Sector Rotation and ETF’s: The Need for a System

We are attempting to comment weekly, each Thursday night, on the subject of system trading.  We are using our own TCA-ETF model as an example, mostly because things are easier to see when the illustrations are clear.

We expect the content of this weekly series to include topics related to System Trading, ETF Matters, Sector Rotation, and our own Weekly Update.  Reader suggestions, as always, are most welcome.  Covering these topics carefully involves a weekly review of developments on all fronts.  Readers might well choose to view this as a "linkfest" of thinking on important topics illuminated by the sector ratings.

System Trading

Most individual investors and traders fail.  Human instincts –perhaps even survival instincts — may teach the wrong lessons for investing.  Two recent posts from Barry Ritholtz illustrate the problem.  One shows the success of email spam ventures.  (Guess what?  The pros are not buying these.)  The other links emotion and trading, citing a book that we join Barry in recommending and one that we now have on our reading list).

As usual, Dr. Brett Steenbarger writes authoritatively on this topic.  He shows how emotions interfere with the normal process of causal reasoning.  Let us consider an example we can document from our own trading.

A system can be based upon fundamental analysis.  For those of us holding Apple Computer, Inc. (AAPL) fifteen months ago, there was a great challenge related here and here.  Since we were confident of our fundamental analysis, we ignored extreme volatility in the stock.  Trying to exit and get back in was almost impossible, unless one is capable of selling and then buying a gap to a higher level.

A quantitative, computer-based system helps with this.  If you are confident in your method, you can ride out adversity.  Getting that confidence requires proper understanding and testing of the model.  (There can be exceptions to the black box approach, but that is a future topic.)

For now, let us merely note that selling Apple (which we still hold) because it looked "toppy" or got "oversold" would have been a major mistake.   A system can help with this temptation.

ETF Matters

International ETF’s are extremely overbought, we learn from the astute technical analysts at Bespoke Investment Group and TickerSense.

Part of the rise has been based upon the falling dollar.  The decline of the dollar is just a question of recency, according to former Fed President Bill McTeer.  Market participants are looking at the wrong index, says Bill Rempel.  An orderly decline of the dollar is a good thing, argues Karl Smith, a young professor who has quickly earned our respect through his writings.

Since many of our positions relate to the dollar, as we noted last week, this bears careful watching.

Sector Rotation

Our TCA-ETF method is based upon sector rotation, a concept we have implemented successfully for nearly ten  years.  We were therefore surprised to learn (thanks to Abnormal Returns–always a great source for new sites) that there is a strong argument against this approach from an authoritative, scholarly source.  Why the difference in conclusions?  While details are beyond the scope of this update, let us merely say that there have been major changes in trading sector rotation.  These are largely due to the trend, described by Tom Lydon, away from mutual funds and toward ETF’s.  Those who have adapted their methods can continue to succeed.  We shall pursue this important subject further.

Weekly Update

Our own sector ratings have changed little from last week.  Here are the ratings and results as of Wednesday’s close.

The energy  position replaced a former holding that was up 5.91%, but was a loser over the course of last week.

Conclusion

A disciplined system can keep one on the right side of the market.  Nearly all of the rated sectors are in the "buy" range, reflecting overall market strength.  Once again, Dr. Brett shows why this is important.  In answering a reader question he illustrates how fundamental analysis of earnings supports the technical picture.  Readers should look at his chart and read the entire analysis.

This type of information is in sharp contrast to the arguments from the bearish punditry, a team on a mission.

Markets described as "overbought" become so on the way to new highs.  Since making new highs is the most bullish event, they get even more "overbought."  There will be future weeks where these sectors decline, get stopped out, and rotation occurs.  One of the themes of this series is that we must understand the inevitability of losses and drawdowns.  Handling these problems is just as important as capitalizing on winners.  That is why we invite readers to look over our shoulder.