A Trend-Follower Positions for 2009

At ETF Digest I provide to our subscribers ten mantras that I’ve respectfully named ETF Digest Sacred Cows (available here). ETF Digest Sacred Cow IX is a self-explanatory quote from economist Edgar R. Fiedler: “If you have to forecast, forecast often.”

Further, while I maintain strong opinions about overall conditions, as a technically based trend-follower the prediction business isn’t relevant to my work.

With those two observations as the lead, I’ll offer what we continue to focus on now and in 2009.

As trend-followers, we look for markets that “trend well.” That may seem obvious, but it bears more scrutiny. There are many new ETFs that have and will enter markets with most based on either well-known indexes or newly created quantitative indexes. We would continue to exclude so-called “actively managed” ETFs unless I personally know and respect the manager.

Many new ETFs sound seductive and that in turn could suck you in. Yet any new index should come with historical data. This is an analytical requirement for trend-followers. If you can’t get the index with adequate history (say, five years at least) then you’re working blind and going with only “coolness” as your guide. This isn’t for me.

There are many new ETFs, such as in alternative investments like commodities and currencies, that are linked to existing products with lengthy data. These can and have performed well.

But if you can’t get the data, forget about it. And if the data you get doesn’t lend itself well to a trend-following system, forget about it.

That said, I continue to believe the best opportunities will remain in those sectors that trend well either from a long or short perspective.

In general, these will include Emerging Markets and overseas ETFs - whether in regional products (ILF, EFA, EEM, etc) or in single country funds (EWA, FXI, EWZ, etc). These products and their associated indexes trend well and, for the most part, have inverse or leveraged issues to utilize.

In US markets, bond sectors offer potential opportunities, problems and risks. Spreads between direct Treasury obligations and corporate issues have never been wider. All these markets trend well and there should be opportunities for arbitrage. Given the advent of some inverse issues in Treasurys (TBT and PST), along with high yield issues (HYG) there can be a narrowing of spreads. Perhaps that time will come in 2009.

In fixed-income markets, there is a problem with obtaining historical data from Lehman-linked issues. As you may know, most fixed-income products are linked to Lehman Indexes. Barclays has purchased these indexes from the now defunct firm, but has decided to charge quote vendors for their use. Many vendors have balked and in a self-destructive way are preventing others from getting the data. It seems silly, but what will happen is hard to say.

Remaining in the fixed-income area, many understandably believe the extensive money printing and bailouts from the Bernanke/Paulson era will lead to inflation. If so, then opportunities should remain in inflation-indexed bond ETFs TIP and WIP. But trend analysis will determine when or if investments there make any sense.

Naturally, if future inflation becomes a problem then commodity issues should rally including commodity tracking indexes (DBC), gold (GLD), base metals (DBB), grains (DBA) and currencies (FXE, FXY and others). The good news here is twofold. First, these markets trend well in both directions, and secondly, all have inverse or leveraged issues available. This area will continue to offer investors, whether long or short, opportunities.

In US sectors, investors should remain focused on the major index-related ETFs (VTI, SPY, RSP, MDY, IWM, QQQQ and so forth) since they offer great liquidity, trend well and have inverse and leveraged issues available. In addition, various sector ETFs (IYR, XLE, XLB, XLY and so forth) will also offer opportunities, and no surprise, also have inverse and leveraged issues available.

As we end 2008, markets are oversold from a long-term perspective and clearly in a bear market. These conditions can last longer than many expect or wish. Nevertheless, as 2009 begins a new administration takes office with the economy in disarray and markets as described.

I believe in 2009 investors should stick to the areas mentioned above and avoid new investment schemes when possible - especially if reliable historical data is hard to find and analyze. Our mission as trend-followers is to identify trends in markets that normally exhibit reliable patterns and seize on those opportunities, whether long or short. Finally, managing risk is always paramount which means standing aside in cash when volatility is too high such as during the last quarter of 2008.

Good luck in 2009!

Comments

[investor88:]

Agree open minded approach important but noticed David has yet to jump into the markets with both feet.

Jan 04 09:09 AM

[fatcat:]

David has been very right for a long time....the last 3 months were treacherous for anyone but the pro traders.I have 35yrs experience,including 10yrs as a broker,and I got stopped out and whipsawed so many times,I finally went to the sidelines to wait it out.It was maddening to see good trades go by,but better opportunities will come...

Jan 04 10:24 AM

[stox2buy:]

hind-sight is always 20-20.

yet hind-sighters are always the crowd seeing trains leaving the station and sigh....well, wtf, it's only money.

there's no safe place in stock market.

if you expect higher return by investing in "safer stocks", you should know by now...have you ever seen a pink elephant?

do your homework, invest with displine, stick to growth stock/industry.

disclosure: long KOOL.

Jan 04 10:46 AM

[Moon Kil Woong:]

The stock market is a great place to hedge or out perform inflation. Without inflation the need to deal with the uncertainty of the market diminishes substantially. It's just another unintended consequence of a Zirp policy.

As argued before. Zirp is never a good policy. Or better argued by the critics, 0% rate policy is tantamount to no policy at all.

Tanks David Fry for the investment warnings.

