A Dash of Insight

Understanding the Debate on the Dollar

2009-11-12T22:08:37-06:00

A strong dollar seems patriotic. It is also meaningful to long-term purchasing power. Weaker dollars mean a higher cost for foreign products, and that is inflationary for the US consumer.

This natural impulse is at odds with current equity trading. A friend asked why the market had 200+ rally in the DJIA on Monday. My answer -- dollar weakness-- was counter-intuitive and unsatisfying, but accurate.

Dollar's Drop Helps Dow Hit New 2009 High, explained Briefing.com.

Today the Dow declined 100 points. Why? Many cited dollar strength.

Investors and traders alike need to pay attention to the dollar.

The Prescriptive Viewpoint

Some commentators who choose to advise the government on preferred policy are outspoken on both the need for dollar strength and the policies required. David Merkel calls for the Fed to raise interest rates and the Obama Administration to balance the budget. The prescription embraces a willingness, perhaps even a necessity, for the recession to become much deeper. The resulting unemployment and business failures are part of a needed cleansing process that will avert an inevitable deeper economic decline. This viewpoint is based upon economic theory, not a political viewpoint.

Others seem to advocate similar views with politics in mind. You can watch any nightly Kudlow show to get this argument about "king dollar."

A third viewpoint, represented by Bob McTeer, suggests an alternative. McTeer is a free-market Republican, but he has a pragmatic approach. He recognizes the need for dollar strength in the long run, but notes a short-term problem.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”
I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

His reason? No individual country can control the currency. All act in accord with internal political mandates.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

The Descriptive Perspective.

David Merkel and other observers are quite correct in noting the divergence between stated and actual public policy. Investors need to understand this.

There is an inverse relationship between the dollar and equity strength. There are several hypotheses (and little evidence) to explain the daily trading.

Investment Implication

There is more here than I can cover in a single piece, so I will take a deeper look. We need to investigate the dollar carry trade, the alternative causal models in the relationships, and the time frames for the various arguments. There may not be enough data for an objective answer, but I will give it a shot.

Meanwhile, investors should realize that actual policy is aimed at improving economic performance, even if the dollar declines. If you are an investor, put aside your opinion about whether the policy is correct.

ETF Update: Recognizing and Reacting to Risk

2009-11-08T16:33:35-06:00

Let us consider this interesting question: What distinguishes the "smart money" from the average investor?

My nomination is a better understanding of risk. The individual investor is always looking backwards and focuses excessively on returns. The pros try to measure risk in many ways -- valuation, economics, or even finding the next black swan. They also implement risk control through the use of sophisticated option positions, long-short trades, or outright short positions.

Determining Equity Risk

Non-quantified measures. There is a group of forecasters who make predictions about consumer behavior (spent-up) or the dollar (under massive pressure), or growing debt and Fed policy (out of control). While the specific contention can be quantified, the relationship to stocks usually is not. The result is a convincing argument about a problem, but lacking a quantifiable relationship to stocks, and especially lacking a time frame. Those taking these views all see higher market risk.

Gold. Gold has an interesting dynamic. It is a gauge of inflation, a verdict on the dollar, and a refuge for those who see systemic risk. The dollar price of gold is an objective measure. It is moving higher, even when near-term inflation risk by many measures seems subdued. The daily newspapers, many blogs, and television advertising play to these fears. It is an interesting measure of perceived risk.

Options volatility. The implied volatility of equity options is an excellent measure of perceived risk. While most think of volatility as downside risk, it can actually work either way. There are excellent sources on this topic, two of which we feature regularly.

Bill Luby at VIX and More has an excellent recent series on using VIX, the most popular volatility measure, as an investment indicator. Start here, but read the linked articles for a more complete understanding of the issues.
Adam Warner also tracks the VIX. He notes both the ascent and the sharp recent decline.

We have our own approach to risk.

Background

We have a disciplined system, where we study sectors continually, looking at the charts and ratings for hundreds of ETF's. Each week we provide a list of our top-rated sectors for the next three weeks, along with some of our current observations. ETF investors can check out the list and compare our findings with their own conclusions.

In our analysis, we consider Trends, Cycles, and a bit of Anticipation. Since we apply the model to nearly 300 ETF's, we call it the TCA-ETF system. (For new readers, there is a more complete description of our methods at the end of the article. We also have a free report with more detail on the system and results, available on request.)

As part of this analysis, we show ETF's that are in the "Penalty Box." Many readers have asked what this means, so let us explain a bit more.

