yield Curve, which first happened last week. Many economists and investors have long used the 2/10 pair as the vital signal of yield inversion that will affect the economy.

Charts 2 and 3 below show the status of the Yield Curve in April 2021 (chart 2) and today, April 4, 2022 (chart 3). The left side of the graphic shows the actual level of yields for each of the 3-Month, 2-Year, 5-Year, 10-Year, 20-Year, and 30-Year Treasury Bonds, while the image on the right shows where the S&P 500 stood at the time.

One Year Ago:


Chart 2: The Yield Curve one year ago (April 2021) is shown on the left, with the S&P 500 on the right (at red verticle line).




Chart 3: The Yield Curve today (April 4, 2022) is shown on the left, with the S&P 500 on the right (at red verticle line).


We can see that on the left side of Chart 3 above, yields are quite flat - with the exception of the 3-Month Yield.

The 2-Year/10-Year Yield Inversion is probably the most-watched Treasury pair inverted, but other yield maturities are also inverted, including the 5-Year/10-Year and the 5-Year/30-Year Treasury yields. Yield-curve inversions occur when the yield on shorter-term bonds (such as the 2-Year Treasury Bond) pays a higher interest rate than longer-term debt instruments (such as the 10-Year Treasury Bond).

Interest-rate inversion implies that there is a slowing of the overall economy by reducing the demand for bank loans with higher rates. For example, you may be able to afford the monthly payments on your mortgage at $2,000 per month, but because yields went up, you would now have to pay $2,800 per month, which is unaffordable on your salary. Meanwhile, banks are disincentivized from making loans because when short-term rates are higher than longer-term rates, loans are no longer profitable for the bank.

Business loans and mortgages are the primary sources of US economic growth because the extension of capital expands the economy more effectively than productivity gains and other contributors to GDP. To understand how the US economy functions and grows, I recommend viewing the excellent animated video by Ray Dalio, "How The Economic Machine Works." Dalio is the co-chief investment officer of one of the world's largest quantitative hedge funds, Bridgewater Associates.

Granted, banks do have other revenue sources to keep the lights on, but lending is the primary source of bank profits. Financial institutions borrow money using short-term bonds (and customer deposits) at low rates, then lend the funds out at longer-term maturities at higher interest rates. Because of the risk of interest-rate changes or other factors affecting loans of longer-term maturities, they usually have higher interest rates than short-term maturities. When short-term rates move above long-term rates, a bank's primary source of revenue is no longer profitable – every loan becomes an additional loss, and banks stop lending.

Which yield pair is the most important? All of them. Inverted yield curves have arrived for many maturity pairs, and it's likely that all the possible pairs will be inverted in the near future, perhaps in the next month, when the Fed is expected to increase the Fed Funds Rate by 0.50%.


The Shortest-Term Popular Treasury Climbing at 192% per Month

The one yield pair that may be the most economically predictive is the short-term, 3-Month Treasury yield compared to the long-term 10-Year Treasury yield. On Monday (April 4), the 3-Month Treasury yield climbed 13 basis points to 0.66% from 0.53% last Friday (a 24.5% increase in one day), and the 10-Year Treasury yield rose four basis points (a 1.68% increase) to 2.42% from 2.38% last Friday.

The 3-Month/10-Year pair currently has a difference of 1.76%. This amount may seem large compared to other rate pairs, but the 3-Month rate is climbing rapidly.

Chart 2 below shows a different presentation – i.e., a performance rather than a price chart. Since last November, when Fed representatives began to speak with urgency about the start of a rate-increase cycle, the 3-Month Treasury yield has climbed a whopping 960%, while the 10-Year Treasury yield has gained only about 54%. The short-term rate is rising at a pace almost 18-times faster than the long-term rate! At this pace, it won't take long for the short-term, 3-Month Treasury yield to catch up to the long-term, 10-Year Treasury yield.




The 3-Month/10-Year Treasury Yield ratio is the favorite pair of many economists and analysts because it may most closely represent the costs and revenues for banks to lend. However, the 2-Year Treasury yield vs. the 10-Year Treasury yield ratio probably remains the most-watched pair.

