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Peering Through The Kaleidoscope
First up, don’t worry, we aren’t going to bother telling you about SPY’s holdings or weightings because (1) you know that already and (2) you can read that in a thousand other places. If you do want to explore the underlying positions, you could start with the Seeking Alpha page covering the instrument (here). We also aren’t going to talk about management fees on the fund because, really, who cares? They’re low. Move on.
So, with that done, let’s set a little context here first, since the whole world and their dog writes about SPY and we would like you to actually read this note, as common a topic as SPY apparently is. Once you’ve read it you can decide whether to lob rocks at it, throw it in the trash, or think about it and use it in your own work. You know best. It’s your money we’re talking about here.
Here at Cestrian we run an independent investment research shop. The raison d’etre of outfits like ours is usually some kind of derriere-intelligente edge on single stock names or investing methods or whatnot. If you run a research shop you generally don’t want to be saying, go buy the S&P 500 folks, because, really, the office dogs around here can work that one out. (They’re German Shepherds. They’re pretty smart.) So nobody is going to give you money for saying it.
Unless, that is, you can figure out when to buy it and when to sell it and why and get that right a few times.
And if you can figure out how to use SPY as a signpost for how to play growth vs value? That can be useful too.
We’ll come back to that stuff.
There’s a reason why the Master, one Mr. W. Buffett, promotes the same old line these last hundred years about what the regular retail investor should do – which is to say, go find a low-cost passive S&P 500 tracker and put your money to work in that, feed it extra money when you have it, get on with your life, and then when it’s time to hang up the laptop, hand in the catered avo lunch ticket, go play Metaverse golf all day, pausing only to WhatsApp your robo-broker and cash in your tidy pile of Corporate American gains. Over most any say five year period of time, this is an excellent strategy. Literally nobody got poorer owning SPY for long enough unless they needed the money during the fallow years.
However. Even though it’s the totally obvious long-term investor play for people who know nothing about investing – watching SPY is absolutely core to our business, and we’ll tell you why.
First up, we do ourselves like to dabble in it with personal money. Because we think about stocks all day and like to think we’re smart, etc., we don’t put all our money to work in say SPY and QQQ and then go do something more interesting instead. Though from a quality of life perspective that would probably be a better idea. On the current trajectory, with our final breath we’ll be telling the grandkids to remember the fractal nature of wave charts and never get suckered into thinking a Wave 5 will go much past a Wave 3 high. SPY investors? They be telling the young ones something useful about life.
But we digress.
We want to talk to you about two things. Firstly, why we think SPY is a compelling buy now, and secondly, how we have used the ETF as a way to manage risk in our subscription service, and accordingly, in staff personal accounts. In our work we cover both growth and value names and we do our best to be buying value when everyone is laughing at value; selling it when everyone is saying value is the new growth; buying growth when everyone is laughing at it (like now); and selling growth when everyone thinks growth is the only thing worth owning. SPY is a great tool to aid us in that quest and we’ll share that method with you here.
Why Buy SPY Now?
If you ask your grump-pa he will tell you to buy the market at a p/e of X and to sell it at a p/e of Y. And he may be right, we don’t know. We take a different tack with index ETFs. Our own view is that the drivers of index ETF pricing – and SPY is of course the daddy of index ETFs – is nothing other than emotion. Capital rushes in when folks are feeling bullish; rushes out when they feel fearful. Funds use SPY as both an instrument in itself and also as a hedge against single stock positions. All of this is sentiment driven. And this is why, we think, SPY and other such index ETFs respond very well to technical analysis.
Technical analysis isn’t really technical – it’s the opposite. It’s simply a way to measure emotion. Emotometrics it should be called. Now, for reasons we know not, nothing much attracts quite as much online rock-lobbing as notes arguing to buy X or Y on the basis of chart logic. But try to keep an open mind on this stuff before you torch it. Charts can be right or wrong as can decisions made on any other method. The trick is to be right a little more often than you are wrong, and wrong with a little less money than you are right. That’s about all we can all hope for in the random walk down Wall Street.
Here’s SPY since the December 2016 lows. (You can open a full page version of this chart, here.)
Allow us to walk you through it.
From Jan 2016 to the pre-COVID crisis highs in Q1 2020, SPY adds +$160/share. That’s a larger-degree Wave 1 up.
In the COVID crash it sheds, almost to the dollar, the amount equal to the 0.786 Fibonacci retracement of that Wave 1 up. That’s a textbook deep Wave 2 correction. It happens quickly, exceptionally quickly, but on the Y-axis? Textbook. Wave 2 bottoms around $218.
Elliott Wave theory tells us to expect a substantial Wave 3 up at that point, and there it is. Ab-so-lute-ly pic-ture per-fect textbook Wave 3 topping at the 100% extension of Wave 1, putting in a high around $480 in Q4 2021.
Sometimes, a wave 3 can run beyond that, maybe to the 1.618 extension of Wave 1, sometimes beyond. Our own experience is that in banzai-type single stocks (IonQ (NYSE:IONQ) is a great example of this as is Upstart (NASDAQ:UPST)) you can sometimes see huge Wave 3 extensions – we just saw a 4.236 extension in USO for instance off the back of the oil woes in the world right now – but for the more grownup names or indices, a 100% extension is common and a 1.618 extension is about as good as you get – in the larger degree at any rate. Dig down into smaller fractal components of these waves and no doubt you can see more banzai movements. We don’t do that – we’re not good at the smaller degree, don’t trade on those timeframes, instead prefer to focus on our fat pitch timeframe of months and years. Anyway, let’s keep going. We’ll get to the so-what in a moment.
