ETF Update: Financials Show Strength

While market averages were little changed over the last week, there was a dramatic change in sector strength.  As so often happens, our weekly TCA-ETF sector ratings provide some insight into emerging trends in the overall market as well as sector shifts.  (For new readers, there is a further explanation of our approach at the end of the article.)

There are three main themes:

1. The overall improvement in market prospects;
2. The rapid rise of financial ETF's, especially regional banks; and
3. The decline of many "weak dollar" ETF's, including country funds and commodities.

Market Conditions

Looking at market sectors provides information that one does not see in the charts of the market averages.  This week's ratings show a much more promising picture than we have seen for several weeks.  More sectors are in the "buy" range, eighteen, up from five just a few weeks ago.  The favored ETF's do not have the same defensive character that we have seen in recent weeks.  Finally, the inverse index ETF's have moved out of the top rankings.

Featured ETF:  iShares DJ Regional Banks

Rising rapidly in our rankings to take the top spot is the iShares Dow Jones U.S. Regional Banks Index Fund (IAT).  Despite the recent rebound, the sector is still down 20% on the year and more than 30% from the highs.  This chart shows the YTD moves along with a comparison to the broad market.

IAT has a P/E ratio of under thirteen and a price-to-book of under 1.5.  While many remain skeptical of the earnings forecasts for financial issues, we think that the housing legislation passed last week will be an important assist for regional banks.  (We expect President Bush to sign the bill).

Tom Lydon also cites Fed Chair Bernanke's recent testimony on the economy, Fannie, and Freddie, as a positive for regional banks.  Gary Gordon notes the Bernanke testimony and also mentions some positive early earnings reports.

Trends I'm Watching had IAT on the top performer list for last week, indicating the market strength accompanying positive comments about Fannie and Freddie.

A little caution?  One cautionary note is that IAT is pretty highly concentrated.  One holding, U.S. Bancorp (USB), makes up 20% of the fund and the top five holdings are almost 50%.  Those who are skeptical about this sector might like to consider Mike Havrilla's list of bearish regional bank plays as a hedge.

The Decline of the "Weak Dollar" Plays

It is usually interesting to look at the bottom of our sector list as well as the top.  The so-called "weak dollar" plays, so successful earlier this year, have fallen out of favor.  They now occupy the bottom spots in the rankings, taking over from the financials and the home builders.

Weekly TCA-ETF Rankings

There were many changes this week, with more indicated for the near future.  We traded out of all of the inverse ETF's.  Since the model does not predict tops in sectors, the exits come when other sectors show more strength.  This type of exit helps to preserve a winning trade.  Our gold position (closed on Friday after the chart update) was not so successful.  The rapid decline violated various model criteria, earning gold our "penalty box" rating, the equivalent of a trading stop.  Most sectors remain in the penalty box, although the overall picture is much stronger.

Using the model as our guide, we modified our multi-week bearish posture and moved to "neutral" in the Ticker Sense blogger sentiment poll.

Listed below are the week's rankings and our trades:

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method.  In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike.  While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks.  The fundamentals may be more difficult to assess.  Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's.  This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves.  Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF.  While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box."  The basic elements are used by many, and widely reported.  We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model.  We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.

Comments

[oldprof]

Venn--

The MER news is pretty disappointing -- mostly because they were supposed to have some good controls. We are long MER in some accounts. I am pretty open about mistakes - -not just success stories.

There is more to say about what went wrong here.

Thanks,

Jeff

[oldprof]

Tim and Vermont -- Good questions. No system of exits is perfect. Every trader grumbles when his stop is hit and the stock immediately bounces. The locals in the Chicago pits love to "run the stops" whenever there is a quiet day. They are looking at the same charts as everyone else.

The questions deserve a more complete answer, so I'll put it on the agenda. Let us just say that it depends on how fast a sector is moving and what is happening everywhere else. Whatever our method is, it has the benefit of extensive testing over plenty of years with a lot of out-of-sample data. This is not like your average five-year backtest.

Thanks again.

Jeff

[VennData]

Merrill, mother to all, took their hit. Based on that sale price to Lone Star, looks to be 18-19 cents on the dollar. So that's what many of the inhabitants of the XLF have to do as well.

[Vermont Trader]

"the model does not predict tops in sectors, the exits come when other sectors show more strength."

I'd be interested to hear more about how you do this.

Tx...

[Tim]

Jeff, taking a little vacation this month. Missing your posts.

I am having an interesting time watching how fast sectors can move from the top to the bottom, and vice-versa, in your ratings. Regional banks were on the very bottom just a couple of weeks ago and energy near the top. Does your model trade you out soon enough when the the market make rapid reversals?

As a contrarian indicator, I now see a bunch of international sectors near the bottom of your score card. That will now be my area to watch. I was considering the other day, if we end up with a Democratic President, House and Senate, will foreign stocks be the place to be until we see the consequences of that much consolidated power?