ETF Update: When System and Reason Diverge; Eye on Telecom

by: Jeff Miller

Anyone who has ever traded using a system has experienced the following situation:

The model has a recommendation. You think it is stupid.

Should you follow the model, or follow your own judgment. In developing our models we addressed this problem using a lot of experience. We knew that traders using our models took the system trade as "advice." Then they made their own decision. Taking that approach is not following a model.

We discovered that traders could take a highly successful model if used in a mechanical fashion, and still lose money by implementing their own discretion. We summarized the situation as follows:

In developing methods with our systems guru, Vince Castelli, we came up with a useful analogy. In the movie, The Right Stuff, the NASA scientists and engineers are competing to put man in space faster than the Soviet competition. They come up with a pilot module with no window. From the engineering perspective, this made sense. They had developed a capsule ridden by a monkey; putting a man in the capsule was symbolic, not essential.

The early astronauts, all high-profile test pilots, had a different view. The window was necessary so that the pilot could control the craft!

With this in mind, we decided that the trader had some ultimate discretion, but had to be used with great restraint. This week's discussion of the telecom sector illustrates the point.

But first, let me take my regular look at how we see the overall market.

The Macro View

From an overall market viewpoint, our indicators show strength, but continued risk. The key elements are as follows:

  • 95% of our ETFs in positive territory (about equal to last week). The median strength rating for the overall list is a plus 27 (down from +42 two weeks ago and +34 last week). A score of "0" implies the average long-term ETF expectancy. The picture is weakening.
  • We see continuing risk, with 62% (down slightly from 66% last week) 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. It also may indicate the need to take profits in a sector where we have done well, but see higher risk. See our article here for a further explanation of this method. We recently implemented some faster filters, accelerating moves both into and out of the Penalty Box. We are also changing some rules to cut down the frequency of trading.
  • Our index package is still positive. For this rating we look at the ETFs (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. Despite the positive ratings, we note risk in both directions. All of the index ETFs are in the penalty box.

This overall picture has been about the same for several weeks.

Featuring Telecom Stocks

To qualify as our top-rated sector, the ETF must not be in the penalty box. This week's winner is the iShares Dow Jones US Telecom (NYSEARCA:IYF). [I realize that there are higher-rated sectors in our table, but I am focusing on the ETFs in our actual trading universe. This constitutes sixty ETFs with little cross-correlation.] Almost 30% of the fund is in AT&T (NYSE:T) and Verizon (NYSE:VZ) and almost 50% is in the top five holdings. The beta is only about .6 and the yield is nearly 4%. The P/E ratio varies dramatically depending upon whether one looks backward or forward. Here is the chart, with a comparison to the S&P 500. You can see the recent upward trend, and also the very recent decline.


Other ETF Experts

I always look to see whether other ETF experts have interest in our top-rated sectors. This week there was no comment on telecom despite the news in the top two holdings.

Brian White's article at Blogging Stocks, Verizon and AT&T in Wireless Plan Pricing War, does a nice job of presenting the issue. There are no winners in price wars. He notes:

Meanwhile, smaller carriers Sprint Nextel (S) and T-Mobile USA are still far cheaper for unlimited voice and data than their larger competitors -- yet the larger competitors rake in more customers and more revenue every quarter.

Investment Conclusion

Should we follow the model? We have done so on a trading basis, but it does not feel right. This is mostly an honest reflection of our hard-fought knowledge:

If you have a system, you should follow it.

Others may disagree!

Weekly TCA-ETF Rankings

We lost about 2.3% last week, trailing the S&P 500 by 1.5%.

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 ETFs are in the penalty box. Based upon the current model signals (and noting the high risk levels), we have continued our bullish posture in the Ticker Sense Blogger Sentiment poll.

Here are the top sectors from our expanded universe of 280 ETFs. The list also includes the values for the broad market ETFs and their inverses (based upon Thursday's close).

Click to enlargeJanuary 14 Ratings

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 for those interested in our weekly trading program.