A Dash of Insight

ETF Update: Trading Discipline in a Time of Turmoil

2009-11-30T00:11:36-06:00

When there is news that seems to be dramatic, it creates a stressful environment for traders and investors alike Everyone should analyze the fundamentals of the situation, as we did on Friday.

It is also helpful to have a system. Understanding your own method is the key. It requires a level of system development and testing where you have real confidence. Our own method is not geared to turning points in the market, but it reacts pretty quickly to key changes.

Background

In our disciplined system, 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.)

The model also provides a nice feel for the overall potential of the market. I'll take a look at the macro picture first, and then take a look at our featured sector of the week.

The Macro View

From an overall market viewpoint, our indicators have improved. The key elements are as follows:

80% of our ETF's in positive territory ( up from 55% last week). The median strength rating for the overall list is a plus 18 (up significantly from +1 last week). A score of "0" implies the average long-term ETF expectancy.
Only 27% (down from 97%) 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. We implemented some faster filters this week, accelerating moves both into and out of the Penalty Box.
Our index package is positive. 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.

Spotlight on Dubai

It was a week of turmoil. Occasionally breaking news seems more important than trading fundamentals. This is especially true in a holiday week, where thin, half-day trading exaggerates the impact.

Looking at Fundamentals

There are many different ways of interpreting the news depending upon one's method and time frame. There were plenty of instant experts on Dubai. At Abnormal Returns, the go-to source when you want viewpoints on a current issues, you can find the expected arguments. These range from those who foresee a massive sell off to those who view the problem as "contained." (Someone needs to find a synonym for that word in a real hurry!)

Abnormal Returns serves up the best arguments from all sides, and then it is up to you. That is fine for a certain audience, which includes those looking for assurance that their current position is correct. Many readers need more, including some interpretation of the conflicting analysis. David Merkel wrote a thoughtful analysis and also included some good links. His conclusion is mixed.

Jim Bianco, writing at The Big Picture, emphasizes the importance of the timing of this issue. His nice article includes capsule summaries of many mainstream media pieces.

My own Friday piece may be useful for those trying to interpret the news. I attempted to highlight the actual analysis and how to interpret the actual trading by following the dollar. If you are not really an expert on Dubai, why pretend? It is better to evaluate the arguments and issues.

In my own review, I was troubled by several prominent bearish arguments:

The market reaction showed the inherent fragility. In fact, the market reaction was little more than normal volatility, especially in thin trading.
The dollar would have a flight-to-quality, leading to major stock selling. Actually, the dollar spiked at the opening and sold off rather quickly. The dollar lost ground to the Yen, but DXY is still in the range from the past week.
The dollar carry trade is about to unwind, and the market could crash. I am really trying to pin down how the cross-currency carry trade relates to US equities. There is a generalized claim about "printing money", borrowing at zero percent, and buying "risk assets" which are deemed to include stocks. I am still looking for the specific mechanism for borrowing at zero percent and buying stocks. I invite reader enlightenment on the specifics. (I wrote about the correlation, but there are many conflicting reasons for that.)
Most of those advancing these arguments have been looking for such signals for many months. There is a natural "reach" for any evidence.

On the other side, there seem to be many reasons to view this problem as a matter for lenders and backers, in an amount that is small compared to their assets. A solid analysis of other areas that are real-estate dependent would be most welcome.

Looking to Your System

An important check on one's fundamental analysis comes from actual trading. Our TCA-ETF system helps us in this way.

By looking at actual trading -- not just the immediate reaction, but data over a few sessions -- one can learn the market verdict. There is an important lesson:

Even if you are correct in your fundamental assessment, the market may disagree.

In such cases it may be better to live to fight another day. Meanwhile, our method smooths out the trading blips from a day or two. It remains bullish, and we will watch to see if the verdict changes.

Weekly TCA-ETF Rankings

We got back into the market this week, and the timing was not good. The S&P was about even while we lost some ground (two percent), especially since foreign markets did not catch up on Friday. We expect more accurate marks on our foreign ETF's on Monday.

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 moved to a bullish posture 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. While the list is, as usual, from the prior day's close (Wednesday), the Friday output is not dramatically different.

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.