The dynamic of interest-rate inversions occurs when the Federal Reserve is tightening conditions using interest-rate hikes on the shortest-term (overnight) lending as its primary means to slow an overheated economy. This activity puts upward pressure on short-term interest rates (such as the 3-Month and 2-Year Treasury Bonds), and this upward pressure flows through to other rate pairs and reduces the desirability of bank loans. Reducing the appeal (and therefore the supply) of bank loans is the primary way the Federal Reserve slows the economy to reduce inflation from overheated demand.

Meanwhile, equity investors become more risk-averse when interest rates and other pressures increase, the economy slows, corporate profits fall, and headwinds accumulate. As an alternative to equity, when the economy slows, investors plow billions of dollars of capital into longer-term, risk-free bonds (such as the 10-Year, 20-Year, or 30-Year Treasury Bonds), causing the price to increase and long-term interest rates to decline (bond prices and bond yields have an inverse relationship).

With short-term rates rising and long-term rates declining or remaining flat when multiple rate combinations cross and become inverted, it has historically been a 100% accurate harbinger of an economic recession within seven to 23 months – and recessions have a 100% correlation with stock market selloffs. This statistic means that interest rate inversions give investors time to prepare (an average of 17 months) for a potential recession and a stock selloff or crash.


The Effect on Our Algorithmic Indicators

The algorithms that drive the decisions for our data-driven investment models include factors that track yield curve inversions. However, a yield-curve inversion is not very valuable as a timely risk-increase signal for data-driven investors. Historically, there's an average of 17-months from the start of a yield-curve inversion to a market selloff.

Inversions set the stage for an economic contraction, but a yield inversion alone cannot trigger our models to jump into risk-off assets. Many other signals will turn bearish as the market gets closer to a selloff, and an inverted yield curve figures into some of these algorithms. However, our composites of macroeconomic signals are still in a bullish mode.

Chart 1 below shows the 2-Year/10-Year Yield Curve Inversions since 1981 in the top window, with recessions designated by the red-shaded areas. The middle pane breaks out the 10-Year Treasury Bond yield, with the bottom window showing the 2-Year Treasury Bond yield alone.

In the top window, when the ratio of the 10-Year Bond yield to the 2-Year Bond yield reaches 1.00 or lower, rates are considered inverted. Notice that after each inversion below 1.00, a recession followed. This has been the case ever since data on GDP, recessions, and yields began being consistently tracked in the late 1800s.


Chart 1: The 2-Year and 10-Year Treasury Bond Yields inverted last week, signaling a likely recession ahead.


While an inverted yield curve can start the clock toward anticipating a recession, investors should keep in mind that we have very unusual conditions today. The Federal Funds Rate – the rate for overnight loans between banks – stands at just 0.33% after the Fed's first rate hike two weeks ago. However, the most recent report (February) of CPI inflation is at 7.9%! That is a huge gap – the largest ever in history – between the rate of inflation and the Fed Funds Rate.

The central bank forecasts the fed-funds rate to reach 2.75% by 2023, which means it would implement 11 total hikes at a quarter of a percentage point (0.25%) each. Meanwhile, the interest-rate futures market is pricing in about ten hikes – a level that is sure to drag down economic growth.

Fed Chairman Powell strongly implied that the next hike could be 0.50%, but if we see a few of those (or a desperate hike of an even more considerable amount), we can expect to see the market spooked into a crash.



Never in history has the Fed been so behind the curve on internet rates relative to inflation. And never in history has the Fed started a rate-increase cycle when interest rates are already inverted!



Federal Reserve Chairman Jerome Powell has – very effectively – talked down the market and talked up short-term interest rates as far back as last summer. Powell has been very hawkish in his statements about what stock and bond investors should expect in the coming months, and if he doesn't see the bearish price action he was expecting after making a tightening move, Powell goes straight to the nearest microphone to be more adamant about how tough it's going to be in the future. Over many decades, this approach became known by the highly technical term "Fed Jawboning."

