Are You Missing the ETF Rally?

How has your portfolio been doing? If you are not happy with the answer, it might be time to ask why.

Best Use of ETF's

We know that many investors and fund managers have been caught in the negativity bubble. They focus on a macro-economic debate, mostly between economists and non-economists. Regular readers know that we have tried to expose this.

Meanwhile, the market is conveying a very different message, as noted in Dr. Brett Steenbarger's must-read article, "Why Aren't Stocks Forecasting Recession?"

Those following a disciplined investment method, adjusting for market cap size and style, have captured the move. My friend and RealMoney colleague, Steve Birenberg of Northlake Capital Management, graciously provides occasional updates for his system. On September 5th, he wrote on RealMoney (subscription required and worth it) as follows:

For the third consecutive month there were no changes to my Market Cap and Style models. The signals remain large cap and growth. Client portfolios own the S&P 500 Spyder (SPY) and the iShares Russell 1000 Growth (IWF) to take advantage of the current signals. The large cap signal from the Market Cap model remains one of the strongest readings in the monthly data I have going back to 1980. All ten factors covering a breadth of economic, interest rate, and stock market technical indicators are flashing a large cap signal. On their own, each factor has in the past shown predictive ability for anticipating relative performance of large caps vs. small caps as measured by the S&P 500 and Russell 2000. With the weight of the evidence from a broad array of previously accurate indicators lined up so solidly in favor of large caps, I feel very good about the prospects for large cap outperformance to continue for at least a few more months.

Our Own Method

Our own TCA-ETF model has captured another dimension, the decline of the dollar. The effect is described in a good column from MarketWatch. Since we use an iShares universe that includes foreign ETF's, we capture all of these effects through computer-based technical analysis. This is the complete set of rankings, showing our actual holdings, entry dates, and returns through last Wednesday.

click to enlarge

This is a complete set of sector ratings. The IEZ position was closed and IXC purchased because of the relative rankings. The sectors marked with an asterisk are in what we call "The Penalty Box," stopped out for violating specific criteria.

The Sector Message

The most important conclusion from the rankings is that almost forty sectors qualify as a "buy" based upon our analysis. The positive expectancy is broad-based.

The next message is that certain themes -- especially foreign ETF's, energy, and basic materials, show the greatest strength.

Why Not All Top Sectors

Our investment discipline attends to risk considerations and diversification, so we have limits on sector concentration. Overweighting some groups is an element in beating the market, but risk control is important.

Stops and Exits

Part of risk control is the use of "stops." This is a tricky topic, worthy of a separate analysis, so it will be part of a future weekly update. All good things have an end, and exits are important. The perceptive Adam Warner highlights the risk in one of our key holdings.

Fundamentals

Some investors focused on fundamentals have enjoyed similar gains. Unlike our partnerships, our individual accounts include no foreign ETF's but there is considerable overlap in holdings. Many US corporations have significant earnings from abroad and strong earnings prospects.

At "A Dash" we view fundamentals in terms of forward earnings prospects versus alternative investments. The market is recognizing that bonds and real estate have weak prospects relative to stocks. This is another way of saying "Fed Model," a valuation topic familiar to regular readers.

Implications for Investors

There are many traps for the investor. Spending a lot of time reading pundits who start with the conclusion and then find the evidence is the single biggest trap. Amazingly, some of these sites are the most popular and highest-rated on the Internet. Go figure.

Another trap comes from the financial media. The stories seem always to focus on the worries. That seems to get reader attention. Few provide good information on the multi-year growth of earnings -- far outstripping stock performance.

Meanwhile, the online brokerage commercials are a huge trap. They lead the investor to think that his/her own market "feel" can beat the experts. Some even encourage one to develop and backtest a trading system. The main purpose of our TCA-ETF series is to describe the challenges in system development and testing, including dealing with the inevitable losing streaks. Most people trying this at home will make all of the common mistakes and get terrible results, as described here.

A thoughtful reader can learn to do better.

Comments

[Uncle Bill]

I noticed that your positions in this article are only a month old, so I checked your previous posts to see how you've been doing. On June 20, with SPX a 1512, your post was Outlook Continues to Be Bullish. About two weeks later, July 3, with SPX at 1534, your title was Outlook Moves to Neutral from Bullish. Three weeks after that, with SPX at 1511, your title was Outlook Shifts to Bullish. Ten days later on August 2, with SPX at 1472, you wrote "What has happened in the last week has little to do with the valuation of most stocks. We find many attractive buys on our "watch list" and we have added to our positions." Two weeks later, on August 17, you wrote, "Our intermediate term model turned neutral as we reported on August 1st, and negative a couple of days later." At the time of the post, SPX stood at 1411. That was pretty much the low for the summer. What's a thoughtful reader to conclude?

[Jeff]

Uncle Bill -
Thanks for your question. I can see that you did some research with genuine interest, so let me try to clarify a few things.

While I have been trading market sectors through model-based rotation systems for nearly ten years, the application to the ETF's, and particularly to iShares, is a new approach for us. I have tried to explain why this universe is especially good for our model, and I'll write more on this in the future. Meanwhile, the record you see here is what we actually did. The articles include a rapid trade in and out of a sector in August, and how we were out of the market for a month.

I am trying to illustrate what it is really like to trade a system. Most people do not understand at all. I do not expect to call bottoms and tops with this method. In fact, I know that I will get whipped around at transitional points. How? From studying the careful, out-of-sample back tests, so I am prepared for what I get. I also know there will be some negative patches and drawdowns.

We use this model for our intermediate outlook even when I personally disagree. (Over the years, the model and I have been pretty close overall, both with excellent records.) Because we make our position public on the Ticker Sense blogger sentiment poll, you can check us out for a longer period. When the model is negative, we include short ETF's to hedge the position. We might still be net long, but the percentage has been reduced.

I am still trying to figure out what to include in these articles, and what the timing should be. Your comment is helpful in that regard.

Thanks,

Jeff