ETF Update: Are you missing the 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 yesterday.   (you can 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

[houston auto glass]

The TCA-ETF series is very rich source of information. It provides leads to describe the challenges in system development and testing, including dealing with the inevitable losing streaks.

[depressione]

it happens, it ll not be the first, even not the last...

[Bill aka NO DooDahs!]

Most liquid ETFs are excellent trackers over time, the errors are mostly of a day to day sort. An exception would be the leveraged and leveraged inverse ETFs, which are very good on a day to day basis during average days, but are horrid over time, and horrific during extreme days, as any holder during the recent correction can attest.

!! The five ETFs you list all track different indices. !!

If you're ever in doubt, visit the sponsoring site (iShares.com) or visit Yahoo! or Google Finance, use the ETF ticker, and view either "profile" or "holdings" to see what's behind the scenes.

[Bryan Wendon]

Hi Jeff,

Sorry to post a comment on this topic so late.

What struck me about the list created by your model was that in some cases similar ETFs produced different scores. For example, the Cohen and Steers REITs (ICF) was ranked 11th while the DJ US home construction ETF (ITB) was down at 43rd, more in line with recent sector performance. It also appears paradoxical that the DJ Financial Sector ETF and S&P global financial ETF (IXG) ranked highly at 7th and 12th yet the regional banking (IAT) and broker dealer (IAI) ETFs are at 40th and 38th.

Do these model scores reflect the fact that some ETFs don't track their indexes partcularly well? I had always assumed that ETFs were good trackers, but perhaps I have spent too much time looking at the more liquid end of the market e.g., SPY, QQQQQ?

It would be very interesting to hear your take on this. Thank you for providing such an excellent blog.

[oldprof]

Tim -

Thanks for the link to some good advice. Developing a system means using variables, measures, and techniques that others have not found. If/when the world catches up, you need to move on. One of our points in this series is describing the process.

Thanks for taking the time to comment.

Jeff

[Tim]

Jeff,
Again, too much good stuff in one post. I really like your sector ETF trading approach. Look forward to how it does, esp. in various market conditions.

Unfortunately in the commission driven brokerage world, they need their customers to trade. Customer profitability is not a high priority. Besides this post by T at Investing from the Right says it all about trading systems: http://investingfromtheright.blogspot.com/2007/09/september-17-2007-investment-review-for.html#links