Our modeling guru, Vince Castelli, recently updated our emphasis on risk analysis. Our concept is the "penalty box." The general interpretation of this approach is that the specific ETF might rise or decline in price, but the potential reward is no longer worth the risk. Here are the key features:

A stock or sector in the penalty box does not merit an investment within our three-week time frame, regardless of recent price appreciation.
The penalty box is derived from an array of technical factors. While price movement is part of the picture, it also includes other key technical elements.
In determining the criteria, we began with key hypotheses about risk, and then sought confirmation. This is not an exercise in data mining or back-fitting results.
The relationships Vince discovered proved out, on balance, in thousands of cases from many different time frames.

Does the penalty box always predict a declining price? Of course not. Risky sectors might move even higher. No one ever knows, in retrospect, how much risk was accepted for a given return. As a simple assumption, pretend that you did not pay your insurance premium last year. If you are still alive or your home did not burn down or you did not have an auto accident, you showed a profit. Was your failure to pay a wise investment?

Understanding risk is crucial to investing in any time frame.

The Macro View

From an overall market viewpoint, our indicators continue to weaken, and now reach negative territory. The key elements are as follows:

We now find only 23% of our ETF's in positive territory (99% last week). The median strength rating for the overall list is only -9 (down from +8 last week). A score of "0" implies the average long-term ETF expectancy.
98% (up from 91%) of our sectors are in the "penalty box." This means that they are currently disqualified from the buy list for technical reasons. You can think of this as a sophisticated "stop loss" rule, often applied in advance. See our article here for a further explanation of this method.
Our index package is neutral. For this rating we look at the ETF's (both long and short) for the S&P 500, the Dow, and the Nasdaq. You can see these ratings is the results table for this week. While the index ETF's have positive ratings, both the longs and the shorts are in the penalty box.

Weekly TCA-ETF Rankings

We were mostly out of the market this week. Since the S&P gained over 3%, we lost ground against our benchmark. We had mid-week sales and did a rare update for readers. We may have some mid-week buying if sectors come out of the penalty box.

We provide these ratings as information for readers who may not trade as frequently as we do. Those signing up for our free weekly email update can also get the entire list.

As noted above, the macro market indicators are in the penalty box, and most other ETF's are in the penalty box. Based upon the current model signals, we have continued our neutral position in the Ticker Sense Blogger Sentiment poll, despite the negative edge in the ratings.

Here are the top sectors from our expanded universe of 280 ETF's. The list also includes the values for the broad market ETF's and their inverses.

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.

Interpreting Conflicting Information

2009-11-07T22:35:39-06:00

A wise and valued friend called my attention to an article on municipal bonds, Short Seller: Dump Munis.

James Chanos, noted for highlighting collapses including Enron, sees bad days ahead for municipalities. State and local governments already have fiscal pressure. They have defined benefit pension programs and "platinum" health care plans. He also raises the specter of the loss of the federal tax exemption if there is a bailout.

To balance this perspective, author Tom Sullivan also cites Gary Pollack, head of fixed-income trading at Deutsche Bank Private Wealth Management. Pollack sees "headline and downgrade risk" but notes the power of these governments to raise taxes.

Even if one hates the idea of tax increases, this is an article about the creditworthiness of bonds, not one about politics. It is easy and tempting to confuse the two.

Our Take

So often these questions are posed in black and white. Either one should buy municipal bonds -- or not.

The answer might be quite different. Suppose that both Chanos and Pollack are correct. Frankly, that is my vote! We should expect a higher than normal rate of failures by municipalities. There will probably also be tax increases.

The real investment question is not which of these experts is correct. It is the following:

Do current municipal bond prices reflect the acknowledged current risks?

The article invites us to choose one side or the other. The market presents a more nuanced challenge. Municipal bonds are not right for everyone. Tax considerations are an important issues. Having said this, there are two possibilities:

An investor who has confidence in a given jurisdiction may find an attractive opportunity; and
An investor who thinks the overall market is too pessimistic may find an attractive muni fund, avoiding the locality-specific risk.

A Further Conclusion

Too many market questions are posed in the form of one side being right and the other wrong. In fact, the market prices usually reflect the debate. You are only looking for an edge.

October Employment Report Preview

2009-11-05T00:05:12-06:00

The monthly employment situation report is the most watched economic release. The attention has never been greater.

Everyone is interested in the unemployment rate, especially when it is approaching 10%. It is a natural topic for the media.
Partisan politics has a jobs focus. While the Obama Administration may be claiming jobs "created or saved," this is of little interest to most. The bottom line for most voters will be whether the net job change turns positive and the unemployment rate declines. Few care about hypothetical results.
Investors and traders question the economic recovery, despite improving data. As long as unemployment remains high, people will question the economic recovery as artificial and temporary.

The massive attention is no surprise.

