ETF Pullback Choices: Focusing on Oil

|
Includes: IYE, PXE, VDE, XLE, XOP
by: Marc Gerstein

So oil prices dip in response to overtures made by Venezuelan President Hugo Chavez to help broker a negotiated outcome to the situation involving his good friend Muammar Gaddafi of Libya. OK. We all feel better about that, and the U.S. can relax and exhale, right?

Whatever; there’s one thing, though, we do at least know. This is exactly the sort of factual backdrop that’s made to order for my weekly ETF Pullback strategy, a technical approach that seeks out ETFs that had been in solid uptrends but which experienced very recent pullbacks. The idea, here, is that the pullback is a pause or correction, and not the start of a significant reversal. (See Appendix below for detailed explanation and performance data.) That’s exactly what the model is assuming about the pullback in oil and oil ETFs, which completely fill this week’s list:

  • iShares Dow Jones US Energy (NYSEARCA:IYE)
  • PowerShares Dynamic Energy Exploration (NYSEARCA:PXE)
  • Vanguard Energy ETF (NYSEARCA:VDE)
  • Energy Select Sector SPDR (NYSEARCA:XLE)
  • SPDR S&P Oil & Gas Explor. & Prod. (NYSEARCA:XOP)

This was last week’s list:

  • First Trust DJ Internet (NYSEARCA:FDN)
  • First Trust Tech AlphaDEX (NYSEARCA:FXL)
  • ETFS Physical Palladium (NYSEARCA:PALL)
  • PowerShares Nasdaq Internet (NASDAQ:PNQI)
  • PowerShares Dynamic Networking (NYSEARCA:PXQ)

Sometimes, it’s hard to reconcile fundamental considerations to the results of this technical model. Other times, it’s easy. This week is an example of the latter.

The basis for the pullback is as clear as anything I’ve seen since this strategy went live. Anything that looks like it has potential to ease tensions in the Middle East diminishes the crisis premium that oil prices have, lately, been incorporating.

The long-term trend is subject to a more interesting debate, since, in stock-market terms, oil is a double-edge sword.

All else being equal, higher oil prices are like a tax increase, and, hence bad. They directly raise business costs for many industries, and indirectly for many more if those impacted directly pass on their higher costs. And they take money out of the pockets of consumers, the last thing we really want to do considering the still-precarious nature of our economy. But in the real world, all else is rarely if ever equal. We can flip the cause-and-effect relationship and see higher oil prices as a result of good things; increasing economic activity, which, most likely correlates with increasing sales in the business world and more disposable income for consumers. Looking at the way events played out over the course of the 2000s, it looks like the latter won out; higher oil prices have been a byproduct of good news elsewhere in the global economy (the operative word being global, since strength in China etc. has been a major factor in pushing oil above decade-ago levels).

The one thing we don’t want with oil is to see prices going up for reasons that have nothing to do with economic activity, the main example being supply disruption due to instability in oil-producing regions. That’s the scenario that’s been in play lately given political upheaval in the Middle East.

Thinking in terms of the ETF model being used here, the uptrend is based mainly on Middle East uncertainty. The longest time frame measured in the model is 120 days, which is too short to pick up the bigger-picture economic case for rising oil. The pullback, of course, is hope that tensions may ease.

Going back to the magic question, whether the pullback is a correction or the start of a significant trend reversal, I can see a case for seeing the underlying uptrend as remaining intact.

That would be obvious if efforts to cool things down in Libya falter. But even if negotiations progress well, the market should still find no shortage of reasons to worry about near-term oil supply. What will the political future of the Middle East look like? We feel easy about Egypt right now. But remember, we’re only in a transition phase. What will follow the current period of military control? And what might happen in Libya if Gaddafi goes; it’s not exactly as if that country has a deep political bench filled with others ready to step in. And are we in a domino situation? Will other autocratic governments topple in turn? Meanwhile, we still have the economic backdrop surrounding oil. China would like to cool, but so far, economic momentum there remains hard to break. Meanwhile, India is growing, and so, too are other developing nations. It’s hard to see a case for energy demand faltering any time soon.

This is a weekly model so it’s hard to say how things will play out within such a short time frame. But as observed on prior occasions, particularly with gold- and silver-oriented ETFs, sometimes this model can function as an audition for things we may want to own longer term. This week may be another one of those instances.

Figure 1, is a screen shot from the FolioInvesting.com account I use to trade.

Figure 1

click to enlarge

As noted previously, the model is going through a bad spell right now as trends have been harder-than-usual to articulate. No model can be hot all the time, so when things go bad, the question is how badly the portfolio is hit. I’ll continue to stick with the strategy (hoping for a return of the sort of trend persistence that helped the backtest period (see Appendix) and the early part of the live period) as long as the penalty for a cold hand remains tendency to more or less keep pace with a still-bullish S&P 500.

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 5 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

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

Disclosure: I am long IYE, PXE, VDE, XLE, XOP.