Imminent Decline Ahead

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Summary

  • The S&P 500 ETF reached an all-time high in the first week of September, followed by a market downturn that spanned until today.
  • High prices and extraordinary valuations are a result of the Fed creating money supply at an exceptionally robust pace.
  • Inflation has skyrocketed across many asset classes, but Energy and Finance are the hottest sectors right now.

financial graph and technology element on mobile phone 3d rendering

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September's decline in the overall market may have given us a taste of what's in store for investors through 2022. It was certainly different from what investors had seen during the prior 17 months, which was something more akin to watching grass grow or paint dry...

In other words, it was a dull market for a very long time. But things may be livening up now - and in this article, we'll tell you why more volatility is likely. One reason we're a bit excited is that there will definitely be more risk ahead for the market. Rules-based models like the ones offered by ETFOptimize provide much higher performance when there's a correction or a bear market during any given year. It gives risk-assessing models the opportunity to outperform the market.

When stocks are steadily climbing higher and there are no pullbacks of -5% or more, it's more difficult for systematic models to outperform. Simply put, there is no risk for them to assess and avoid. That said, several factors are now aligning that will cause stocks to be more volatile in the future, likely beginning as soon as early November, if not during what remains of October.

What caused the slide in recent weeks? The most significant concern was that politicians played brinksmanship with the Debt Ceiling to score political points with their base (yet again). The last time politicians played chicken with the Debt Ceiling was in 2011, and it caused a -19.99% market selloff before wealthy investors/donors called their Senators, putting a stop to the hyperbolic nonsense.

If the Debt Ceiling is not increased, the Treasury can't pay for needed and popular programs like Medicare, Social Security, Veterans Administration Hospitals, the Department of Defense, payrolls for families in the military, highway repair, clean drinking water, clean air, drug safety regulation, food (grocery and restaurant) safety regulation, and many more. The list of Americans affected by the government's ability to pay its bills is extensive, which makes this issue so impactful across all economic classes.

I just don't get how a game of economic chicken can be resolved in any politician's favor. What are they thinking to be so nihilistic? On the other hand, there's a lot about politics that is opaque these days. However, millions of investors must have shared my opinion because the stock market began declining on concerns that a Debt Ceiling increase would not get passed. Even if both sides intend to take care of it at the last minute - because they get so close to the deadline, the chances are higher that human error could lead to financial catastrophe.

Here's what happened last week, explained in the top window of Chart 1 below:

S&P 500, with 50, 75, and 100-day moving averags

Chart 1

Why the Trend Change?

Likely, the easy days of going a year without a -5% decline are over for now. The 18-month, nearly 45-degree-straight line, lower-left-to-upper-right chart for the S&P 500 since the Covid Crash is now likely to morph into a volatile chart pattern that may make up for the last 18 sedentary months. That's just the way the market works.

I've often said, "Mean Reversion is the most powerful force in investing" - and that principle applies to volatility, returns, sectors, large-cap vs. small-cap, value vs. growth - you name it - after one market aspect dominates for a while, its opposite will soon dominate with equal energy.

Besides the Debt Ceiling nonsense, change is occurring now because Federal Reserve policy is again the dominant factor in the investment arena. Having created an inflation issue, the Fed will now reverse from stimulative to contractionary - and the markets will follow with a predictable outcome.

With the Fed in charge of the US money supply, unemployment, inflation, and interest rates, it is regularly the most powerful force affecting the US economy and virtually all investments - hence, the elephant in the room.

Unfortunately, it's easy to make the case that the Fed has been the problem, rather than the solution. The Fed created overstimulated, dovish, inflationary conditions, and now it will reverse and create contractionary, bearish, and volatile conditions. Some observers accuse the Fed is playing the role of both fireman and arsonist.

A Quick Review of What Happened in 2020

For this article, I did a deep-dive review into the details of what happened over the last three years to cause this unusual situation in which unemployment is still higher than acceptable (and could increase if there's a Fed-fueled economic contraction) and at the same time, inflation remains elevated more than double the Fed's target rate (at 5.3% instead of 2.5%). Based on their comments, it looks like the Fed is likely to pour a lot of cold water on the overheated economy in the coming months.

