ETF Update: Winners Choose and Respect Their System

Do you have a systematic approach to your investing?

You do, whether you know it or not.  If you float from one idea of the moment to another — well — that is a system.  And it is a very bad one.

ETF investors need to make several important decisions.  In today's article I want to step away from my regular weekly feature of our top sector, and focus on the important strategic choices for investors.

You need to pick a method and have the discipline to follow it.

Background – a Brief Digression

To provide some context, I provide regular updates about ETFs.  Some have found this helpful in their own ETF research.  I hope you find the series helpful, and I invite comments and questions.

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 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 clients with different needs and risk appetite.  [New readers can
find more information about the models at the end of this article.]

Momentum Investing

The inspiration for this article came from a typically excellent piece at Abnormal Returns.  Tadas explains the history of momentum investing, shows where to check out academic literature, and provides a link for those wanting to review success of the method.  He raises interesting questions about how and why this approach seems to work.  I strongly encourage readers to review the entire article and also to consider the links.  This is an important topic.

If you choose your system correctly, it will, in the end,  save a great deal of time.

Two Small Additions

As a long-time student of these methods, I suggest two small additions to consider.

First, there is the long tradition of trading price trends.  Richard Dennis, the legendary Chicago trader, in an experiment not unlike the movie, Trading Places, recruited and trained a group called the Turtles.  One of the original Turtles has (controversially) revealed some of the methods.  He makes a distinction between trends and momentum in this article.

It is beyond my scope to review the whole story, but this link will get you started if you are interested.  The Turtle alums have done very well, and so can you if you learn how to apply these methods.

Second, there is a plausible explanation for momentum.  Please keep in mind that according to the Efficient Market Theory, momentum trading should not work.  Warren Buffett has famously noted that if EMT was correct, he would be selling pencils on a street corner.  So what is the problem?

Tom Brakke, one of the very best sources on earnings and analysts (and now added to our list of featured sources), explained why momentum usually occurs as analysts revise ratings.  Briefly put, an analyst gets a new idea about a copmany and it deviates wildly from the pack.  Why beat the rest of the analysts by so much?  He posts new estimates that are only a bit higher.  Others eventually see the light, so you get a leapfrog effect.  Tom explains it much better than I have, so read his excellent piece.  If you do, you will see why it is important to watch the changes in earnings estimates. something that Zack's also emphasizes.

To summarize, the trend-following trader expects something that happened in "Time A" to continue into "Time B."  The reason is twofold:

1. Trend-following satisfies the natural human urge to connect the dots.
2. Trend-following methods actually work, with long track records of success.

It all comes down to how one defines the time periods.

Other Systems

I have had several inquiries about doomsday market predictions.  Doom and gloom sells papers and page views.  Peter Lynch once said that he could not predict the next 1000 points in the market, but he knew about the next 10,000.  This is no longer a blogworthy observation and it won't get you on CNBC!

As you read this, please understand that my company is known as a system developer and reviewer.  I am bombarded with ideas and approaches, including technical analysts of all stripes.  I could choose any method for our clients.  My comments reflect a considered evaluation.  If there were good evidence to do so, I could add a new method to our current systems (now four approaches.  I understand that loyal adherents of other methods will disagree, so feel free to chime in via comments.  My only request is that you actually use data and evidence.

Here are two recent questions:

Q: What do you think about the Elliot Wave Theory prediction that we are in the midst of a grand super-cycle correction to …….?

J:  I am not convinced.  The underlying theory lacks intellectual and evidentiary support.  The results are erratic and very subjective.  This is from technical analyst David Aronson:

The Elliott Wave Principle, as popularly practiced, is not a legitimate
theory, but a story, and a compelling one that is eloquently told by
Robert Prechter. The account is especially persuasive because EWP has
the seemingly remarkable ability to fit any segment of market history
down to its most minute fluctuations. I contend this is made possible by
the method's loosely defined rules and the ability to postulate a large
number of nested waves of varying magnitude. This gives the Elliott
analyst the same freedom and flexibility that allowed pre-Copernican
astronomers to explain all observed planet movements even though their
underlying theory of an Earth-centered universe was wrong.

The long-term results have been terrible, but the method is getting recent buzz since Robert Prechter called two recent moves for followers who had any money left.  This is very dangerous, because many observers look to systems that are "hot."

Using data from newsletter tracker Mark Hulbert, syndicated columnist
Eric Tyson showed that Robert Prechter, publisher of the Elliott Wave Theorist and
leading practitioner, has underperformed the broad market averages by 25
percent per year since 1985.^[24].
Mark Hulbert in November 2009 wrote "Prechter's advice over the last
couple of years has been top-rated. It's not just that he was bearish
during the financial meltdown — he also did a good job of playing the
various intermediate-term corrections along the way." However this
top-rated performance was short lived given that Hulbert notes that
"Prechter's longer-term record couldn't be more different. The last time
that his newsletter recommended that traders be long stocks was in
1997, some 12 years ago. In fact, during the bull market of the 1990s,
traders following his advice spent most of the time short the market or
in cash. This helps to explain why the newsletter's timing advice for
traders is in last place for performance over the last 20 years among
all stock market timing strategies tracked by the Hulbert Financial
Digest." ^[13].

Q:  What about the recent Dow Theory sell signal from Richard Russell?

A:  Our own sector models are showing the same things as the Dow theory, at least on the three-week time frame.  If you are a trader, it may be a good call for that time horizon.  Our method is an improvement on Dow Theory since it covers 55 sectors.  Meanwhile, here is a good analysis of Russell's long-term performance.  You will see that it has not been good for many years.  It is not as flexible and timely as a method that considers more sectors.

To emphasize — these are short-term predictions.  It may be completely correct for the long-term investor to buy at the same time that short-term traders are selling.  It is all about individual needs, time frames, and risk tolerance.

You need to decide if you are a trader or an investor.

Weekly TCA-ETF Rankings

We are currently short in our ETF
programs,  invested only in inverse ETF's.  (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).

I am changing the timing schedule for this weekly article.  It will now appear mid-week, with a one-day delay in the ratings.  The ratings below are from Tuesday's close.

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.  Last week I predicted that everything would be in the penalty box, and I was right.

Here are the current
rankings for
both Oscar and Felix.

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.