Lack of Timely Data

Most casual observers take the reports at face value. Those watching closely understand the challenges in trying to do contemporaneous estimates of employment changes. This is not like an election, where we can have a "polling place" to determine who is working and who is not.

We actually have excellent employment data, a hard count from state employment agencies. The problem is that it takes six to nine months to get the solid results. I wrote about this three years ago in my article, Data We Have vs Data We Need.

Real-Time Measurements

I am going to repeat a careful explanation that I suggested two months ago. There are many sources trying to measure monthly employment changes. Eventually the state data will show who was right.

Each of the sources we cite is attempting to measure the actual net job change. A wise stat prof once said, "Suppose God whispered into your ear and told you the TRUTH."
The BLS is attempting to do the same thing, with dramatically different methods. The BLS result is not TRUTH. It is a statistical estimate. Actual TRUTH for a specific month will not be known for many months, when the state employment data are analyzed. The BLS tries to count all of the jobs in one month, all of the jobs in the next month, and then report the difference. They do this very well, but it is inherently difficult. It does not focus directly on the actual changes, as other methods attempt to do.
Meanwhile, the forecasters will all be graded by how well they predicted the BLS number -- the BLS estimate of TRUTH.
That is the wrong attitude. The BLS number is just another estimate -- and one which will not be official until all of the revisions are in. Despite this, the market will trade on the preliminary estimate revealed Friday morning.
Briefly put, everyone is trying to estimate monthly changes in a work force of over 130 million. The error band is small. The BLS -- and all of the other sources -- are doing a great job with various differing approaches.
Market participants would like to have more data, faster data, more accurate data.

It is my long-held position that too much emphasis is placed upon the BLS estimate as "official." The BLS does excellent and honest work, but other approaches deserve attention.

Few observers understand the nature and sources of error in the BLS estimate. Pundits routinely draw major conclusions from discrepancies of 50,000 jobs, when the sampling error alone is +/- 100,000+ jobs. And this does not include assorted non-sampling problems, like dealing with new job creation.

The BLS versus the Critics

The BLS approach is to make an estimate of the total payroll jobs in one month, make another estimate for the next month, and subtract the two to determine the change. They use an excellent and sophisticated survey technique to do this. Their historical record, judged by the eventual count from the states, has been very good -- until quite recently.

Some readers have asked me why the BLS even attempts to include job creation in their estimates, using their much-maligned Birth/Death adjustment. I will attempt the simplest possible explanation.

Any time you do a survey, there will be non-respondents. When the question is something like "How many people favor health care with a public option?" the non-respondent problem takes a simple form. You need only ask whether the non-respondents are similar to those who actually answered. Most polls make this assumption.

The employment question is qualitatively different. We are not asking the opinions of non-respondents. We are asking whether they are even still in business. If the BLS were to assume that non-respondents had all ceased operations, they would seriously underestimate total employment. Historical data conclusively show that the non-respondents are split between those who did not answer and those who are out of business. The data also show that new job creation, running at about 2 million jobs per month even in recessions, are a predictable function of dying businesses.

Because of this, the BLS employs a two-step process. The imputation step forecasts job creation from job destruction, and includes a cyclical component.. The Birth/Death adjustment, (the only thing cited by most critics, who ignore the more important imputation step), is a residual. For many years this residual was stable. The most recent test against the state data indicated a significant error, showing that the BLS estimates have been wrong for nearly a year, especially starting in Q1 09.

Were the Critics Correct?

The BLS critics do not look at the ultimate scorecard, the state data. I expect that most of them will "claim victory" in their criticisms, even though they never looked at the many years when they were wrong and the BLS was right. We should note the following:

There was no intentional distortion of data or results, dictated by whomever was President, as many allege.
The method worked well for more than five years, as measured by the final data.
The breakdown did not come at a "turning point" as many suggested it would. That would have happened at the end of 2007.
The breakdown did not occur because the model worked in expansion and not in recession. The big divergence happened in the first quarter of this year. The big job losses right after the Lehman downfall were not that far from the truth. Job creation seemed to stall a few months after the major credit contraction in September, 2008.

The actual breakdown in the BLS method happened one full quarter after the biggest job losses in many years. It means that job creation was seriously impaired from January to March of this year. At the moment, this is all we really know from hard data.

There may be some critic who predicted the timing of this breakdown, but I have not seen one -- and I follow this carefully. Whether or not the long-term BLS relationships resume the multi-year pattern is yet to be determined.

To repeat my main theme --- there are several methods of estimating the monthly job change. No one has a monopoly on the truth. I invite reader comment on this point. Any critic who actually looked at the state data, acknowledged the BLS when it was accurate, and forecast when their model would break down deserves some recognition.

Our Approach

Each month we ask the question, "What change in payroll employment would be consistent with other economic data from the same time period (the middle of the prior month)?