As SPY hit that 100% extension in November, we shouted loud and clear in our Growth Investor Pro service that we were likely topping in the main indices. We don’t need to deal with it here but QQQ was showing a similar topping pattern. And so we said this:
As it turned out this was a righteous call. The index ETF charts suggested that SPY and QQQ – the S&P and the Nasdaq-100 – were topping out, that the small-cap Russell2K was doing the same, but that the Dow and its old-line components could keep going.
This informed our risk appetite going into December and then Q1 this year. Because as you know, the S&P and the Nasdaq-100 are dominated by Big Tech – they are in essence growth funds. And they are low beta growth funds. Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Apple (NASDAQ:AAPL), they don’t swing wildly around so much. But if those names are starting to correct and move down, you know what moves down a whole lot faster?
High beta growth. That’s why it’s called high beta. Because it changes a lot faster to the upside and the downside than your vanilla index does. So we figured, with not a little help from our membership community, that high beta was in for some trouble – time to lighten up on those names. We’d already been selling down some of our growth favorites earlier in Q4 as they topped out on the same kind of chart method.
The Dow chart said to us that value stocks could run awhile, which they did. As the whole world became dividend growth investors we then sat happily selling down the defense names we owned during Q1 as they topped out.
SPY gave us just a little bit of insight into this. Because, again, if SPY is topping out, Big Tech is topping out (particularly if the QQQ chart tells you the same story at the same time). If Big Tech is going to move down some, then Scary Growth Tech is going to move down a lot more. And when scary moves down, comfy-armchair-value tends to move up. So in Q4, SPY helped us rotate out of tech and into cash, and helped us hold onto the value names we had been buying earlier in the year at lower prices.
Now none of this was executed perfectly, it all sounds a little neater and less fraught than it was, but it’s all true, and it’s all still in our Growth Investor Pro service if you care to read it. Turned out to be a good call.
Our view now is – buy SPY. And that means – buy SPY, buy Big Tech, but also, Buy Scary Growth Tech. Because if we’re right that SPY has bottomed and is moving up, then Big Tech is moving up, and Scary Growth Tech will be moving up more. High beta, remember.
Let’s look again at the same chart above and we can explain why we think SPY is a buy. This is a zoomed-in version of the same chart – you can open a full page version, here.
Elliott Wave theory tells us that if Wave 2 was a brutal correction – and it was remember, that was the COVID crash, a 0.786 correction in only a few weeks – then the Wave 4 down can be fairly gentle. So in that November 28 note we mention above, we said we thought SPY might find support around the 0.236 retracement of the Wave 3 up. That’s approx $418/share.
Well, if we’ve bottomed then we can say the lowest close of this correction was in the $416 zip code and the lowest intraday price was around $410. In which case calling $418 as the bottom back in November will look not too shabby. (We were too bullish on the QQQ by the way. Thought it would bottom at $350 and if it’s bottomed it will have done so around $317. A whole Fibonacci level lower than we thought, urgh. Can’t win ’em all.)
We’re calling Buy on SPY now because this textbook, beauty of a waves and Fibonacci levels chart – truly it’s a thing to behold so closely has it traded to theory – suggests that we will now see SPY make a final Wave 5 run up to complete this five-wave cycle.
Now, Wave 5s. Theory says they will make a new high, so, as a minimum target we can say that we think SPY will hit $480 in the next few months; that’s around a 10% gain from here, and if you like to use stops you could more than justify placing a stop in that $415 lowest-recent-close level, setting yourself up for a 2:1 risk/reward on even a minimum upside target. More likely in our view is that Wave 5 delivers a move of equal amplitude to Wave 1, which we will remind you was a +$160/share move.
If that happens that means a Wave 5 high of $410 (the Wave 4 low) + 160 = $570/share. That’s around a 30% move up from here and you could use the same stop level against it, giving you a 6:1 risk/reward ratio, which isn’t so bad given that it’s the S&P 500 we’re talking about here, not some crazy high beta single name stock.
If SPY does make it up to $570 then that is highly likely to mean that high beta Scary Growth Tech is going to motor upwards too. And so we’re once again using SPY as our guide. It told us in Q4 2021 when to lighten up on growth names, correctly as it turned out. And now towards the end of Q1 2022 we think it’s telling us to add exposure to growth names. If and when we get near that $570? Time to sell-sell-sell SPY and the scary growth stuff too. And given that speaking for staff personal accounts, we always sell too early, we’ll likely be cashing in our chips some time before that $570 level.
Here’s what we think that Wave 5 can look like. (Full page version, here).
In Conclusion – Go Warren!
OK, so, long way to say what the office dogs already worked out, which is, buy the S&P. But we think it is truly a good time to do so. The ETF is to our mind giving you an opportunity to achieve a 6:1 risk/reward ratio, and it is telegraphing “buy high beta” too, at a time when most of FinTwit is still cope-posting about how dumb they were to think that growth could grow forever and how, really, it was a humbling lesson and it’s great to be humble, and, how about buying some wireline telco or defense stocks now? As usual the talking heads are at grave risk of being taken very much by surprise if SPY moves up as we think it will, particularly if it drags up those high growth names as we expect it to.
We hope this note can help you in your work. Now… we’re thinking about buying more UPRO here… that’s the 3x levered version of SPY… because we bore easily and we never did learn to play golf!
Cestrian Capital Research, Inc. – 16 March 2022.