Sector rotation is a matter of time frames. The TV pundits use the term whenever the daily trade is to sell one group and buy another. The news story is measured from one day to another.
The problem for investors, and perhaps even traders, is that these very short-term moves must be guessed in advance. This is not very helpful for system traders. One needs time to read a new signal.
The Fundamental Problem
Last week we enjoyed a day back in the classroom -- a guest lecture invitation. It is a good opportunity to think about one's message. What can one say to a group of very intelligent and eager young students?
Here was part of our message:
Many trading models take data from period "A" and forecast period "B". The time frame for these periods can range from seconds to months. Each model gives a different answer. In particular, fundamental analysis has a longer time frame.
It is important to find a system that fits one's personal trading style. We have had excellent trend-following models that did not work for traders? Why not? Their psychology was to "sell the rips and buy the dips." The model was designed to cash in when there was a big breakout. The traders were out of the market in a big upside breakout, and some were even short.
Are we at the top of a range, or is the market breaking out?
The Current Market
Our own approach to sector rotation makes a 30-day forecast. There is some smoothing of past data to improve the signal-to-noise ratio. It identifies Trends, Cycles, and employs a bit of Anticipation. Since we use a universe of ETF's, we call it the TCA-ETF model.
We have done some sophisticated back testing so we know the best and worst circumstances for our approach. The best runs come when sector strength moves from one group to another - -handing off the baton.
The worst conditions come when all sectors are correlated in a trading-range market. This has been the situation for the early months of this year.
Knowing this makes us especially interested when new sectors show strength. (For new readers, there is a more complete description of our methods and ratings at the end of the article.)
Featuring Basic Materials
Moving up rapidly in our sector ratings is the Dow Jones U.S. Basic Materials Sector Index Fund (IYM). This group is pretty concentrated with 40% of the holdings in five names that you know (DuPont (DD), Praxair (PX), Newmont Mining (NEM), Freeport-McMoRan (FCX), and Nucor (NUE)) and 60% in the top ten. The average price/cash flow is about 4 and the P/E is about 12.5. These ratios reflect the current negative economic sentiment. The beta is about 1.4.
Each week we do a search on the leading ETF gurus to see if anyone else is highlighting a sector, but this one draws a blank. It is a real play on an economic rebound, and few see that. Here is the picture our model is picking up (click to enlarge).
It is always interesting when the model highlights something unusual. There is some support from the ECRI leading indicators, as noted here.
Meanwhile, the sectors featured in the last two weeks -- financials and home builders - - have done well, but we are watching for new leadership.
Weekly TCA-ETF Rankings
Almost all of our sectors except the inverse ETF's are now in the "buy" range, with high ratings for financials and many other groups (click on chart to enlarge). It was an excellent week for the system, gaining over four percent (after a bad start) and beating the S&P by a point.
Based upon the model signals, we continue our official bullish position in the Ticker Sense Blogger Sentiment poll.
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.