This is not a forecast, per se, since we do not posit any causal relationship among these variables. They are all concomitant indicators of economic activity.

We use the four-week moving average of initial unemployment claims, culminating in the week of the employment survey. This is the best direct indicator of new lob losses. This has improved in the last two months to a loss of 532K

We look at the University of Michigan sentiment survey, which we found more useful than the Conference Board's sentiment index. Michigan uses a panel, where some families are carried over from month to month. This is a good technique. Sentiment is influenced by employment. When people have lost jobs, or are worried about losing jobs, it shows up in sentiment. It is a good concurrent indicator. The Michigan index is now at 70.6, about the same as last month.

We us the ISM manufacturing index, which showed improvement from 52.6 to 55.7 This is solid expansion in the manufacturing sector, it is quite bullish for the overall economy. The ISM's research shows that this rating, if annualized, corresponds to a 4.5% increase in GDP, better than the preliminary report for the 3rd quarter, and occurring after the cash for clunkers and homeowner stimulus boosts.

Our long-term record has been pretty good, especially when compared to the final revised data. This makes sense because our model was derived from the final data. In recent months we have been too bearish. The BLS benchmark revisions suggest that we have been much better than first thought.

This Month's Prediction

Our indicators suggest a net job loss of about 140,000, a little better than the Street estimates of -175K.

Our estimate reflects two contradictory forces. The initial claims are still elevated, not indicating economic expansion. The ISM data are strongly positive. Our forecast suggests that we are still a few months away from real job growth. We need to see lower unemployment claims before there will be net job gains.

Other Forecasts

It is always interesting to compare the job forecasts from different sources. We follow several because of the interesting and widely varying methods they use. A wise interpretation would be to consider all of these disparate sources of information.

ADP has proprietary data because of its payroll management business. ADP sees losses of 203K.

TrimTabs also uses real time data. Their estimates are based upon tax deposits for salaried employees. They see a net job loss of 284K.

WANTED Technologies, a relatively new entrant in this field, has a model based upon online help-wanted advertising. This is an innovative and different approach to real-time data. They see a net job loss of 224k.

Conclusion

While we are (for a change) less bearish than other forecasters this month, we do not see it as the basis for a change in our trading outlook. We expect the usual full assault on the integrity and methods of the BLS, with the spinmeisters out in full force. The short-term risk/reward still leans to the short side.

Has the Market Already Made the High for the Year?

2009-11-03T22:22:33-06:00

Market followers love to make timing predictions. They come in all time frames and flavors:

The market has made the high for the day, and will now trade down. Or the opposite.
This is the bottom. Or the top.
We have seen the highs (or lows) for the year.
Or when the Dow was at 9500, would we see 10000 before 9000?

Bold Predictions

Doug Kass, on August 26th, called the high. He was off by a few weeks and a few percentage points, but he has continued to argue for this viewpoint in columns at TheStreet.com and in appearances on CNBC.

His colleague Jim Cramer has now agreed, and recommends reducing portfolios.

James Altucher sees explosive potential, after reviewing a list of inaccurate bearish predictions, writes as follows:

The economy is recovering nicely, says Altucher, and 2010 is going to be a huge year. Companies that stopped making things and fired thousands of employees last winter out of fear of a second Great Depression will restock their shelves and start hiring like mad. The federal stimulus, which has barely kicked in yet, will really get cranking. Consumers will find jobs much easier to get, and the resulting optimism (and income) will prompt them to start spending again.
And the market?
It's going to the moon, says Altucher.

Ken Fisher is looking for a 20-25% gain "by January" which is not quite the end of the year. Fisher earns one of the highest ratings from CXO Advisory, one of our featured sites.

Less Bold Predictions

Barry Ritholtz on October 27th predicted a possible 5% to 15% correction, after leaning bullish for much of the year.

Our own official predictions, recorded weekly, were correctly bullish through September, but shifted to neutral two weeks ago. We use a three-week time horizon for this forecast.

What Does it All Mean?

It all depends upon one's time frame. Are you trying to trade the market intra-day? Are you using a one-month time horizon? Do you have the long run in mind?

Each investor is different -- different in risk tolerance, time to retirement, time to a need for college funds, mix of asset allocation. It is not all about market timing.

In my conversations I find that most investors are missing the big picture. Peter Lynch (with the Dow at 4000 or so) famously noted that he could not predict the next 1000 point move, but he was confident of the next 10,000 points.

I agree, and here is the main problem:

Most investors are still responding to fear.

The current fear dates from last year, causing most to miss the market rebound. Now many feel that they have "missed the move" and what they read reinforces the fear.

