ETF Update: Recognizing and Reacting to Risk

by: Jeff Miller

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.


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.

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.)

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.

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 negative 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 (click to enlarge).


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.