SPY: Solid Price Action And Fundamental Strength

About: SPDR S&P 500 Trust ETF (SPY)
by: Andres Cardenal, CFA

SPY broke above a key resistance level around $295 recently.

In this context, investors are wondering if this is the beginning of a new upward move for SPY or just another false start.

The future is always a matter of probabilities as opposed to certainties. However, price trends and fundamentals can have a big impact on returns.

Considering both the price action under the surface and the fundamental picture, there are some reasons to be bullish on SPY going forward.

The SPDR S&P 500 Trust ETF (SPY) broke above a key technical level last week, and investors are wondering if this is a real breakout leading to further gains or just another false start like the ones we have seen over the past year.

Nobody can predict the future; however, variables such as price trends and economic fundamentals can have a big impact on returns. As of the time of this writing, both the price action and the economic fundamentals are pointing towards further gains for SPY in the middle term.

Solid Action Under The Surface

SPY is going through a key inflection point in terms of price action. The ETF is now above the key level of $295, which has acted as resistance on multiple occasions over recent months. In addition to this, SPY is above the 200-day moving average, which is a key long-term trend indicator.

Source: Thinkorswim

Importantly, the price action under the surface is even more encouraging than the price action for the ETF itself. SPY tracks the S&P 500 index - as such, it can be heavily influenced by the companies with the largest market capitalization weights in the index.

Watching the price action below the surface can tell us if the price movements are supported by a large number of participating companies or only a handful of stocks with a big weight in the portfolio. The more participation in a particular movement, the more sustainable it can be considered.

The advance/decline (A/D) line takes the net number of advancing NYSE stocks on a daily basis and then sums that number from one day to the next. If the line is moving up, that means there are more advancing stocks than declining stocks.

Source: Yardeni Research

The A/D line made new highs last week, but the SPY remains below its highs of the year. The chart bellows shows the performance numbers for a strategy that buys the S&P 500 when the A/D line makes a new high but the S&P 500 remains below such highs. As we can see, this tends to produce solid gains.

Source: Quantifiable Edges

It's not only that the SPY broke above the range last week, but the price action under the surface was even more encouraging than the price action from the ETF itself, and this has positive implications for future returns.

The Fundamentals Remain Supportive

We can have a big decline in SPY without a recession, there is no law against it. However, history shows that the most concerning declines tend to happen during recessionary periods for the US economy.

The chart below shows the evolution SPY over the long term, with the shaded areas highlighting recessions. It's easy to see how the deepest drawdowns generally happen during recessions.

Chart Data by YCharts

Investors have been getting increasingly concerned about the possibility of a recession lately, and this is mostly due to economic sectors being hurt by the trade war uncertainty, such as exports and manufacturing. On the other hand, sectors like the consumer, the labor market, and services remain remarkably strong.

The MRB Recession Checklist Indicator, which includes measures of U.S. business activity, consumer spending, labor market activity, credit, and financial market performance and ex-U.S. macro activity, is indicating a low risk of a recession at present.

Source: MRBPartners

The media coverage typically puts more focus on the economic data points that indicate economic weakness and increased probability of a recession. These kinds of headlines obviously gather more clicks and attention than the news about indicators coming in better than expected.

However, the Citigroup Economic Surprise Index, which measures economic data in comparison to expectations, is showing considerable improvement and moving above zero in recent days. This means that more data points are actually outperforming versus underperforming expectations.

Source: Yardeni Research

A Simple Risk Management Framework

In order to combine both price action and fundamentals, we can take a look at a simple quantitative strategy that follows a very basic rule. This strategy is allocated to SPY unless the ETF is below its 200-day moving average and earnings estimates for companies in the portfolio are declining.

Again, the two conditions need to be met - prices are in a downtrend and earnings estimates are declining - for the strategy to sell SPY and go to cash.

The main idea behind this double-signal requirement is trying to have a long-term approach to risk management, only going to cash when market conditions are particularly concerning in terms of both price action and the top-down fundamentals.

The chart below shows how the strategy has performed over time. Since January 1999, the strategy gained 441.8% versus a cumulative gain of 252.9% for buy-and-hold investors in SPY over the same period.

Importantly, the maximum drawdown, meaning maximum capital loss from the peak, was 25.3% for the quantitative strategy, less than half the 55.4% maximum loss suffered by buy-and-hold investors in SPY.

Data from S&P Global via Portfolio123

Since 1999, the strategy has avoided massive losses in 2001 and in 2008. This is the main reason why it has performed so well in the long term.

On the other hand, the strategy also went to cash during 2016 and in December 2019. The market sold off substantially during those periods, but then it rapidly recovered. From that perspective, the corrections in 2016 and December of last year could have been interpreted as buying opportunities as opposed to reasons to sell stocks.

It is important to acknowledge that a strategy such as this one only produces superior returns when the market goes through severe drawdowns such as the ones in 2001 and 2008. When market pullbacks are shallow and short-lived, protecting your portfolio in times of uncertainty will ultimately have a negative impact on returns.

The strategy remains long in SPY since January 2019, with both price trends and earnings estimates signaling a long position in SPY. This can change in the coming days, and no strategy whatsoever can make the right call every time.

However, investment decisions supported by hard data are superior to those based on opinions and speculations, and the quantitative strategy based on price trends and earnings is sending a bullish signal for SPY right now.

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.