Here are some thoughts that I am sharing with my own clients:

My initial target for this year was the pre-Lehman level from last fall. We have not yet reached this target, but we will. We have averted the Great Depression that the market was forecasting at that time.
There are many attractive stocks. I am selling some holdings only because there are others that offer even better chances. Try to focus on specific company chances instead of general market commentary.
The analysis of economic prospects is polluted by political punditry. Many commentators have a vested interest in a certain political outcome. Others are trying to sell books or high commission products. It is a minefield for the general and inexperienced reader.
Economic data continues to improve, despite a well-orchestrated chorus of critics.
The stimulus efforts have worked, and there is plenty more in the pipeline. Most of the pop economists have the viewpoint that the stimulus will stop and the economy will fail.

Reactions on the Economy

Stimulus efforts may jump start a real move. Check out today's auto sales data, after the cash for clunkers initiative, and you will see a real improvement -- small, but a start, not a bubble.

Most of the stimulus funds are still in the pipeline.
The Obama Administration is committed to keeping this going until it works, including things like the incentives for home buyers.
The major complaints -- deficit spending -- are in a different time frame.
Watch Warren Buffett, who made the deal of his lifetime buying a railroad today.

It is a time to separate one's political viewpoint from one's investment viewpoint. Those who are fighting the Fed, fighting Obama, and fighting Congress are spitting into the wind.

ETF Position Update

2009-11-02T21:21:26-06:00

Each week we publish the ratings from our TCA-ETF model. Regular readers know that we use sector information to take a market perspective, but also choose individual ETF's.

I also choose a sector to highlight each week, providing fundamental information, a chart, our reasoning, and comments from other experts.

As we always note, this is not intended as investment advice. A sector rotation program is not suitable for all investors. Our time frame may be different from the reader's. It is news information, intended to be an additional source of information -- only a part of your own due diligence.

We strongly recommend that readers who like the system should just call me and consider becoming a client. We run the model twice a day (at least) and respond immediately to any changes. I try to keep costs low and deliver a service that adds value. We help investors determine suitability, needed account size, and expected trading costs.

Having said this, I know that some readers are trading the (delayed) signals on their own. I try very hard to highlight sectors that I think will be strong candidates, at least for the upcoming week. In yesterday's article I noted that many sectors were getting a penalty box flag, and that this might happen mid-week.

In general, I do not provide mid-week updates on ETF's. This is mostly out of respect to our clients, who pay for a real-time service. Having said this, I am uncomfortable with yesterday's highlight of VGT, which hit our penalty box today. I still like VGT for a longer-term play, but we will sell tomorrow in trading accounts. Given the swift change, I feel it appropriate to give a "mid-week" update. We respect the current level of risk in the market, and hold only partial positions in our ETF trading.

ETF Update: A Glimmer of Hope for Growth Stocks?

2009-11-01T20:23:45-06:00

After last week, traders may wonder if there is a glimmer of hope anywhere. The market correction expected by many pundits for months finally had a serious impact. Sentiment and expectations have shifted despite a solid earnings season. The market debate continues to focus on the economy, with each data point the subject of both careful analysis and also plenty of spin.

While we participate in the analysis of economic data, we also have a reality check. Our model-driven approach is based upon market data.

Our Approach

We stick to the system, studying sectors continually, looking at the charts and ratings for hundreds of ETF's. Each week we provide a list of our top-rated sectors for the next three weeks, along with some of our current observations. ETF investors can check out the list and compare our findings with their own conclusions.

The Macro View

From an overall market viewpoint, our indicators continue to weaken. The key elements are as follows:

We now find 99% of our ETF's in positive territory (89% last week), but that is a bit deceptive. The median strength rating for the overall list is only 8 (down from 21 last week). A score of "0" implies the average long-term ETF expectancy.
91% (up slightly from 89%) of our sectors are in the "penalty box." This means that they are currently disqualified from the buy list for technical reasons. You can think of this as a sophisticated "stop loss" rule, often applied in advance. See our article here for a further explanation of this method.
Our index package is neutral. For this rating we look at the ETF's (both long and short) for the S&P 500, the Dow, and the Nasdaq. You can see these ratings is the results table for this week. While the index ETF's have positive ratings, both the longs and the shorts are in the penalty box.

Spotlight on Technology Growth Stocks

There are few bright spots among market sectors, but we see some opportunity in the Vanguard Information Technology ETF (VGT). The fund seems pretty expensive with a P/E ratio of 40 and earnings growth of 20%. This PEG ratio of 2 is not attractive to long-term growth investors. 56% of the fund is in the top ten holdings, including names we know. Here are the top five: MSFT, AAPL, IBM, CSCO, and GOOG.

So why is the fund attracting interest?