We can lay the responsibility for this situation, as usual, at the Federal Reserve's doorstep. What you'll find in this article is a discussion of critical details that have caused today's economic conditions to be exceptionally skewed. We're presenting the Reader's Digest version of those details, with the level of terminology democratized so that individuals early in their investment pursuits are not alienated by unfamiliar terms.

The Biggest Mistake: Economic Overstimulation

The Covid Pandemic began costing American lives in early 2020, and citizens began taking it seriously and changing their day-to-day activities in late February 2020. The pandemic prompted governors to order millions of American businesses to close in March, April, and May 2020 - and some that depended on face-to-face interactions (such as restaurants) for much longer.

In response to the Covid Crash and business closures, the Fed stimulated - by an ENORMOUS amount. The Federal Reserve Board threw the kitchen sink at the Covid problem, and it ultimately turned out to be FAR more sink than required. The Federal Reserve initially pushed $3.5 Trillion into the banking system during the first three months - a shockingly large amount of money at the time. Indeed, Americans rarely heard the word 'Trillion' mentioned before the pandemic. Lately, it seems like we read or hear that word about 50 times a day.

Then, in July 2020, the Fed began purchasing an average of $180 Billion of Treasuries and Mortgage-Backed Securities (MBS) every month. With this consistent flow of billions of dollars created out of thin air at the push of a button, the Fed created the conditions for an 18-month bull market that was as smooth as a baby's butt.

Investors in the S&P 500 were the biggest beneficiaries of the Fed's consistent largess, as they felt the Fed would always have their back. That allowed millions of investors to buy shares anytime the S&P 500 ETF (SPY) would dip to its 50-day moving average, and before September, the index never experienced a decline of -5% for the last year.

However, the Fed created out-of-balance conditions and zombie companies in many industries by stimulating FAR too much. Because of the overstimulated financial quagmire it created, we have inflation at 5.3%, and the Fed will be forced to reduce quantitative easing and tighten interest rates at a Far More Aggressive Pace than investors had anticipated.

After the Fed began its massive stimulation program, the stock market and US economy immediately surged right back to normal levels, as if Americans had experienced an afternoon siesta - not an 18-month pandemic that killed more than 700,000 Americans.

And therein lies the rub: the economy bounced back on track so quickly - within six months, and the Federal Reserve should have 'tapered' its stimulation immediately - at least a year ago, and optimally, even before. But that's not what happened. Instead, 1.5 years later, and the status quo remains the same - the Fed continues buying $180 Billion of Treasuries and MBS as recently as this month!

The Covid Pandemic and Gross Domestic Product

The US economy - as measured by Gross Domestic Product (GDP), reached a pre-Covid, all-time high of $21.7 Trillion in the 4th Quarter of 2019. As Covid began to affect the US and the world in the first quarter of 2020, events were canceled, businesses shut down, and US GDP declined sharply. GDP only declined by 0.99% in 1Q-2020 but dropped more significantly in the 2nd Quarter of 2020. However, the total decline was only $2.2 Trillion, so GDP did not drop by nearly as much as many executives (or the Fed) expected.

THE BIG PROBLEM: The Federal Reserve dramatically overestimated the economic impact of Covid. It was a $2.2 Trillion hole in the US economy, and the Fed immediately threw $3.5 Trillion into that pothole in March, April, and May 2020. Then the Fed began a steady, monthly stimulation program, purchasing an average of $180 Billion of Treasury Bonds and Mortgage-Backed Securities (MBS) every 30 days since July 2020, for a total of another $2.7 Trillion injected into the financial system, and a total expansion of the Fed's Balance Sheet of $6.2 Trillion.

Since the Federal Reserve created that money out of thin air with the push of a button, depositing it into the accounts of US banks, those funds were also a direct increase in the Money Supply - i.e., cash and equivalents circulating in the economy. Banks can leverage those funds, typically at a ratio of 10:1, and lend it out into the economy to finance business activity, new mortgages, personal loans, and many other uses.