Reacting to News: What to Make of Dubai?

2009-11-28T00:19:41-06:00

Here at "A Dash" we try to identify the best experts on any subject. Since we are free to position our clients in any way, we are consumers of news and analysis. So are you.

While I manage client portfolios in real time, my writing is after hours. I am not trying to advise people with short-term trading horizons. Our TCA-ETF approach (still bullish) has a three-week time horizon. Our program for long-term investors has an even longer time frame.

When I write, it is an honest assessment of my own views and an attempt to find the real authorities. It is not trading or investment advice. It is just something you might want to consider.

The Issue

Each night I get the daily report from Charles Kirk, a valuable service for his subscribers. Charles (who is currently neutral on the market in all time frames) always includes a quotation with his analysis, and today's is especially apt:

"Look at market fluctuations as your
friend rather than your enemy; profit
from folly rather than participate in it."
- Warren Buffett

This is a great statement of the issue. Is the Dubai reaction the start of something bigger, or an opportunity to "buy a dip?"

The Analytical Viewpoint

At TheStreet.com's Real Money site (subscription required) Marc Chandler, a source for whom we have great respect, wrote as follows:

We stress again that the current troubles being seen in Dubai are a direct result of its efforts to tie its fortunes to global real estate, tourism and services, and are particularly unique to Dubai and should not have wider implications for sovereign EM risk. The property boom helped this strategy work in the good times, but the popping of the global real estate market has put severe strains on Dubai.
Developments in Dubai should thus be seen in the context of the entire country basically being geared toward real estate development and not in the context of EM sovereign risk and fundamentals. Thus, while the current period of risk-off trading could yet persist, longer-term investors should be looking for buying opportunities in EM during this correction.

We note the careful analysis of the nature of the problem, and how it might be connected to various markets.

The World Leadership Viewpoint

Other sources also provided perspective on this issue.

Banks, world leaders play down Dubai debt threat, from Reuters. The article quotes leaders from the US, Britain, France and Japan.

The Bearish Viewpoint

Those who have been calling for a market correction see this as the start of something big.

Pimco, with a bearish viewpoint on stocks and now even seeking less risk in bonds, calls it the start of an "overdue correction."

Others, whom we will not name, see this as the first step in the decline of commercial real estate. Or they say that we should not believe anyone who sees this as "contained" because someone or other said that subprime would be "contained."

The Trading Viewpoint

Barry Ritholtz, despite a continuing bearish tone from most articles, expected a rebound from the overnight bottom and was pretty accurate with his pre-opening call.

Our Take

There is a widespread acceptance that any warning of doom is correct, and every event is proof. If so, the case against buying stocks is clear. There will always be something to worry about.

Today's bears did not make a very good case.

I watched the currency trading closely. The dollar flight to quality ended rather quickly. The trade-weighted dollar is about where it has been for the last week. And I am still waiting for someone to show a good link between low treasury rates and the ability to speculate on US stocks.

There were plenty of buys in individual stocks that have nothing to do with Dubai, European banks with big exposure, or even the dollar carry trade.

I don't know if Warren Buffett was buying today, but I was.

ETF Update: Mid-Week Bullish Changes

2009-11-23T22:22:06-06:00

Each week we provide a ranking of ETF's. We show our macro perspective as well as highlighting specific sectors of interest. We do this based upon closing data from Thursday, with a complete record of our positions and trading from the prior week.

Mid-week trading is part of our business. We run our model twice daily and adjust positions as indicated for individual accounts -- our customers.

For this reason, we do not advertise our ratings as a "trading signal." It is intended as news information, something that the ETF investor can consider as part of his/her own decision process.

Occasionally, something happens that is pretty dramatic. When it occurs very quickly after my weekly update, I feel uncomfortable about the message from my regular weekend article.

Today we saw a major change in our ratings, with many sectors emerging from our penalty box. With the market highly correlated to the dollar, this is not a big surprise. Many technically-based methods trigger with breakouts when there are new highs.

Summary

Our posture changed dramatically today with a number of new buys. These include several of the top ETF's in our list, escaping the penalty box. We hinted that this might happen, but in addition to RYH, we bought GDX, QQQQ, and some other highly ranked sectors. We are now fully invested.

