If you ever needed proof that sound bites, one-liners, rules of thumb, etc., however helpful and comforting they may seem, are actually terrible as a tool for making sense of the day-to-day markets, consider energy. That’s the theme of the funds listed now in my ETF Pullback strategy (see appendix below for details and performance information), as was the case last week. Here’s the current list:
- iShares Dow Jones U.S. Oil Equip. & Serv. (NYSEARCA:IEZ)
- PowerShares Dynamic Energy Explor. & Prod. (NYSEARCA:PXE)
- PowerShares Dynamic Oil & Gas Services (NYSEARCA:PXJ)
- SPDR S&P Oil & Gas Equip. & Serv. (NYSEARCA:XES)
- SPDR S&P Oil & Gas Exploration & Prod. (NYSEARCA:XOP)
This was last week’s list:
- iShares Dow Jones U.S. Oil & Gas Explor. & Prod. (NYSEARCA:IEO)
- iShares Dow Jones U.S. Oil Equip. & Serv. (IEZ)
- PowerShares Dynamic Oil & Gas Services (PXJ)
- Rydex S&P Equal Weight Energy (NYSEARCA:RYE)
- SPDR S&P Oil & Gas Equip. & Serv. (XES)
Here’s a simple clear-cut proposition: Diminished supply exerts upward pressure on pricing. This isn’t just for oil. It’s for everything. You learn it early in any basic economics course.
Here’s another clear-cut proposition: Diminished demand exerts downward pressure on pricing. This, too, is one of the foundations of economics.
When graphs depicting supply and demand trends are displayed on a lecture-hall blackboard or in a textbook, it all seems so clear. A supply curve slopes in one direction. A demand curve slopes in another direction. There is one point of intersection, equilibrium, which represents the correct price.
If only the real world were so clean! It’s easy for an economics professor to draw the proper graphs and show you exactly where the price of oil, or anything else, should be. But for investors and traders, it seems like an impossible task.
Looking at energy, we know supply is under pressure. We know about the political upheavals in the Middle East and the impact this can have on global production. As to what’s real as opposed to potential, we know U.S. stockpiles of gasoline and distillates (used for heating oil and diesel fuel) dropped significantly. We also know that demand is about to rise due to seasonal considerations even if nothing else (the summer driving season). Those are short-term considerations. Longer-term, we know energy demand is associated with economic activity and living standards, and that this should continue to spur demand as global economies expand. Look at what happened when China burst onto the world economic stage in the 2000s! There’s still more to come there, as well as potential in many other parts of the developing world. And it’s not as if the developed world is about to close up shop.
Based on those supply and demand charts we learned about in Economics 101, it’s easy to assume oil prices are most likely to rise and to be bullish on shares and ETFs tied to the price of oil.
But last week, oil prices weakened, pulling my portfolio performance downward along with it (see Appendix).
Pricing is not just an outcome; a result of the intersection of supply and demand curves. It’s also a cause; a factor in determining how those curves are drawn. The higher a price, the lower the demand is for an item. (Pricing isn’t the only factor impacting the level of demand, but it’s an important one.) As oil prices rise, money available for consumers to spend and for businesses to invest on other things diminishes. An increase in the dollar, which we experienced, exacerbates this: oil is priced in dollars, so if the Greenback rises, many countries will experience a price increase for oil even if the actual quote stays flat. If the actual price of oil rises as well, so much the worse.
Consider what’s happening here. Increasing demand pushes the price of oil up, which causes demand to drop, thereby pulling the price down, which causes demand to rise pushing the price up, which causes demand to fall pulling the price back down, which causes ... enough! We get it. We should not really be looking at supply-demand graphs. We need to be looking at perpetually-moving supply-demand animations (like the animated weather maps we see on TV).
When we think long term, it’s plausible to make assumptions about this chicken-and-egg conundrum. Speaking for myself, I do expect rising demand to exert upward pressure on oil prices and I further expect the world to gradually adapt to it in such a way as to prevent demand from continually pushing it back down.
The near-term is a whole different situation. If we could create supply-demand animations and analyze them, that would be fine. But we can’t. Unlike weather maps, these movements do not follow any sort of regular pattern. Theoretically, someone might be able to forecast ahead of the zigs and zags we tend to see. I’m not that smart. The problem here is we can’t even use economic data to build a forecast. Short-term movements depend not on the global economic facts as they are, but on the sort of global economic facts people predict, fear, and anticipate will come into being.
This trading strategy was caught with a bad hand last week. Looking ahead, I’ll close my eyes, grit my teeth, and hope for a better outcome in the coming week.
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% 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 1 shows the result of a StockScreen123 backtest of the strategy from 3/31/01 through 12/30/10.
Click to enlarge charts
Figure 2 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, a screen shot from the FolioInvesting.com account I use to trade the strategy.
Clearly, the model has been cold for much of the past six months as trends have come and gone with unusual rapidity. But it seemed to have been recovering up until last week, when it got caught flat-footed by the reversal in oil prices.