ETF Update: The Financial Rebound

In the midst of extreme volatility, financial stocks have shown some relative strength.  Some have described this as a rotation out of the popular hedge fund position:  long energy, short financials.  There are many different ETF choices related to financial sectors.  Two weeks ago we highlighted the rise of these sectors, featuring regional banks (IAT), but the strength ratings were relatively modest.  This week our ratings show strength in the 100 range.  Sectors with this rating are forecast to perform in the top two percent of historic sector returns over the next month.  (For new readers, there is a further explanation of our approach at the end of the article.)

As usual, we shall look more deeply into the fundamental factors that underly this change in strength and consider the implications for the overall market.

Dow Jones U.S. Financial Services Index Fund


Our featured ETF this week is the iShares Dow Jones U.S. Financial Services Index Fund (IYG) .  It includes 135 securities split 60-40 between banks and financial services companies.  The top five holdings constitute 40% of the fund including Bank of America (BAC), JP Morgan Chase (JPM), Citigroup (C), Wells Fargo (WFC), and Goldman Sachs (GS).  The P/E ratio is 15.6, book value is 2.15, and a beta of 1.4.

Earnings reports from Freddie and Fannie affected the group this week.  Estimating the extent of further markdowns and write offs of assets is a continuing challenge.  Both Fannie and Freddie disappointed with their reports, weighing on the other major financial companies.

Another factor is the continuing story about Auction Rate Securities.  As Tom Lydon noted early in the week, the New York investigation of Citigroup posed a challenge for many financial ETF's.  With the announcement of the settlement, Citi traded lower and there was speculation about the impact on other firms that had offered these securities.

Writing in Barron's, Jacqueline Doherty has a nice summary and analysis of the current state of the ARS problem.  There is a wide range of security values depending upon the original issuer.  Also, some of the dealers have developed alternative structures to help in restoring liquidity.  The large dealers might choose to (or be forced to) repurchase the securities at a loss, perhaps pending the development of new structures.

We agree with this conclusion from the article:

"This is a relatively low-cost political settlement," says Brad Hintz,
a brokerage analyst at Sanford C. Bernstein. Buying the securities
won't help the firms' efforts to shrink their own bloated balance
sheets, but even at Merrill, the $12 billion of auction-rate securities
it agreed to purchase is tiny relative to its balance sheet of about $1

When prices get low enough, investors sometimes see value despite the mixed fundamental picture.

Weekly TCA-ETF Rankings

There were no trades this week.  The positions have done pretty well in a very difficult market.

The fraction of sectors in the "penalty box" is now about half, a great improvement in the overall picture.  The overall market indexes have pulled significantly ahead of  the inverse index ETF's.

Using the model as our guide, we shifted from our recent "neutral" forecast to "bullish" 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

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.

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  • VennData August 11, 2008  

    It’s not, as Brad Hintz states, whether the write off is a function of Citi’s balance sheet, but Citi’s capital.
    Furthermore Citi does NOT have a “[$1T] balance sheet,” but – might, since no on knows – have $1T in assets …at last reckoning …maybe.
    As for comparison purposes, Lone Star may agree with Citi’s balance sheet values, while John Thain at Merrill probably doesn’t agree.

  • Jeff Miller August 11, 2008  

    Venn — Maybe I should have said a bit more after capturing the quotation. The ARS firms are developing some alternative products that will take these off balance sheet. There was a delay in doing this while waiting for some Treasury tax rulings on new products.
    It is, as usual, a case of money market investors reaching for extra yield. Dealers try to provide a product to meet the demand and make a profit. The main point is that many articles act as though the entire notional amount is at risk. In fact, the issues is the imputed value from a change in rates and time period.
    Thanks for your comment. I could have been sharper in the explanation.