Once again for emphasis, I am not promising to do a mid-week update any time there is a change in the model. In this case, it seemed especially important to share the change with loyal readers.

ETF Update: Health Care Legislation and Health Stocks

2009-11-22T21:49:22-06:00

"What's the news?" is the first question when we see a big move in a stock or sector. There is always some reason, valid or not. Knowing the news explanation is an important step for those who trade on fundamentals.

After months on the national stage, the debate over health care reform has reached the final act. In the next few weeks we will know whether national policy will change, and the nature of that change. Meanwhile, the health stocks have been signaling "There's news" on a regular basis.

Let us first take a look at our approach to spotting emerging sectors.

Background

The model also provides a nice feel for the overall potential of the market. I'll take a look at the macro picture first, and then take a look at our featured sector of the week.

The Macro View

From an overall market viewpoint, our indicators have improved. The key elements are as follows:

55% of our ETF's in positive territory ( up from 31% last week). The median strength rating for the overall list is a plus 1 (up slightly from -6 last week). A score of "0" implies the average long-term ETF expectancy.
97% (up from 93%) 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, but leaning positive. 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.

Spotlighting Health Care

Our ETF universe has several health care choices, but the fastest-moving is the Rydex S&P Equal Weight Health Care ETF (RYH). ETF expert Tom Lydon notes that, as opposed to other health care ETF's, RYH emphasizes small and mid-cap holdings. RYH has a diverse holding including 52 stocks. The P/E is 20.4 and the price-to-book is over 3. The beta is currently 1.0, but we expect it to move higher as the health care legislation progresses.

Health care stocks have responded mostly to the market, but partly to the twists and turns of health care legislation. Here is the chart for RYH. The charts for other choices -- IHF and IYH -- are similar.

This is a key situation. We would not be surprised to see the sector pop out of our "penalty box" for a purchase this week. This may depend upon the health care legislation.

A Look at the Fundamentals

Health care stocks have operated under a cloud because of the ongoing debate over reform legislation. Analyzing public policy and the impact on stocks is our sweet spot, so this could be a special opportunity in the weeks to come. Here is what you need to know and where to look for more information.

The Basics. Major legislation is a process of coalition-building. The result is a compromise program that no one really loves. It goes with the territory in a representative democracy. We expect our representatives to angle for legislation that reflects the needs of their districts.

This concept -- the formation of a minimal winning coalition -- is well-established political theory. Interested readers should check out William H. Riker's seminal work from 1962. There is a long political science literature on the theory of the minimal winning coalition. To build a majority, the coalition adds provisions that attract the marginal voter. That voter, honestly and wisely representing his/her district, bargains for provisions in the new law.

I understand that opponents of health legislation are calling this bribery. This is as old as the hills. You can find legislative examples from many countries and many eras -- all showing the same thing. To decry this form of coalition-building is the functional equivalent of condemning representative government. It merely means that the critic does not like the outcome, and therefore criticizes the process -- usually without any constructive alternative. It is not partisan, since all parties have used this approach.

The Implementation. I strongly recommend that investors put aside their opinions about the policy and focus on what stocks will benefit.

Where to Look. Our sister site, ElectionStocks.com, has extensive coverage of the health reform legislation and the potential stock impact. We expect a resolution of the health issue to help the entire sector. The market hates uncertainty, and this will be lifted. The health group may well emerge from our "penalty box."

Weekly TCA-ETF Rankings

We were mostly out of the market this week. The S&P lost a little ground and we did also on small positions.

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 slight positive 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

A Profitable Pattern

2009-11-20T22:13:02-06:00

I have noticed a profitable pattern. I am going to cast this from the bearish perspective, but in theory it could work either way. I have a few other historical examples, but let us focus on the present.

Background

Investors have many time frames, and so do those managing money. When you see someone interviewed on CNBC it could be a mutual fund manager, a hedge fund manager, or a trader. It is natural for everyone to talk his book, but the time frame is relevant.

A mutual fund manager likes to see holding increase, get publicity, and attract new assets. Having said this, these managers are not likely to sell into rallies. Instead, new money in their funds gets invested at current prices in current holdings.