Jan 04 12:06 PM

[cma:]

David refers 3 times to inverse and 2ble ETFs. But many posts and articles on Seeking Alpha have shown that these ETFs employ derivatives (mostly long options and swaps) to achieve their stated investment objective over only a 1-day time frame. Over longer periods, such as a one month, let alone several months, these inverse and 2ble ETFs vastly underperform their theoretical returns vs. their tracked index.
Here is a sample article showing the enormus underperformance of the inverse ETFs:

"2008 August through December 19th, the S&P 500 has fallen 30.8%. Many traders would assume that SDS should have returned 61.6% because that is double the inverse of the index, right? Oddly enough, SDS only gained 37.3%, nearly 25% below what many would have thought in less than four months. The ProShares Short S&P 500 ETF (SH) during the same timeframe gained 25.9%; according to the company SH should give investors the inverse performance on a 1-to-1 daily basis."

Jan 04 12:41 PM

[pitaking:]

True that 2X and 3X ETF's don't match overall performance, but as David says, they are great in trend following markets. When the trend emerges they are the play.

Jan 05 12:00 AM

[sundrenched:]

SDS (ultrashort S&P500) is down 10% since its inception 2.5 years ago, where it should have increased by 50% based on the S&P's 25% drop over the same period. That's downright scary! Granted, very few people are going to hold these ultrashort ETFs for 2.5 years, but even over a few months you pretty bad drift. This is a real problem if you want to implement a macro approach and you may have to wait a while for things to play out. For instance, I expect commodities to recover strongly once the economy picks up, but I'd never use an ultralong ETF to wait for that to happen.

Jan 05 06:36 AM

[Steve in TN:]

I would recommend those investors using ETF trend following strategy to use the method employed by NoLoad FundX, a historically very highly rated newsletter. That is, take the average of four total return time periods for an ETF and compare that value to all other ETFs in that risk category (or you could just subscribe to the service). The 4 time periods are: 1 month, 3 months, 6 months and one year. If you follow their methodology you will always be in the "right" ETF at any particular time period.

In addition, I don't know why David doesn't recommend dollar cost averaging into the equity markets at this time. To do otherwise is just guessing whether we've hit bottom or still have a way to go. Spread your investments over a 9 month period and you'll probably do fine.

Jan 05 08:53 AM

[David Fry:]

In our experience, leveraged and inverse issues have worked well. But, it's how we use them that counts.

You can cherry-pick occasions when they don't work as has been pointed out. For our use, we've benefited greatly by their existence.

Jan 05 10:23 AM

[MichaelZChi...:]

David (or others),
Are there inverse ETFs or other plays that can more accurately short a position such as S&P500 or the Commercial Real Estate sector? The daily compounding negates longer term trends.

Jan 05 12:27 PM

[dc1:]

Hi Dave. Thanks for the info and advice.

Jan 05 01:05 PM

[NOWHEREMAN:]

Great as usual.

I especially liked your Caveat: "These conditions can last longer than many expect or wish".

David, If Nov. was indeed the Bottom, extrapolating the DOW forward a few years, I hope it goes to a new all time high. If it stalls around 12,000 and starts down, Bob Prechter might finally be proven right. IMO

Jan 05 03:31 PM

[bobbobwhite:]

I spent 17 years as a broker and 7 years as a senior trader and I never did LTBH for myself even though I advised it early on to retails in the 80's and early 90's due to company demands. I do not advise it for anyone now that I am retired and out of the business. The past 10 years have been overall negative for LTBH, and the market has too low of a risk/reward for anyone now other than experienced traders with many info feeds. The foreseeable future probably won't be what the past was for LTBH stock returns, but will always make profits for traders who know how.

Also, I do not think an amateur can learn to trade effectively, as the immediate info feeds you must have are far too expensive. My company told me my 32 feeds cost $125k/yr for each trader, and to me, that info was absolutely necessary to trade profitably. I used to make up to 100 daytrades, but I won't even try now as I would feel naked among lions w/o those info feeds. And those who say they daytrade profitably using Tradestation or the like would have to prove it to me as I don't think it can be done over the long haul.

Jan 05 03:37 PM

[polishlogician:]

I was wondering if anyone could help me out today; namely, if you examine the ETF BGZ (3x bear large cap) it shows a meek gain, though the index it tracks was much lower. There are some BGZ holders pissed that this ETF did not leverage today's declines effectively, the Russell 1000, I believe. However, one commentator wrote that the spread between NAV and pps today were so wide that this created the problem. Can anyone explain or point to where I could study how the effects of the NAV spread (premium/discount) make an ETF (3x) move relative to its index? Thanks.

Jan 05 04:24 PM

[David White:]

Great article David. I have been thinking about buying TBT for a while now. I did this morning. It did really well today. I think it is likely a long term strong buy at this point. The interest rates can't really go any lower (i.e. Treasury bonds can't really go up in value). Thus it seems this EFT almost has to perform well. The extra bonds that need to be sold to cover the bailouts should push Treasuries down. People getting back into stocks (the Obama effect) should push Treasuries down in the near term. Eventually there will be inflation (and the Fed will raise interest rates). This will certainly push Treasuries down. An ETF that shorts Treasuries almost has to do well for the next year or more (probably 2 or 3 years). Plus this ETF has such high visibility that I don't think there is any chance that it can turn into a Madhoff fiasco. I just can't see a big downside.

Jan 05 04:36 PM

[Market Folly:]

we think an outright short of long term treasuries (via TBT) should be profitable over the longer term once inflationary pressures kick in again. here's our rationale: www.marketfolly.com/20...

Jan 05 08:22 PM

[David Fry:]

ETF Digest Sacred Cow VI states: "Have respect for the successful methods of others."

If I didn't believe it, it wouldn't be there. So, if you follow a different path and are successful, great!

Jan 06 10:26 AM

[oldman:]

There must be a better way to hedge a portfolio than inverse ETF's. At least I would like to know how.

Feb 12 10:37 AM