One factor is that some of the biggest holdings (Microsoft and Apple) are companies with strong balance sheets and plenty of cash. In these circumstances, the trailing P/E ratio may not tell the entire story. While there is controversy about valuation, many are looking for the best ways to play a rebound.

ETF Database highlighted the sector at mid-month with the following comment:

As with most Vanguard Funds, this Technology ETF does a great job at keeping expenses down; its expense ratio comes in at 0.25%, making it the lowest in the category. The fund also has one of the highest percentage weightings to Google and IBM (a combined 13.2%). This ETF also offers deep exposure to the tech sector, with more than 400 individual holdings.

Early in the month Tom Lydon noted interest in this ETF, something that continued during earnings season.

Gary Gordon also had his finger on a key market concern. Were earnings driven merely by cost cutting, or were some companies achieving revenue increases? He mentioned VGT as an ETF to watch in his article, Stock ETF's Most Likely to Win the Revenue Race.

Here is the chart.

The ETF appears to be at a key point. It is quite possible that a decline could trigger a "penalty box" sale. Meanwhile, there also seems to be rebound potential and we added the position for some accounts on Friday.

Weekly TCA-ETF Rankings

We lost over 4.5% last week, slightly worse than the S&P 500. We do not currently hold a full position, since few ETF's outside the penalty box have strong ratings. We do not buy ETF's in the penalty box or those with poor liquidity. With the market decline, the penalty box was active, so we had more frequent trading. This may also be true when we get a rebound and sectors come out of the penalty box.

We provide these ratings as information for readers who may not trade as frequently as we do. Those signing up for our free weekly email update can also get the entire list.

Here are the top sectors from our expanded universe of 280 ETF's. The list also includes the values for the broad market ETF's and their inverses.

Note for New Readers

[Full disclosure: We are long VGT, MSFT, and AAPL in various accounts.]

Understanding Market Volatility

2009-10-30T21:31:46-05:00

Investors and traders alike need to understand market volatility. Many market observers use volatility as a euphemism for price declines. This is completely wrong.

The astute options analyst Adam Warner (one of our featured sources), does a great job with this concept. Writing about the Market Vectors Gold Miners (GDX), he makes this important point:

Volatility is about fear of the unknown, and so long as gold and currencies get out of range a bit, there's apparently a bit of fear around of either missing another leg up or missing an about face down. (emphasis added)

A Natural Human Trait

Accepted lore is that markets hate uncertainty. It is a normal human trait, one that is manifested in collective behavior as well. Here is a simple example.

Airline passengers are quite sensitive to the unusual. I was thinking about this on my trip this week to the West Coast. (I always expect to post an article or two on these business trips, but usually fail. Sorry!) My seatmates on both flights had a lot to say about the pilots who somehow missed their destination, flying 150 miles past the airport and losing contact with air traffic control for more than an hour. Everyone I talked to was confident that the pilots dozed off, and dismissed other explanations.

I fly on United and enjoy the flight deck feed on Channel 9, the conversation with ATC and the towers. The Wall Street Journal cited the calming effect of this feature:

Many passengers take comfort in the back and forth between pilots and air-traffic control. Mr. Ohnstad, a technology project manager in the banking industry, says he sometimes worries about noises and jolts while in flight. "But I hear the pilot's calm voice telling ATC that 'We're experiencing continuous light chop,' and I can relax more," he said. "It's fear of the unknown that causes apprehension. Pilots can't update you every 30 seconds."

Personally, I have often enjoyed specific benefits from the flight deck commentary--often warning that choppy skies are ahead. The funniest case was when we were parked at O'Hare waiting for a gate and the pilot asked for a small move to a new parking spot. His passengers were getting restless! I was one of the few to know the secret.

Anyone who flies often will enjoy the excellent blog from Captain Dave, who provides inside information from the perspective of the pilot, including an insightful treatment of the recent incident.

Applying the Lesson to the Market

When following the market, an explanation of each day's trading can be a calming influence, just like communication from the pilot.

The problem? The explanations are all different and generally lack any evidence. Here are today's candidates.

Business Week explained as follows:

U.S. stocks closed sharply and broadly lower Friday, led by financial issues, as disappointing reports on personal spending and consumer confidence stoked investors' concerns about the economy. Treasuries jumped as stocks skidded.

MarketBeat had a similar take:

For months, investors have worried that the recovery of both the economy and the stock market had more to do with heavy government stimulus than with fundamental economic improvement. Now those fears are raising their heads again.
The concerns sent stocks down sharply back on Wednesday, but seemed to dissipate Thursday, as a stronger-than-expected government estimate of third-quarter economic growth helped stocks erase the week’s losses in a single day. Today, weak reports on consumer spending and consumer sentiment have put the bears in the driver’s seat again.