A hedge fund manager or trader is different. Their disclosures warn that they may change opinions and trades in a heartbeat. They can, and should, do so. A five percent move in a stock is a major trading profit.

The Process

A portion of the hedge fund community takes a position. For this example, it is a short in semiconductor stocks. The position is supported with plenty of reasoning they deem to be rigorous and also by technical analysis. It is especially desirable to find a situation where a sector has made a big run. A chart of the SOX tells the story.

I haven't added any lines in this, and readers should ignore the last decline, since that is the end of the story. The point is that analysts could have a field day with this chart -- before the decline.

Cocking the Hammer

Those establishing a bearish position wish to highlight major concerns. In this case the "hammer" was the question of double booking of orders. This occurs when inventories are so low that those building mother boards want to be assured of needed parts. To do this, the theory holds, they place multiple orders for needed parts in short supply, canceling some orders when their needs are met.

It is an argument that raises a question about the validity of reported orders, and creates fear that the orders will decline.

Pulling the Trigger

One might think that actual evidence of order decline would be necessary to trigger the fear. That assumption is incorrect. It is easy to grasp any news as evidence that this prophecy has been fulfilled.

Yesterday the B of A/Merrill analyst downgraded the entire sector. The resulting report, which I have read carefully, is based upon an inventory model and some assumptions about where we are in the cycle. It does not specifically refer to any double booking, and the resulting forecasts are still above many other Street observers. It was a big call, getting a lot of play, and knocking down the stocks by 5 percent or so, as the chart indicates.

Bearish observers incorrectly cited the double booking argument, not actually mentioned in the report. It talks about a small "overshoot" in inventories, not mentioning any double booking. It is based upon a theoretical model, without a lot of supporting evidence. Since few actually read these reports, the inaccurate summaries gain credence.

The Result

Anyone with a short position can cover for a nice trade. It was a nice setup. Any downgrade could be cited as evidence. When the analyst from a big firm downgrades, everyone pays respect, at least in the short term. That is long enough for traders and hedge fund types.

The Facts

There is plenty of evidence contradicting the double-counting argument:

From iSupplyCorp we have the following:

In their earnings announcements, leading semiconductor suppliers, including Texas Instruments, STMicroelectronics and Intersil, all reported they saw no signs of double-booking during the third quarter, said Ciriello. “This should give the semiconductor industry confidence that the magnitude of the current recovery accurately reflects real demand levels.”

A balanced article at the WSJ mentions the double-booking issue:

Another analyst, FBR Capital's Craig Berger, also cited signs of weakening PC demand, though he said in a note, "We do not want to get overly bearish on the PC space given improving global demand and still-unknown holiday sell-through trends."
Berger said he remains "bullish" on the semiconductor sector. "We think fears of a first half of 2010 estimate cuts from double ordering are overblown, that global supply chain inventories are at or near all-time lows, that global demand trends will continue to recover in 2010."

Astute tech stock observer Bob Faulkner writes as follows (see the full article for his nice inventory charts and complete analysis):

I've tracked inventory in the electronics-supply chain for years. While it’s too early in earnings season to draw any final conclusions, I think it’s very safe to say that inventory is quite tight on a relative basis.

Steve Ballmer reports that Microsoft sees "fantastic sales" for Windows 7. If this is accurate, it should stimulate a new cycle of purchases. More people and businesses replace computers -- especially those who avoided VISTA -- than upgrade existing machines. The current hardware may not be adequate and is difficult to configure.

Our Take

The trading setup is a real dilemma for managers with a long-run horizon. It was completely predictable that something -- anything -- would be seized upon as confirmation for the double-booking argument. There was no need to wait for actual evidence. Even knowing this, should the manager blow out all of his chip holdings, expecting a pull back of unknown size?

The real answer for those with a longer perspective is to focus on the actual time frame and ignore the bumps in the road. The traders will make their profits, and eventually the results will tell the story. It is an opportunity to add to positions for those who disagree with the thesis.

An Interesting Exercise

There was a similar setup -- hammer pulled back -- on car sales after the Cash for Clunkers expired. Perhaps this is a good topic for an example where we now have more evidence -- an immediate decline, followed by a restoration in sales.

