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ETF Investors hope to achieve the right level of diversification.

Making sector-specific investments provides a chance to beat the market averages through focus. Buying ETF's lets you avoid some of the risks that come with individual stock purchases.

An ETF portfolio can be very concentrated, or it can represent several diverse sectors. Sometimes there is less diversification than one might think. There can be an underlying theme, creating a correlation in the performance of apparently unrelated sectors.

Such is the current case with many attractive sectors which are all linked to weakness in the dollar. This week's ETF update takes a closer look at currency moves and the effects on an ETF portfolio.

Background

What do we mean by an "attractive sector?"

We study sectors continually, looking at the charts and ratings of 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 Macro View

From an overall market viewpoint, our indicators continue in positive territory. The key elements are as follows:

  • We now find 96% of our ETF's in positive territory (98% last week). The average strength rating for the overall list is 31, down from 43 last week. (A score of "0" implies the average long-term ETF expectancy.)
  • 70% (up from 24%) 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 remains 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.

Focus on the Dollar

US equities have recently been trading in an inverse relationship with the dollar. What is the nature of this apparent correlation?

In a review of the fundamentals, Currency Specialist Adam Kritzer takes a look at the relationship between gold and the dollar. In particular, he analyzes theories from Peter Schiff. Kritzer takes a careful and balanced view, concluding:

Still, perception is reality in financial markets. If investors want to see a connection between a weak Dollar and strong gold, they will simply contrive one.

Here is a look at the dollar, using the (trade-weighted) dollar index (click to enlarge).

Dxy

There has been a sharp decline from the March (multi-year) highs. What does this really mean?

The currency specialists at The LFB provide an analysis that we find confusing. They write as follows:

The main reason for the stronger dollar on Thursday was the sell-off in the equity market after the Existing Home Sales report, which declined 2.7% in August compared to the numbers from July. During the equity sell-off, gold and oil traded significantly lower, while the dollar index hit new daily highs.

and later...

The caveat to that is the dollar not getting sold is a msjor swing change in sentiment, if the swing change morphs into a near-term trend on dollar buying, it will signal weakness in equities that will then have followed the drop in speculative interest out of the crude oil markets.

Our read is that there is inferred causation without the needed evidence. US equities are currently trading higher when the dollar is weaker, but we do not see evidence that the stock market is driving currency trades.

What is the long-term relationship? CXO Advisory always does an excellent job with such questions. Using the dollar/Euro relationship (as good as any), CXO points out conflicting theories about whether a strong dollar or a weak dollar is good for stocks.

The overall conclusion? Here is the CXO Summary:

The following chart tracks the dollar-euro exchange rate (dollars per euro) and the S&P 500 Index over the entire sample period. During this time the dollar generally weakens (the number of dollars per euro rises), and the stock market exhibits fits of historically high volatility. Visual inspection suggests that the exchange rate and stock market sometimes move oppositely and sometime move together.

The rest of the article does what we have come to expect from CXO -- looking at correlations and possible leading indicators. Any serious reader should check out the entire article.

Our take? We see two markets currently moving together without real evidence of causation.

In Betting on the Weaker Buck, MarketWatch outlines five different strategies for playing a weak dollar. Two of these are reflected in our current ratings. Whether this works has a lot to do with the time frame of the trader or investor.

Weekly TCA-ETF Rankings

We had a loss of about 4.2% last week, trailing the S&P 500 by about two points, mostly as a result of strength in the dollar. Our current holdings, while lower in rank, still have good strength ratings. 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.

We also note that this week implements what our modeling guru, Vince Castelli, calls an improved filter. While the underlying model has not changed, the inputs used reflect our best efforts to improve the signal-to-noise ratio. We have advanced the timing (the Anticipation factor) reflecting the recent "hot money" tendencies in ETF's. This means earlier recognition and also faster moves to the penalty box.

As noted above, all of the macro market indicators remain positive, although a bit lower than last week. Based upon the current model signals, we have maintained our bullish position 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 (click to enlarge).

092409

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.

Source: ETF Update: Here's How Currency Moves Affect Your Positions