ETF Spotlight: The Controversy over Retail

Investing in retail stocks has involved a double-pronged controversy.  The first problem is the fundamental merits of the sector — questions related to the consumer and the economy.  There is a second problem about the structure of the ETF and the possible risks.

An additional theme for all investors is why some of the biggest names in financial journalism ran with a story that was basically inaccurate.  This is something that would not have happened in the days when editors required fact-checking before publishing.

It is also an interesting story for ETF investors, but first, let me provide some background on our perspective.


Traders all seek rewards but they have differing appetites for risk.  It is important to find a method that suits your personality and needs.  Our short-term trading systems are basically Trend-following, but also include recognition of Cycles and a touch of Anticipation.  Since we apply the method to ETFs, we call it the TCA-ETF system.  We follow two versions of this method, designed for two hypothetical clients (Oscar and Felix) with different needs and risk appetite.  [New readers can find more information about the models at the end of this article.]  For convenience, we have named the models based upon the intended clients.

Featuring Retail Stocks

We trade retail stocks via SPDR S&P Retail ETF (XRT).  The fund has 68 holdings with nearly equal weightings, so there is no major concentration.  The P/E ratio is about 14, which is in line with expected long-term growth.  The dividend yield is only 1.36%

Here is the chart.

Xrt Sept 2010

We have enjoyed part of the rally, and we still own the position. Whether we stay with it will depend on trading over the next week.  There could be a breakout to the April highs, but we could also see selling or continued consolidation.  Felix likes this position, as you can see from the details in our full table of sector ratings.

Other Opinions

We always survey commentary from other experts on the ETFs in our buy zone.  There has not been much commentary on the merits of owning XRT, but there has been controversy over the large short position.

Raising a warning is Andrew Bogan, a PhD biophysicist, university scientist, and venture capitalist.  He described a theory of ETF implosion based upon his understanding of how the ETF redemptions worked.  His story was quickly picked up by big name sources like this one and that one (to pick just two examples).  Bogan claimed that the actual holders of XRT outnumbered the stock held by the ETF managers due to massive short selling.  The concern was that redemptions might leave the XRT "longs" holding the bag.

There were some comments on the stories that explained why this reasoning was incorrect, but the best actual article I found was this post from Kid Dynamite (now added to our featured sources):

Now, Bogan fears a "run" on the ETF.  That's not going to happen (at least not for the reasons he fears), for a few reasons.  Let's start with the more complicated one, using Bogan's own numbers:  as Bogan notes, now 95mm people think they "own" the XRT.  Well, we know that only 17mm of them actually have possession of the XRT, since the other 78mm have lent their shares out to others.  You can't redeem something you don't have (remember, you've lent it out), so it's not possible for 95mm shares to be redeemed.  If some of the people who have lent their XRT out (maybe they even lent it out unknowingly) decide they want their shares back, it's not the end of the world!  The short sellers of XRT will have a few choices to return the XRT that they "owe."  They might go out in the marketplace and simply cover their short positions, or they might buy the underlying basket of XRT stocks, deliver them in to the trust, and "create" new XRT shares to deliver to the person they borrowed them from.   As Swaldman puts it, "The missing supply of ETFs would create itself."

 Anyone interested in ETFs should read the entire Kid Dynamite articleIn fact, they should read it twice.  There is a lot of information, but it is all something that you should know.

Meanwhile, we are all left to wonder why the Bogan piece got such widespread attention with so little checking.  I hope that the Kid Dynamite response gets equal billing.

 This Week's Results

Felix, the cautious approach, has continued to be mostly on the sideline with a slight negative lean.  Nearly everything is in the penalty box.  Felix sees the world as too unpredictable right now, but we are seeing a few attractive candidates.

Oscar, the more aggressive approach, is always looking for a way to win.  Oscar is unafraid of the volatility and now has many suggestions for fresh buys — mostly energy and emerging markets.

Weekly TCA-ETF Rankings

We are currently fully invested in our Felix ETF program and also for those following Oscar.  (We are happy to report and discuss performance with interested investors.  We also offer a report on how we use the models, and a free weekly email update.  Write to etf at newarc dot com.  Our actual trading is a combination of both models and some weekly timing).

Please note that these are not recommendations.  Investor needs and risk tolerance varies.  We hope everyone finds the ratings to be a useful supplement to their own work.  The recommendations can change quite rapidly in this environment.  It is quite possible for investors with different time frames to reach opposite conclusions about a specific trade.

Here are the current rankings for both Oscar and Felix.  I also note the nice move in XME and QQQQ.

Felix 092310

  Oscar 092310

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  We also have free reports, available upon request to etf at newarc dot com.  These reports describe how we use the system, compare results from Oscar and Felix, and contrast the method with our long-term trading approach.

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.

Oscar and Felix. We follow two versions of this method, designed for two clients with different needs.

  • Oscar believes in the long-term strength of the economy and the stock market.  He has a lovable and irrepressible enthusiasm.  When things go wrong, he steps back for a bit, but soon tries again.  He expects to do better than others during good times.  Oscar understands that this approach involves more risk.  Oscar is opportunistic.
  • Felix also has a positive long-term outlook, but he is something of a fussbudget.  He is much more cautious, with an emphasis on capital preservation.  He is perfectly willing to step aside from the market when there are signs of danger.  He knows that he will miss some moves, but that is OK.  He scores big gains when the market moves lower and he escapes the loss.

There is more detail on Oscar and Felix in this article.  There is more about the Penalty Box here.

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