I invite other examples -- both long and short -- from readers. Look for the setup -- what we all should watch for-- and then look for evidence.

Our position: Long INTC, MSFT, and AAPL.

Specific Expertise: Insisting on the Best Information

2009-11-17T21:55:09-06:00

Here at "A Dash" we have emphasized that we are all consumers. We are consumers of data, of analysis, and of opinion. Our principal mission is helping readers understand their role as consumers and figure out what sources and information to follow.

Background

Here are two widely-accepted findings to consider. Both have strong support from empirical evidence on market returns.

Stock analyst ratings often lag, so the wise contrarian investor fades the consensus opinion.
Chasing performance is a major source of losses. Those who "called the last move" are often the mean-reverting cases. One needs to look at long-term performance.

These precepts are widely accepted in the investing community. (I will add that both are part of my own approach to stock-picking, with a nice long-term return.)

Meredith Whitney

Yesterday afternoon CNBC indicated that Meredith Whitney would be featured on Maria Bartiromo's program. Regular readers know that we are big fans of Maria. We think that she asks the right questions and draws out interesting answers from high-profile guests. Many market participants guessed at the nature of the interview and sold the market before and during her interview.

You can check out the key points of the Whitney interview here.

Our Take

Meredith Whitney, in her prior role as bank analyst with Oppenheimer, did one thing well --- very well. She accurately predicted that banks would need to write down assets. She accurately predicted that there would be no FAS 157 relief on mark-to-market accounting, so there would be a death spiral of bank value declines. Those following her predictions made significant profits and/or avoided losses.

Since starting her own firm, Whitney has expanded her universe of predictions. She is now making forecasts about the economy, the housing market, and consumer behavior. (I regularly read her work via my helpful Oppenheimer rep when she worked there, but now I get the information along with everyone else).

It is quite fair to question Whitney's skill at economic forecasting. Her success related to analyzing bank holdings, not forecasting the economy. Personally, I prefer a different approach to economic forecasting, and so should you.

Her current bearishness is grounded in valuation -- financial stocks should return to tangible book value. When asked what would make her bullish, she responded in valuation terms, giving the example of BAC at 3. She does not believe that banks have sound core earnings, despite an attractive yield curve.

Others have commented on Whitney's bearishness, with varying conclusions. Quite frankly, most of them use the wrong criterion. They talk about how well she has predicted the market -- either last year, or this year, or both. This is a very small universe for inference, dependent on a couple of key conclusions in each case. The circumstance this year, including marking assets to market, are quite different from last year. Whether or not one agrees with government policy, the various arms of our Federal government are all on a concerted mission.

A More General Conclusion

We are all bombarded each day with fresh opinions about our investments. These are now taking the form of the CEO interview. I modestly suggest the following guidelines:

CEO's are great at discussing their current business;
CEO's are sometimes helpful in discussing what is in their pipeline (analyze this skeptically and carefully);
CEO's have no added advantage when offering opinions about the future of the economy, beyond what they see in their own business. They are reading and analyzing the same news that we are.

Readers might enjoy revisiting our Ted Williams strike zone article --- emphasizing the importance of staying in your "happy zone."

[I am long GS in personal and client accounts and hold a small BAC position as well. I am slightly long in trading accounts and remain fully invested in long-term accounts.]

ETF Update: Rebound in China?

2009-11-15T19:05:38-06:00

President Obama's China visit will be a news focus for the next few days. Investors will follow developments closely for hints about trade, the dollar, implications for the U.S. economy, as well as several important challenges to international cooperation. Because China is the biggest lender to the US, the relationship is changing.

This occasion is also a good time to consider the prospects for direct Chinese investments. We identify such opportunities through our sector rotation model.

The model also provides a nice feel for the overall potential of the market. I'll take a look at the macro picture first, and then take a look at our featured sector of the week.

The Macro View

From an overall market viewpoint, our indicators remained weak. The key elements are as follows:

31% of our ETF's in positive territory ( up from 23% last week). The median strength rating for the overall list is a negative 6 (up slightly from -9 last week). A score of "0" implies the average long-term ETF expectancy.
93% (down from 98%) 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.

