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Precious metals exposure has been quite conspicuous lately in this weekly ETF pullback strategy (see Appendix below for explanation and performance data), and it has contributed to some incredible volatility of late, as can be seen in Figure 1, a screen shot from the FolioInvesting.com account I use to trade the model.

Figure 1


(Click to enlarge)

In the early period after the model went live on July 21, it had moderately outperformed the S&P 500 but with a bit less volatility. Fluctuations widened starting in November and escalated most recently, as precious metals ETFs (which came to dominate the selections late in the year) plummeted based, it seems, on correction, and possibly interest rate concerns going forward. Then, last week, they rallied as events in Egypt brought the famous four-letter word (f-e-a-r) to the forefront.

For now, I can catch my breath as I notice that the metals are gone. I’m OK with that area as a long-term stake (see last week’s article), and wouldn’t be at all surprised to see them come back soon, but for now, I can use a break – sort of.

Here’s this week’s list:

  • iShares MSCI Sweden (NYSEARCA:EWD)
  • WisdomTree Middle East Dividend (NASDAQ:GULF)
  • Market Vectors Gulf States (NYSEARCA:MES)
  • Consumer Discretionary SPDR (NYSEARCA:XLY)
  • SPDR S&P Retail (NYSEARCA:XRT)

NOTE: One of the five ETFs that originally appeared in the list, a recently-launched fund focusing on France, is presently available for trading in FolioInvesting.com window system so I substituted the sixth ranked fund, the Consumer Discretionary SPDR.

This was last week’s list:

  • PowerShares DB Silver Fund (NYSEARCA:DBS)
  • Global X Silver Miners (NYSEARCA:SIL)
  • ETFS Silver Trust (NYSEARCA:SIVR)
  • iShares Silver Trust (NYSEARCA:SLV)
  • PowerShares Dynamic Networking (NYSEARCA:PXQ)

The new list is not exactly a bastion of comfort.

Two of the new ETFs focus on the Middle East, where financial markets are being buffeted by events in Egypt. The end of the Mubarak era seems a fait accompli, but the details on how it’s going to happen, what will come next, and what it means for the rest of the region and the rest of the world remain very much in doubt. There’s a new cabinet, a new prime minister, and an announcement that Mubarak will step down in due course after the next election. But many in Egypt remain unimpressed.

I wonder if there’s a bit of kismet involved in the fact that one of the cable networks aired the movie "Nicholas and Alexandra" this week, which I, something of a Russian history buff back in my college days, recorded on my DVR. The analogy between the fall of the Romanovs and the apparent ongoing fall of Mubarak is by no means perfect, but it is at least instructive. When Tsar Nicholas II abdicated in response to popular uprisings not unlike what Egypt is experiencing now (in terms of passion and resolve, if not ideology), he gave way to parliamentary rule under a government headed by Alexander Kernsky. To the global community, that seemed like that would suffice, much the way we want to view the Egypt’s new cabinet and upcoming elections as constructive measures. But as we know, that’s not the way it worked out in Russia. Once the opposition was unleashed, it wasn’t ready to stop until a much more radical turn of events: the Bolshevik (communist) takeover. That’s what I wonder about with Egypt. Will the chaos stop merely with a Mubarak-free government? Or will it press forward to a bolder change. (In Europe a century ago, that meant communism; in much of the Middle East today, that often means Islamic fundamentalism.)

The unfolding of events could make for lots of brisk short-term moves in both directions. News stories reporting on positive or at least diminution of negative developments should spark brisk rallies, and vice versa. This will clearly add volatility to the Middle Eastern ETFs, although the Wisdom Tree entry is something of an odd duck. The dividend label doesn’t have to mean it’s a yield play; Wisdom Tree uses total dividend payments as one of several alternative (to market capitalization) weighting methods. As it turns out, GULF has a yield in the neighborhood of 3%.

The two U.S. consumer-oriented ETFs may also be impacted by these developments as the ebb and flow of events in the Middle East impacts changes in the price of oil.

Ugh, I think I’m already starting to miss my precious metals ETFs!

At least one of the ETFs focuses on Sweden, a bastion of calm compared to what’s around it. GDP growth there is reasonable and the budget is balanced.

On the whole, though, it looks like the equity market is likely to continue to favor oscillating trading strategies, rather than those that depend on trend. That’s definitely a challenge for this particular strategy. The pullback flavor does represent a nod to oscillation, but in this context, I’m looking for temporary pullback within a larger trend that ultimately remains in place.

If the strategy were restricted to equity ETFs, I’d have to give careful thought as to whether I should suspend its use. Actually, though, it’s a multi-asset approach. As noted, we’ve seen considerable precious metals exposure in the recent past, and review of backtested performance shows periods when fixed income took over for overly changeable equity exposure. Both could recur going forward, but if I were a betting man (some would say I already am), I’d assume precious metals will reappear first. As to the week ahead, I have to hope for at least a temporary cooling in the intensity of the Egypt-related news flow.

SPECIAL NOTE: Due to travel plans (if any of you plan on being at the World Money Show in Orlando next week, and assuming this dreadful winter allows any of us to actually fly someplace, I hope you’ll drop by my low-priced stocks workshop on Friday and say hello), I may not have an opportunity to re-balance this model next Thursday. My current intention is to do so a day earlier. I don’t worry about the “purity” of implementation as a result of this (or with the swapping in of XLY as discussed above). As big a fan as I am of disciplined investing protocols, I never carry it to extremes. There’s no point in doing so. No matter how effectively studied and tested a model may be, we can never be sure the future will match the past, so the best any of us can do, using any strategy at any time, is approximate.

APPENDIX

To create this model, I started with a very broad-based ETF screen I created in StockScreen123.com.

  • Eliminate ETFs for which volume averaged less than 10,000 shares over the past five trading days.
  • Eliminate HOLDRs (I don't want to be bothered with the need to trade in multiples of 100 shares).
  • Eliminate leveraged and short ETFs (I think of these as hedging tools rather than standard ETF investments of even trading vehicles).

Then I sorted the results and select the top five ETFs based on the StockScreen123 ETF Rotation - Basic ranking system, which is based on the following factors:

  • 120-day share price percent change - higher is better (15%).
  • 1-Year Sharpe Ratio - higher is better (15%).
  • 5-day share price percent change - lower is better (70%).

The idea of using weakness as a bullish indicator is certainly not new. But often, it's an add-on to other factors that, on the whole, emphasize strength. Here, the weakness factor is dominant, with a 70 percent weighting.

This model is designed to be re-run every week with the list being refreshed accordingly. I trade through FolioInvesting.com, where I pay a flat annual fee rather than a per-trade commission, so I don't care about the fact that turnover form week to week is often 80%-100%. If you want to follow an approach like this but do have to worry about commissions, the strategy tests reasonably well with three ETFs, or even with one. (Cutting the number of ETFs is far preferable to extending the holding period.)

Figure 2 shows the result of a StockScreen123 backtest of the strategy from 3/31/01 through 12/30/10.

Figure 2


(Click to enlarge)

Figure 3 covers the past five years, a very challenging market environment that witnessed the fizzling of many strategies that had succeeded for a long time.

Figure 3


(Click to enlarge)

Disclosure: I am long EWD, GULF, MES, XLY, XRT.

Source: The Trend Has No Friend: Today's ETF Pullback Choices