Briefing.com has a very different viewpoint:

There wasn't any immediate cause for this session's decline, though some market watchers point out that stocks have had an increasingly difficult time of climbing higher since making their strong runs in recent months. Others have pointed out that there may be some month-end portfolio rebalancing and window dressing accounting for the recent whipsaw trade.
Nonetheless, the concerted selling effort brought about a spike in volatility. That sent the Volatility Index, often dubbed the Fear Gauge, up 24%, which marks its sharpest single-session spike by percent this year. Moreover, the VIX now stands at its highest level since July. Complementing the spike in the VIX is an elevated put-to-call ratio of 1.2, which is indicative of positioning for downside protection.

Art Cashin, a great reporter of floor sentiment, emphasizes the relationship between stocks and the dollar. He notes that there is a high correlation -- weak dollar, stronger stocks. He believes there is great risk in a dollar spike. The CNBC interviewer pushes him hard on the nature of this relationship, suggesting that both the dollar and stocks are reacting to a change in appetite for risk. Watch the video, beginning at 3:21.

Our Take

The question to Cashin was a good one. It is what is called a "spurious" relationship. Two variables are highly correlated. Observers, in this case the NYSE floor traders, infer causation.

Here is an example I used in class. You have a person in the middle of a traffic intersection with a stoplight. When the light turns green in a given direction, he waves the traffic to go through. The actions of the guy doing the waving are perfectly correlated with the traffic movement, but there is no causation.

Now let us suppose that the traffic light is out, and the person in the middle is wearing a police uniform. The inference of causation is quite different.

Proving causation requires more than showing a correlation. It requires solid evidence of timing, one variable leading another, and also a strong hypothesis about the logic of causation. It is also useful to have statistical controls. Art Cashin is on target when it comes to the floor trader attitudes, but they might all be fooled by a spurious relationship.

Meanwhile, there is plenty of evidence that the market is currently trading on perceptions of economic strength. It is quite possible that we could see a stronger economy, a stronger dollar, and stronger stocks. Or the opposite.

This explanation may not be comforting to investors, but at least it suggests what to watch. That remains our focus.

ETF Update: Looking to the Internet

2009-10-25T22:00:55-05:00

With the market treading water, it is ever more difficult to find a promising sector. Each week we use our sector model to find the best ETF's and give us some insight into the overall market. Our macro look has become more negative, but there are still a few bright spots.

Our Approach

The Macro View

From an overall market viewpoint, our indicators continue in positive territory, although it is a close call. The key elements are as follows:

We now find 89% of our ETF's in positive territory (94% last week). The median strength rating for the overall list is 21 (down from 25 last week). A score of "0" implies the average long-term ETF expectancy.
89% (up from 75%) of our sectors are in the "penalty box." This means that they are currently disqualified from the buy list for technical reasons. You can think of this as a sophisticated "stop loss" rule, often applied in advance.
Our index package is neutral. For this rating we look at the ETF's (both long and short) for the S&P 500, the Dow, and the Nasdaq. You can see these ratings is the results table for this week. While the index ETF's have positive ratings, both the longs and the shorts are in the penalty box.

Spotlight on the Internet

We trade the Internet stocks via the PowerShares NASDAQ Intenet Portfolio (PNQI). The Internet group includes top holdings in the names everyone knows, with the top five constituting 45% of the fund. As we might expect, the dividend yield is zilch, the P/E ratio is a touch over 30, and the price-to-book is over 3. This is a growth story. Here is the chart.

It is easy to see from the chart why the model has picked up this sector.

Eric Dutram at ETF Database highlights the fundamental support for the sector, citing strong earnings from Microsoft and Amazon.

Most of our regular ETF sources have little to say about the Internet.

Weekly TCA-ETF Rankings

We had a small loss last week, a bit better than the S&P 500. Our current holdings are still not near the top in strength rank, but they still have good ratings. Our testing has shown what Vince calls "robust" results for anything with a positive strength rating. We do not buy ETF's in the penalty box or those with poor liquidity. We provide these ratings as information for readers who may not trade as frequently as we do. Those signing up for our free weekly email update can also get the entire list.

As noted above, the macro market indicators are in the penalty box, and most other ETF's are in the penalty box. Based upon the current model signals, we have shifted our marginally bullish position to neutral in the Ticker Sense Blogger Sentiment poll.

Here are the top sectors from our expanded universe of 280 ETF's. The list also includes the values for the broad market ETF's and their inverses.

Note for New Readers

Finding Stock Ideas

2009-10-21T21:14:39-05:00

When there has been a nice market rebound, we should expect to hear the familiar refrain: It is a stock picker's market.