Spotlighting China

This week we see a number of China plays near the top of our list. While the Thursday closing ratings listed below show the various China sectors in our penalty box (described in some detail last week), some of the ETF's emerged from the penalty box on Friday. In an effort to be both topical and timely, I am going to highlight one of the ETF's we bought, the FTSE China (HK Listed) Index Fund (FCHI).

As the fund name indicates, it tracks the FTSE China Index, emphasizing Chinese companies available for international investment. The holdings are pretty concentrated with the top ten names constituting over 62% of the fund. The P/E ratio is about 23, and price-to-book over 3. The beta is only 0.78.

Here is the chart.

The model may be reacting to the pattern of higher highs, and higher lows.

Expert Commentary

Gary Gordon reviews several China plays and wisely calls attention to the varying levels of concentration in financial stocks. FCHI has about 45% exposure. While Gary does not object to Chinese financial stocks per se, he warns about excessive concentration in any sector.

Michael Johnston at the ETF Database reviews a number of attractive choices for US investors. He notes that Burton Malkiel has maintained that US investors are underexposed to China.

Tom Lydon emphasizes the fundamentals of the Chinese economic rebound.

Weekly TCA-ETF Rankings

We were mostly out of the market this week. Since the S&P gained about 2.5%, we lost ground against our benchmark.

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

Dollar Weakness and Stock Market Strength -- the Data

2009-11-14T20:17:26-06:00

Anyone who is following the market on a daily basis is paying attention to the strength of the dollar versus other currencies. It can be confusing. While a strong dollar might seem like a good thing, there is actually an inverse market relationship with stocks -- at least in recent times.

I described the basics of the dollar debate here: Understanding the Debate on the Dollar. There are many opinions -- prescriptive, political, and descriptive. The next step is to consider some data.

Dollar Strength and U.S. Equity Market Returns

In my last article I highlighted the inverse relationship between a strong dollar and the stock market. This chart provides a dramatic illustration of the relationship for calendar 2009.

Sometimes a chart tells the story in a glance, but I always like to look at data as well. I used the Fed's measure of the dollar versus a broad basket of currencies, weighted by trade. The series started in 1995.

The correlation for this year is an almost perfect negative relationship: -.96.

A negative relationship sometimes stands out even more if you invert one of the scales. Here is that chart.

The data are the same, but the tight relationship is especially clear using the inverted scale.

So much for what we know. An obvious question for investors in stocks is what would happen if the dollar gets stronger. Perhaps we should look at more data.

A Longer Perspective

Some believe that a strong dollar is consistent with economic growth and a strong stock market. To examine this concept, we need to consider more data.

If we look at the full data series, we see long periods where dollar strength was consistent with a rising stock market. In fact, the correlation between the two series is a positive value: .35.

For an objective analyst of data, the chart suggests three conclusions:

The relationship changes over time;
The last year is quite atypical;
There are other important variables at work.

The Carry Trade

The prevailing hypothesis about the dollar/stock relationship is the "carry trade." Supposedly there are investors/companies/speculators who are able to borrow in dollars at a very low interest rate. This makes the dollar the "funding currency." Most outspoken on this subject is Nouriel Roubini, who sees disaster ahead. [Full disclosure -- I am a contributor at Nouriel's valuable site. I respect and appreciate his encouragement of alternative viewpoints.]

The borrowers do not then do the obvious -- lend in another currency, hedging the difference with a forex trade. Instead they supposedly use the borrowed funds to engage in a variety of speculative trades -- emerging markets, real estate, and, of course, US stocks.

Following this logic, there is now a speculative bubble of major proportions. This seems implausible.

My skepticism comes partly from the lack of any real data supporting this viewpoint, and partly from the daily trading. If you really had this trade on, would you really take it off if the dollar moved by 0.4%? The carry trade hypothesis does not explain the closely calibrated trade between the dollar and stocks, but we see this every day.

For now, let us stick to conclusions supported by data. There is a strong inverse relationship. If you are a trader, you had better pay attention. If you are a long-term investor, you need to understand the long-term relationship.

Meanwhile, I invite reader comments, citations for new data, and fresh hypotheses. I will pursue this for at least one more article, considering various causal models.

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.

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.

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