ADDITIONAL STIMULUS: I've also tried to assess the amount of additional Stimulus transferred by Congress to the American people and American businesses. Of course, these programs are primarily one-time programs that won't repeat, but they have increased the nation's wealth during the Covid Pandemic. The total I can identify is an additional $7.6 Trillion, but I'm sure there's a lot more money I am missing.

$14 TRILLION - That is the total amount from both the Fed and Congress in the last 18 months to support the American financial system in the face of the Covid Pandemic. That amount is approximately 63% of one year of US GDP. Imagine if you received a bonus paycheck for 63% of a full year's income. Most people would feel pretty flush, right? That's a good analogy for the situation because the US economy is virtually swimming in excess cash.

Moreover, it could increase even more with the passage of President Biden's 3.5 Trillion 'Build Back Better' program and an increased US budget.

Chart 2 below shows the US GDP from 1Q-2019 to the present (2Q-2021). From the pre-Covid GDP high in 4Q-2019 to the lowest point in 2Q-2020, US GDP declined just -$2.2 Trillion in total, or about -10.2%, to a GDP low of approximately $19.5 Trillion.

Covid and GDP

Chart 2

Following the 2nd-Quarter 2020 low, GDP reversed higher and went BALLISTIC. One quarter after the 2nd-Quarter 2020 Covid GDP low, Gross Domestic Profit had grown by $3.263 Trillion for a one-quarter GDP gain of 7.86%!

Chart 3 below shows the most recent four quarters since the Covid low has produced the highest GDP growth of any 4-consecutive-quarters in history, and the average quarterly GDP percentage gain for the last four quarters is a robust 3.77%.

Since the 2Q-2020 low, GDP has grown by an astounding 16.76% in 4-quarters!

Quarterly GDP Data

Chart 3

Chart 4 below: The Federal Reserve controls inflation through the expansion or contraction of the US money supply. All else being equal, an increase in the supply of money will have an inflationary effect because there is more cash chasing the same amount of products. The Fed has increased Money Supply (M1) by 400% since 2019, which helps explain why inflation is so out of control.

M1 Money Supply

Chart 4

Chart 5 below: Perhaps due to the Fed's quadrupling of Money Supply in the last 18 months, inflation accelerated sharply in May 2021 to 5%. It increased to 5.4% in June and July, then in August 2021, it nudged down very slightly to 5.3%, and the forecast remains for inflation to stay at about 5.3%.

Monthly US Inflation

Chart 5

What's the most likely item that could trigger stock selling? The Federal Reserve is the elephant in the room, having inflated asset prices to the moon. The Fed wanted inflation to 'run hot' to make up for all the months and years when inflation has been below the optimum target rate of 2% (we're in a long-term deflationary environment from technology, productivity advances, and declining labor-force participation). However, the Fed got more than it asked for - i.e., at 5.3%, it got double its target rate. The Fed stated early in September that it would start tapering its QE bond purchases by the end of the year.

However, with the Fed seeing the error of its ways, I sense that Jerome Powell and the Federal Reserve Board don't want the ignominious distinction of being in charge of the Fed when it caused a disastrous increase in inflation. The name 'Jerome Powell' could go down in history as an economic villain for that record!

Based on current conditions, it's likely that the Fed will announce 'tapering' that is FAR more aggressive than anyone imagines. And I suspect that the Fed will also feel pressured to raise rates very soon, but it must eliminate the $180 per month of stimulus first. That will shock investors and could trigger a selloff - which the Fed may now see as the better of two bad options.

A market crash is bad, but the Fed may see inflation as far worse because it is an insidious force that lives in the human mind. Like a persistent virus, inflation is extremely difficult to get rid of once it has gotten its hooks into the economy.

Chart 6 below: The start of a long-term slump?

