These 3 Measures Forecasted Every Major Downturn Since QT Started: What's Next

Summary

• Readers were cautioned on July 12th that the S&P 500 was "ominously quiet" with volatility events trending more than 50% below the ten-year average for 2% daily moves.
• Then, last Thursday, the daily Momentum Gauge signals turned negative for only the third time since the October 2018 correction.
• Despite a 25 bps cut, the Fed conducted what they say will be the last quantitative tightening event with a $23.18 billion reduction.
• One estimate calculates that 19% of the S&P 500 gains since 2011 are due entirely to $3.5 trillion in record corporate repurchases.
• So, what happens post quantitative tightening now that the Fed says it has ended efforts to reduce the balance sheet effective August 1st?
• This idea was discussed in more depth with members of my private investing community, Value & Momentum Breakouts. Start your free trial today »

Introduction

To call something hot, you need to see some heat" - Fed Chairman Powell (July 10, 2019)

Fed Chairman Powell gave us a lead-in on July 10th that all was not well. By the FOMC meeting on July 31st, we had our first reversal in Fed fund rate policy in 10 years. Critics suggest the 25 bps cut was too little, too late. My view is that the Fed's asset normalization policy that started in earnest in 2018 and still continues today may be too much, too fast.

So following the Federal Reserve Chairman's testimony before Congress on July 12th, I wrote this cautionary article to readers that the markets were poised to crack.

The Fed talks about a rate cut, while their Quantitative Tightening policy continues down by $687 billion from the peak in the aggressive unwind.

Where is the volatility?

While this fundamental divergence continues, we have only seen FOUR moves of the S&P 500 up or down of more than 2% so far this year. The 2019 S&P 500 volatility is strangely 50% below the average of the last ten years."

Then, the answer arrived last Thursday, on August 1st. For only the third time in the past year, these key signals converged again to alert subscribers of my service and regular readers that another downturn of significance was underway. I will detail the prior events and the best signals I have found to forecast each of these corrections.

The QT/Volatility Relationship

As a long-time VIX volatility trader, some major shifts at the start of 2018 jolted my perspective on a new market paradigm. From 2009, we had three Quantitative Easing (QE) programs that managed to increase liquidity, stabilize market conditions, and bring about the lowest levels of volatility we have seen in a six-year period. Top among them was the entire 2017 year with not a single S&P 500 daily move above 2%.

Then, the start of a new Quantitative Tightening (QT) policy descended upon us, ever so blandly called the Fed's "balance sheet normalization policy." One of the largest initial asset rolloffs contributed to a huge liquidity shock to the markets in January 2018. Not surprisingly, a strong inverse effect to the success of the QE programs emerged so that the more the Federal Reserve drained market liquidity, the more fragile the market growth picture would become. The paradigm had shifted.

(Federal Reserve)

As I tracked and measured the reaction of the VIX volatility index into every scheduled asset rolloff event through 2018, we experienced increasingly frequent market volatility events at levels not seen in 7 years. Nine months ago, my December 7, 2018, forecast anticipated an inverse to the Fed liquidity activity in the chart above.

What I anticipate in my working theory of this QT activity is a steady increase in volatility as measured by 2%+ daily S&P 500 moves. Just as the three QE programs effectively reduced market volatility through additional liquidity, I anticipate the reduction in Fed assets will cause the volatility events to increase." ~ JD Henning, Profiting With Volatility Gains As The Fed Drains

(JD Henning's Articles)

So, contrasting the prior volatility forecast above with actual volatility moves over 9 months below and you can see there were more 2% moves just in December last year than there have been through July 10th of 2019.

(JD Henning's Articles)

This simple but effective measure alerted me that some non-random condition was disrupting the high negative liquidity effects of 2018. Even past the midpoint of 2019, we were looking at volatility events more than 50% below the 10-year average. I had expected these events to increase substantially to levels consistent and higher than last year, and I would still expect volatility events to play catch up in Q3 and Q4 if the Fed maintains its QT schedule as originally published.

