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This is a description of my quantitative investment model for tactical asset allocation (TAA) among the ten U.S. economic sectors. These ten sectors are well covered by the following ETFs I use for asset allocation across the U.S. stock market:

ETF Ticker ETF Name
IYZ iShares Dow Jones U.S. Telecommunications Sector Index Fund
IYM iShares Dow Jones U.S. Basic Materials Sector Index Fund
IDU iShares Dow Jones U.S. Utilities Sector Index Fund
IYJ iShares Dow Jones U.S. Industrial Sector Index Fund
IYC iShares Dow Jones U.S. Consumer Services Sector Index Fund
IYE iShares Dow Jones U.S. Energy Sector Index Fund
IYK iShares Dow Jones U.S. Consumer Goods Sector Index Fund
IYW iShares Dow Jones U.S. Technology Sector Index Fund
IYF iShares Dow Jones U.S. Financial Sector Index Fund
IYH iShares Dow Jones U.S. Healthcare Sector Index Fund

TAA is the decision making process for choosing the appropriate short-term asset weights from this targeted universe of ETFs. TAA is undertaken after the long-term or normal asset mix has been set using strategic asset allocation (SAA).

To follow my TAA process, you would shift the asset mix in the short-term based on expectations of the relative excess returns offered by these various ETFs.

Mine is a bottom-up process based on forecasts for the expected return of each ETF constructed using quantitative techniques and aggregated across all stocks in that ETF to generate a forecast for the entire sector. Contrast this with an equally valid top-down approach, where gross forecasts are simply made for each ETF reflecting the judgment of the expected performance of that sector by an experienced market strategist or economist.

In my bottom-up process, alpha forecasts for fundamental data on individual stocks in an ETF are combined using their weightings to generate a market-cap weighted average forecast for the entire ETF. The process is repeated for each ETF in the universe. The ETFs are then ranked based on their under-valuation percentage and then the top and bottom quintiles are picked to go long and short. The fundamental insight is that cheap beats expensive more than it should. The tacit assumption is that mean-reversion happens over time.

The pluses of this bottom up process for doing your periodic rebalancing or tactical asset reallocation is that:

  • it takes into account all available information for all stocks belonging to that ETF, and therefore to its economic sector
  • it reflects a synthesis of expectations and experience of all industry analysts that follow each constituent stock of an ETF in detail.

The minuses of this bottom up process are that it may fail to work during infrequent times of hundred-year floods even if there is no equity bear market, such as during:

  • the Internet bubble, when outrageously expensive tech stocks kept getting more expensive, or
  • in the October, 1987 stock market crash, when all sectors tanked together.

As of market close on Aug 5, 2013, here's the ordered list of the sector ETFs (from least overvalued to most overvalued) with %overvaluation shown being computed with an assessment of the fair price of the typical stock in the universe of about 1266 stocks in all these ETFs


(Click to enlarge)

rankOrderedETFs
(Click to enlarge)

ETF Ticker ETF Name NumIssues Last FMV % Overvalued
IYZ iShares Dow Jones U.S. Telecommunications Sector Index Fund 26 28.36 48.6 -41.6
IYM iShares Dow Jones U.S. Basic Materials Sector Index Fund 60 71.59 115.8 -38.2
IDU iShares Dow Jones U.S. Utilities Sector Index Fund 65 98.75 153.0 -35.5
IYJ iShares Dow Jones U.S. Industrial Sector Index Fund 223 89.49 117.2 -23.6
IYC iShares Dow Jones U.S. Consumer Services Sector Index Fund 183 110.2 142.4 -22.6
IYE iShares Dow Jones U.S. Energy Sector Index Fund 82 47.23 57.2 -17.5
IYK iShares Dow Jones U.S. Consumer Goods Sector Index Fund 120 91.83 99.9 -8.1
IYW iShares Dow Jones U.S. Technology Sector Index Fund 133 78.63 59.8 31.5
IYF iShares Dow Jones U.S. Financial Sector Index Fund 261 75.97 55.4 37.2
IYH iShares Dow Jones U.S. Healthcare Sector Index Fund 113 108.28 50.0 116.7

To follow the recommendations of this model, you could go long the top quintile: top two ETFs and sell short the bottom quintile: bottom two ETFs.

So, go long

IYZ iShares Dow Jones U.S. Telecommunications Sector Index Fund 26 28.36 48.6 -41.6
IYM iShares Dow Jones U.S. Basic Materials Sector Index Fund

and go short

IYF iShares Dow Jones U.S. Financial Sector Index Fund 261 75.97 55.4 37.2
IYH iShares Dow Jones U.S. Healthcare Sector Index Fund

One could be more sophisticated and use an optimizer for risk-optimization to come up with differing amounts of the ETF to go long or short, or to keep it simple, you could simply use equal amounts of each ETF to go long and short with.

Disclosure:

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Tactical Asset Allocation Among The 10 Economic Sectors