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I've never been among those who see fundamental analysis and technical analysis as being enemies facing off across no-man's-land. The price and volume trends studied by technicians are, actually, generated by the investment community's collective reaction to fundamentals, almost the way a film critic assesses a movie. On that basis, this week's listings for my ETF Pullback strategy (see Appendix below for details and performance information), might be seen as a set of reviews of a movie entitled something like "Our Intractable Inflation Problem." Interestingly, for this "film," critical opinion is divided. Here's this week's list:

  • Brazil Infrastructure Index (NYSEARCA:BRXX)
  • GREENHAVEN Continuous Commodity (NYSEARCA:GCC)
  • iShares MSCI Thailand (NYSEARCA:THD)
  • PowerShares DB Agriculture (NYSEARCA:DBA)
  • SPDR Barclays Capital TIPS (NYSEARCA:IPE)

Note: The model actually pointed to Global X China Technology (CHIB), but I was unable to trade that ETF in the FolioInvesting.com window protocol (the one that minimizes trading costs), so I substituted BRXX, the ETF that ranked sixth.)

This was the list for last week:

  • MSCI Emerging Markets Eastern Europe (NYSEARCA:ESR)
  • SPDR S&P Emerging Europe (NYSEARCA:GUR)
  • ETFS Physical Palladium (NYSEARCA:PALL)
  • SPDR S&P Russia (NYSEARCA:RBL)
  • Vanguard Telecommunication Serv. (NYSEARCA:VOX)

Three of this week's ETFs, the Greenhaven Commodity, PowerShares Agriculture, and TIPS funds, are clearly among the kinds you'd want to own if you fear inflation would be troublesome; if you agree with the critics who say "yes, the inflation problem really is something about which we must worry." The other two ETFs, Thailand and Brazil Infrastructure (and even Global X China Tech) represent critics who pan the inflation move saying something like "yes, it's a concern, but we can deal with it" (governments in all of these countries are concerned about inflation but are attempting to take measures they believe will keep things from getting out of hand).

In this era of mass-media sound bites, it's tempting to brush over complex issues and say "Wall Street thinks such and such" as if everybody speaks with one voice. Actually, though, that's never been true. If all of Wall Street is bearish, priced would be at zero. If all of Wall Street is bullish, priced would be incredibly high, at infinity. Difference of opinion is what generates prices that can serve as the basis for trading.

Clearly, we have difference of opinion when it comes to inflation. There's no real dispute about it being a here-and-now concern. The divergent opinions relate to how bad it might get and how effectively it can be managed, for example, by raising interest rates and letting economic activity cool (hopefully without precipitating a recession).

Speaking for myself, I'm fine with all five ETFs as a one-week technical trade (and I'd also be OK with CHIB). If I were going to hold for a longer period, I'd lean more toward the three obvious inflation plays: GCC, DBA and IPE.

With regard to the bigger picture, which, necessarily raises questions about the extent to which inflation can be managed, I'm not that concerned about the U.S. (I think too many investors and commentators burdened by too much youth and/or inadequate study of history are underestimating how much inflation the U.S. economy could comfortably handle; if anything I think economic activity has been choking as a result of inflation rates that have been too low, as I previously explained on Seeking Alpha.) Inflation in the developing world is a very different story. We've seen there how managing it has been easier said than done, and how extremes can devastate economies. So for anything more than a short-term trade, I'd be much more mindful of inflation-oriented news relating to Thailand or Brazil. Regarding the latter, I really do like the infrastructure theme (development here is very important to Brazil), but we still need to see how still-relatively-new President Rousseff will manage the economy she inherited from her ally and predecessor.

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

Figure 1


(Click to enlarge)

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 2


(Click to enlarge)

Figure 3, a screen shot from the FolioInvesting.com account I use to trade the strategy.


(Click to enlarge)

Clearly, the model has been cold for much of the past six months as trends have come and gone with unusual rapidity. Volatility, noteworthy for being low early on, has really picked up of late. Frankly, though, all strategies have hot and cold periods, and if more-or-less matching a strong S&P 500 is what comes from a cold spell, I'll take it.

Source: ETF Pullback Choices for 4/28/11: Playing Two Sides of the Inflation Fence