For example, after the Fed's mid-March 0.25% rate increase, which was less than the half-point increase many expected, stocks shot higher in a robust, two-week relief rally. However, that's not what Powell was expecting, and in the days after the rate increase, Powell made two more presentations to the press, assuring the world that he was earnest about increasing rates rapidly. Powell made it very clear that we should expect a half-point increase for the next FOMC rate meeting (May 3-4).

However, it seems apparent to this analyst that the Fed remains exceptionally dovish while Chairman Powell uses all the communication tools available to him to talk down investment markets and economic activity – without actually taking much action. If Powell can get stocks, bonds, interest rates, economic growth, and inflation to move in the ways he desires without actually doing anything measurable, he has succeeded in doing his job.

In the investment world, expectations of events are as significant a factor in prices as are the actual events when they occur. The current situation is a perfect case-in-point. Fed Chairman Powell has already talked the credit markets into an inverted condition without doing much of anything.

Normalization Signals Recession, Not Inversion

Notice from Chart 1 above that recessions doesn't begin when yields first invert. Instead, recessions begin when those inversions reverse back to their normal status. That is - a status in which longer-term bonds pay a higher rate than shorter-term bonds. The reversal of the current Inverted Yield Curve invariably occurs when the Fed ends its previous tightening policy and resumes stimulative measures, primarily by slashing interest rates and "printing" an abundance of dollars in response to economic weakness.

Yield-curve inversions have a near-perfect record of signaling an impending recession. The Fed has inadvertently engineered every US recession for the last 100+ years through its consistently late policy responses. Following the Covid Crash about two years ago, the Fed overstimulated the economy with rates at zero and unprecedented money creation through Quantitative Easing – juicing asset prices by pouring $120 Billion into the economy every month for far too long.

The Fed's overstimulation has caused America's current predicament of an overheated economy, with demand overwhelming supply, resulting in a 40-year high in inflation. As Nobel Prize-winning economist Milton Friedman said,


"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output."

— Milton Friedman, Nobel Prize-winning Economist



Even with inflation still climbing to a 40-year high, far more available jobs than workers, the unemployment rate down to 3.6%, and near a 50-year low, the Fed continues its Quantitative Easing program. Asset purchases slowed in the last few weeks (down by $25 billion), but the Fed continues its stimulative, money-creation program nevertheless, recently reaching $8.937 Trillion on March 30.

Many investment advisors are already making the "this time is different" argument, claiming that the economy is so robust it can't possibly go into recession. However, historically, the economy has been strong every time the Fed begins a tightening cycle (otherwise, it wouldn't be tightening).

However, it's never really different – it's the same cycle of the past repeated with various players each time. Many of the bullish advisors on CNBC or the internet have a self-focused need to be bullish because their service/product requires bullish conditions. However, as a market-neutral, data-driven advisor, we have no dog fighting for bullish or bearish conditions.

Our job is to use sophisticated algorithms and robust data sets to identify when risk has increased to a level that can cause market crashes and catastrophic damage to an investor's portfolio.



For SUCCESS with a Rules-Based, Data-Driven Investment Model,
FOLLOW YOUR STRATEGY'S GUIDANCE 100% – Don't SECOND GUESS your Scientifically Tested Model!

Investor’s all-too-human emotions and subconscious biases relentlessly sabotage their investment results. Trying to follow the news or any other discretionary, judgment-based approach will only exacerbate these underlying challenges, invariably causing investors – whether amateur or professional – to buy after a stock has been rising (high) and sell near the bottom (low), capitulating to avoid losing more. Buying high and selling low attains the opposite result of a classic successful investment approach.

A carefully crafted, systematic investment strategy will eliminate these issues — BUT — you must follow your strategy's recommendations without second guessing them! Execute your strategy's trade recommendations TO THE LETTER if you wish to succeed and match your model's historical and prospective results.

That doesn't mean every trade will be a winner, and the selections will often be counter-intuitive – or they might go against the current generally accepted "wisdom" of the market. However, the probability that you'll succeed reach your long-term financial goals is far greater if you use a scientifically tested, rules-based strategy.

The ETFOptimize Premium Strategy lineup doesn't collectively (across six models) have a record of more than 100 consecutive years of profitability without a good reason:

Rules-based, data-driven investing works!

However, it only works... if you work it as designed!



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