The Start of a Long-Term Downturn

Chart 6

A downturn related to the Fed tightening to battle inflation, interspersed with volatility and occasional rallies, is likely just ahead. The Fed has already told us that 'tapering' of the stimulus will begin before the end of the year. Since the Fed has a scheduled meeting on November 2-3, we can likely expect an announcement about a reduction in bond purchases at that time.

Then, in December, investors can follow the Senate taking up the Debt Ceiling madness once again. That issue is sure to bring fresh worries to investors. Because polarity is so heightened now, US politicians often assume extreme positions to appease their base, but this can cause deep existential angst for opposing party members. That angst can cause investors to make emotional decisions that aren't in their best interest, and these arguments can sway you in ways that might result in losses.

Rules-based, quantitative investment strategies can pierce those emotions and subconscious biases, making 100% rational decisions that have the highest probability of profitability. However, the one weak link in this system is that YOU must execute your model's systematic decisions as recommended.

The environment ahead is likely to be one in which an algorithmic strategy will excel, so please execute your model's recommendations precisely as recommended!

New Equity ETF Positions

Speaking of recommendations, some clients may wonder why their model is buying new positions on Monday when there is likely to be trouble ahead for the market.

Chart 7 below shows our ULTIMATE 6-Model Combo Strategy, those clients will get the selections from all the models, which provides wide diversification.

Ultimate 6-Model Combo Strategy

Chart 7

While our models currently hold significant exposure to short-term Treasury ETFs from the strategies based on the S&P 500 or the Nasdaq 100, our Equity+ and Equity++ Strategies are also holding Financial and Energy ETFs and are buying more exposure to those sectors Monday. Those selections are perfectly reasonable for the following reasons:

1) The Financial sector should do exceptionally well in the coming months because we're entering a rising-rate environment in which the Fed is raising interest rates to fight inflation. Banks and other lenders and investors (such as insurance companies) make a significant portion of their profits from the spread in interest rates. A rising-rate environment should spur increased earnings for these companies.

Highly ranked ETFs in this sector include KIE, XLF, KBE, KRE.

2) As discussed in our recent ETFOptimize Insights Report, old-school Energy companies (crude oil, natural gas, etc.)

Are experiencing a severe shortage in Europe and Asia, and prices are skyrocketing. Additionally, commodity (such as oil) producers/distributors usually have higher unit prices and more substantial profits as the overall economy and market decline. Since we're likely in that cycle now, it should multiply the profit increases related to Covid shortages as winter approaches.

Highly ranked ETFs in this sector include XLE, XOP, FCG, DBE.

Bottom line: The ETF selections made by the models this week appear to be spot-on. As advocated above, for optimum investment profits, follow your model's selections to the letter!

Follow Your Quant Strategy's Recommendations

Quantitative Strategies are not for everyone. They are designed for investors who have the discipline to stay focused on achieving their long-term goals, not being distracted by the latest shiny object and its artificially created angst that demands that you "beat the market" at all times or you are considered a failure.

Anybody can beat the market in the short-term, but that's often when the drumbeat begins and the shiny object is trotted out to lure in short-term traders who are chasing performance - just before the shiny object's mean-reversion begins and those high-flying investments become 'last week's forgotten trade.'

Our models include mean-reversion signals to avoid owning ETFs that are overextended.

This article was written by

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ETFOptimize.com offers rules-based, quantitative investment strategies via low-cost subscription for individual investors and bespoke designs for professional fund managers. We base each of our six models on indicator composites built from more than 50 uncorrelated data sets in the Fundamental, Macroeconomic, Sentiment, and Technical categories. This diversification of indicators drives our models to select the optimum ETF for conditions, generating profits whether stocks rise or fall. Our collective track record across six live, out-of-sample strategies includes 100% consecutive winning years since 1998 – with subscriptions starting as low as $9/month. Learn more about the profound performance breakthrough offered by the data-driven investment strategies at https://ETFOptimize.com.
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Disclosure: I/we have a beneficial long position in the shares of SPY, KIE, DBE, XLE AND XLF either through stock ownership, options, or other derivatives. 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.

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