This wise-sounding expression means that it is no longer good enough to "buy the market" whether through index funds or market stocks. It is time for some actual analysis.

There is some truth to the claim. Last autumn nearly everything went down. Even the hedge funds with inside information, with managers going to jail, lost on their long positions! At times this year, everything has gone up, no matter how weak the company.

This is not the "new normal" and it is certainly not the old normal.

The ability to find outstanding stocks is important.

The New Weekly Series

As I noted in yesterday's piece about my blog agenda, I am going to write something each week about how the individual investor can find attractive stocks. This is not directed to traders, although they may find a few interesting ideas. Each article will be a building block for my work in progress, a book for people who are not currently reading investment blogs. Since I have investment advisors and individual investors in my readership, I am hoping for plenty of suggestions and comments to keep me on the right track.

Each week I plan to do an article that considers one part of the stock-picking process. I hope that it keeps up with reality, generates ideas and selections, and helps us all make money. I might be too slow in the writing, but you can all join in the criticism.

Passive Approaches

There are many sources of stock ideas, but passive approaches are not the focus of this article, Maybe I will revisit this topic, but there is a big hurdle for most investors. I spend many hours each week reading opinions, analysis, and data about stocks. The individual investor cannot match this.

Those favoring this approach might consider the following:

Jim Cramer's work, both on his website TheStreet.com and his CNBC program is a source of stock opinion and investor education. I like it better as education, since the many recommendations may be difficult to track. Anyone regularly watching Cramer should have learned the need to do homework -- an hour a week on each stock position. This is the minimum.

Seeking Alpha "investment ideas" is another fine source. Check it out.

There are many other sources of ideas from reading -- the subject for another article. Here is the most important piece of advice about passive approaches:

Beware of Stock Tips

The problem is twofold. The tipster is almost always swinging for the fences -- high reward, but high risk. More importantly, you will not know when to exit. Buying on a tip puts you at the mercy of the continued advice of the tipster.

This is a big mistake of the individual investor, and a common one.

Active Approaches

Stock screening is a great way to find new ideas, if you have a sound approach. The emergence of various screening tools have put dangerous instruments into the hands of the inexperienced.

Let us suppose, for example, that you are worried about the market and decide that a great dividend yield will provide protection. If you screen for the highest-yielding stocks, you might simply generate a list of companies that are about to cut their dividends! It is not so easy.

If you want to explore stock screening you can do no better than paying the modest membership fee and joining The Kirk Report. Charles Kirk is an expert at this technique and he highlights screens that have a proven record. This is a continuing source of great ideas.

Thematic screening is another approach, the basis of my own Great Stocks program. In my first article in this series, I suggested some interesting current themes. If you have not read that article, I suggest that you review it before proceeding.

Pursuing a Theme

I start with the assumption of a theme. For the purpose of this example, the theme is a continuing economic rebound. I realize that many reject this assumption, and that is fine. It actually helps in finding good opportunities.

I am looking for companies that could have explosive earnings growth potential if the economy continues to improve. That is the first screen. I then try to analyze the company in more detail. Most importantly, how much downside might there be if the thesis does not play out?

The point of this article is to find candidates. In future articles I will examine how the investor should be skeptical and challenge the potential stock price increase.

One of the very best sources for this type of screening come from the companies themselves. What is the business model? How are they developing a strong position? And most importantly, can there be explosive stock price appreciation.

Today's key concept is earnings leverage. A company that has costs under control and a business model prepared to deliver should be talking about earnings leverage.

The key resource is the Seeking Alpha transcripts of conference calls. The Seeking Alpha team covers many calls and it is a searchable database. If you search the transcripts for "earnings leverage" you get 128 hits, and you can sort by date. This means that you can look at companies that claimed leverage earlier this year and see how they are doing.

This is a powerful and valuable resource. A couple of years ago conference calls were a high-priced subscription service, available only to the pros. It is now free, available to us all, if you only know how to use it.

Finding a Case Study

The first step from a screen is putting the stock on your "watch list." You follow the company news, the chart, and the economic backdrop to see if the story is playing out. We are not trying to pick bottoms. It is completely acceptable to buy a stock at a higher price when the reward/risk ratio has improved.

Here are some ideas from the search. I invite reader nominations for our more detailed analysis.

Zebra Technologies Corp. (ZBRA)

Lennox International, Inc. (LII)

Manhattan Associates, Inc. (MANH)

Zep, Inc. (ZEP)

Applied Materials, Inc. (AMAT)

Varian Semiconductor Equipment Associates, Inc. (VSEA)

Teradyne, Inc. (TER)

Other suggestions are most welcome. To be continued.

[No current positions in mentioned stocks, but I am watching.]