Where had the volatility gone? While readers may have many other good or even better ideas concerning what alternate liquidity effect(s) may have intruded on this measure, I embraced the all-time highest level of corporate buybacks and dividends that was reached in 2019. This is my alternate explanatory source of liquidity that is keeping the markets stable for now:

In the lower half of the chart, I placed a box where the contrast between 2018 and 2019 shows more than a 10% difference in Buybacks+Dividends as a percentage of Operating Earnings. This difference is very significant in dollar amount especially for corporate buybacks (red line) as seen on the upper half of the chart. In the early part of 2018, buybacks are shown below $500 billion, then rising to over $823 billion by Q1 2019. In the simplest terms, I believe the expected volatility through the first half of 2019 did not show up in large part due to the massive stock buyback surge.

One analyst calculated that:

since the beginning of 2011, the S&P 500 would have been 19% lower than it is today if no buybacks were performed at all.

Three Forecasted Correction Events in the Past Year

Each of the three largest correction events in the past year had these three things in common.

1. The Federal Reserve had scheduled one of the largest asset rolloffs that week in their continuing Quantitative Tightening program.

2. The Momentum Gauges converged and crossed into strong negative momentum conditions on the daily chart. This proprietary momentum model is built on the negative/positive accelerating segments of my MDA research.

3. Strong market outflows from the mega-cap FANG+ Index bull fund (FNGU) increased rapidly during the week along with multiple technical breakdown indicators from my research.

These 3 indicators in combination provide significant reliability that, (1) a disruptive Federal Reserve QT liquidity event is about to occur [blue bar], (2) an immediate intraday confirmation that market momentum has turned more negative than positive [red over green], and (3) the technical breakdown of the FANG+ stocks signals that the largest fund flows from institutional and fund managers are going to be unwinding positions for a substantial period.

FNGU works nicely as a market proxy of more than $3.2 trillion in mega-cap stocks representing a highly disproportionate level of institutional and fund holdings. Other major indexes could be used like the SPDR S&P 500 ETF (SPY), ProShares UltraPro S&P 500 (UPRO), ProShares Ultra S&P 500 (SSO), iShares Russell 1000 ETF (IWB), ProShares UltraPro Dow30 (UDOW), or each of the inverse correlation funds to these alternatives. The purpose of applying the FANG+ Index breakdown is to help quantify the element of sustained market deterioration to evaluate the longevity of events strength.

The Weekly Momentum Gauge Chart above shows the Negative Momentum value on the red line, Positive Momentum on the green line, S&P 500 price changes on the yellow line, Actual QT weekly amounts in billions in dark blue, and the originally scheduled QT weekly amounts to the end of 2019 in light blue. Absent any future QT events, we could return to very low volatility conditions as we experienced during the quantitative easing years.

The three major market correction events including the current August event are identified with numbered circles on the gauge chart above. The next large QT event was scheduled for August 21 or Week 34 on the chart above. The Fed has announced the end of quantitative tightening last week fully two months earlier than planned. No significant tightening was originally scheduled for two weeks and so it will not be confirmed on the Fed's SOMA transaction report until later this month that these adjustments have ceased. We will also look for any potential easing if the Fed has completely reversed their balance sheet policy.

I. October 2018 Breakdown Event

The October 2018 breakdown event saw a 71% increase in the CBOE VIX volatility index that coincided with an increase in the Fed's QT cap for monthly asset rolloff amounts.

As I wrote back in that time period when the Momentum Gauges were in their original gauge format:

The Positive Momentum gauge dropped from a steady medium value around 65 in Week 39 (end of September) to values below 15 well into the red zone every week since September. Similarly, the Negative Momentum gauge that has not gone over 90 in the last two years is now setting new highs over 100 every week in October. Ending this past week at 118 Negative momentum."

- October 28, 2018, summary: 8 Warning Signals Of Deteriorating Market Conditions

We were seeing the strong correlations with the Fed's scheduled QT events and members were profiting on inverse market funds like Direxion Daily S&P Biotech Bear 3X Shares (LABD), Direxion Daily Semiconductor Bear 3X Shares (SOXS), Direxion Daily Technology Bear 3X Shares (TECS), ProShares UltraPro Short QQQ (SQQQ) during this period.

II. May 2019 Breakdown Event

The Momentum Gauge turned negative again on May 1st for the first time in 7 months. Members of my service were alerted repeatedly of a market downturn that saw -6.5% erased from the S&P 500 in May.

The technical indicators followed predictable patterns from May 1st, 14th, and May 24th before recovering again.

The Daily Momentum Gauge Chart for May shows the negative crossover that confirmed the S&P 500 breakdown conditions to the end of the month. The extremely low positive momentum conditions highlighted in the chart below also corresponded with prior low levels back in December when the momentum finally reversed to highly positive conditions into January. Likewise, June and July delivered very positive results for the momentum stocks.

The concern in May highlighted many parallels to last year that begged the question: Is The DJIA Signaling A Repeat Of 2018 Market Declines?

III. August 2019 Breakdown Event

One of the prime catalysts on August 1st was news that President Trump had announced increases on tariffs of Chinese goods and signalled an escalation in the US-China trade war.

In the same week, the Federal Reserve had convened another FOMC meeting and decided to reduce Fed funds rates by 25 bps. At the same time, QT kicked off again on July 31st significantly draining liquidity and creating additional market fragility that made another Trump tweet a significant market downturn catalyst.

Members were alerted immediately:

Fed's QT largest tightening days recently were May 1st, May 15th, and July 31st. Next largest event is Aug 21st. Case can be made that liquidity tightening makes markets more sensitive to news and more volatile. High correlation continues between VIX and QT.

At this time, the VIX volatility 2x Bull fund (TVIX) began a technical breakout on August 1st that has seen prices now exceed $23/share even as recently as today on greater than 20% gains since the technical confirmation.

The following day, on August 2nd, more confirmation was obtained from the Momentum Gauge signals with a strong crossover to negative momentum.

The momentum gauges closed yesterday after hours at 46 negative and 32 positive. This is a strong negative cross signaling the first strong negative signal for the market since May.

Where are we now?

The S&P 500 is rebounding in a short leg up that has not yet broken from prior patterns.

Are we headed to another "3" on the S&P 500 index as shown above?

It is hard to know with certainty, but (1) the Federal Reserve's QT calendar has been halted that originally called for another event on August 21st of $35.3 billion, (2) the Momentum Gauges are in strong negative conditions, and (3) the FNGU bullish FANG+ Index ETN is in negative technical breakdown conditions with early signals of improvement from these levels.

What will the Fed do next?

The Federal Reserve's decision last week to stop shrinking its balance sheet two months sooner than previously announced leaves several questions. Will the Fed now leave the balance sheet unchanged to the end of the year? Will they consider returning to QE programs that added assets to the balance sheet?

Bank of America's research report by Marc Cabana is garnering tremendous interest after the Federal Reserve reached out to Zerohedge.com in a now published email to obtain additional analysis from the Cabana report.

What the Fed will do with this report is a subject of much speculation, but we do know that the Cabana report claimed the "Fed may be forced to launch Quantitative Easing as soon as Q4 to provide the market with the much-needed liquidity, or else suffer the consequences of a major liquidity shortage." The exact words of the BofA analyst were:

Outright QE: after OMO dealer capacity is exhausted the Fed may need to start permanently expanding its balance sheet. The Fed would likely describe this as offsetting "bank reserve demand and growth in other non-reserve liabilities". Regardless, it would represent the Fed permanently buying USTs outright to maintain control of funding markets well above the ZLB.

I will continue to watch this major shift in balance sheet policy unfold and take the best responsive actions to profit in an uncertain environment.

I hope this analysis and the links from over 2 years of research serve to benefit readers as much as they have benefited members of my service with daily updates. The markets are a subject of measuring probabilities with limited certainty, but so far, the signals and conditions measure into 2019 are showing the potential for many more volatility events. I hope you will use every advantage to your benefit!

All the very best!

JD Henning, PhD, MBA, CFE, CAMS

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.