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Finally, after an adventurous (and painful) romp through the commodities arena and a bit of contrarianism last week involving Healthcare and China, my ETF Pullback strategy (see Appendix below for details and performance information) has taken cover in areas traditionally known for relative safety. Here’s the current list:

  • WisdomTree Dividend ex-Financials (NYSEARCA:DTN)
  • First Trust Morningstar Dividend Leaders (NYSEARCA:FDL)
  • First Trust Large Cap Value AlphaDEX (NYSEARCA:FTA)
  • PowerShares Dynamic Food & Beverage (NYSEARCA:PBJ)
  • Consumer Staples Select (NYSEARCA:XLP)

This was last week’s selections:

  • iShares MSCI South Korea (NYSEARCA:EWY)
  • First Trust Health Care AlphaDEX (NYSEARCA:FXH)
  • iShares Dow Jones US Healthcare Provider (NYSEARCA:IHF)
  • PowerShares FTSE RAFI Asia Pacific ex Japan (NYSEARCA:PAF)
  • Rydex S&P Equal Weight Health Care (NYSEARCA:RYH)

In a way, the current list is a bit nostalgic for me. My first investment-related job was as an analyst at Value Line and I began in 1980. Hence the steep recession that followed was an important part of my formative experience, with the themes now spotlighted by the model – yield, consumer staples, and large value plays – having been huge.

“Defensive” was the label used to describe such areas. It was never suggested that any of these would be counter-cyclical; i.e. that they would actually go up in tough times.

That was a disappointing but necessary introduction to the real world, after having just completed a standard MBA finance program that was typically heavy in quant modeling wherein it was an article of faith that an investor could easily blast through hard times simply by having a bunch of uncorrelated investments. Judging by what quants delivered to us in the late 2000s, it seems, sadly, that academicians continue to propagate such ideas, only this time around, it seemed that the market lacked a sufficient number of experienced veterans to teach them that the real world doesn’t actually work that way. (Either that, or the old pros were deemed too quaint to be worthy of continuing attention.)

Actually, the fantasy of counter-cyclicality wasn’t confined to Wall Street. Back in the 1960s, conglomerates were constructed based on the notion that during recessions, some businesses would rise thereby offsetting the cyclical units and producing a nice, steady, profit stream year in and year out. That, too, turned out to be baloney, and by the time I became an analyst, the business world had figured that out, leading to some interesting special-situation opportunities that came from the dismantling of old conglomerates.

The upshot of all this is that when times are hard, there really is no place in the stock market to completely hide. Defensive investing does not mean we pick stocks likely to go up in a recession. Instead, it means we pick stocks likely to fall, but to lesser degrees than the market as a whole.

Consumer Staples is a classic example, based on the tendencies of these companies to make small-ticket everyday necessities. Consumers may not purchase as much during hard times, or they may price-shop more aggressively. But they aren’t likely to go without, as might be the case, say, with a new car or high-definition TV.

Income investing is another classic defensive area. Yields tend to cushion the impact of falling stock prices. And besides, companies that pay generous dividends tend to be those that have more stable profit streams.

As to large-cap value, “large” is seen to benefit from “flight to quality” (whether such quality is real or imagined). But “value” is definitely much easier to embrace when times are tough.

But is that really all there is to hard-times investing? What about different asset classes?

It’s been almost reflexive lately to think “commodities” as soon as one hears the phrase “asset class.” Whatever the case may have been in the past, however, we’ve been seeing lately, that commodities tend to be tied to global economic activity and that different parts of the world are increasingly economically linked. Anybody touting commodities as a low-correlation asset class should have an easy time producing a ton of data showing low correlations. But that’s the past. Even if you really hate to listen to legalese, take seriously the phrase “past performance does not assure future outcomes.” Although there will be odd opportunities here and there, assume a lot more overall correlation between commodities and equities than we’ve seen in the past.

Back in 1980, fixed income was a great alternative to stocks. Recessions cut into demand for money resulting in lower interest rates which helped bonds. But back then, interest rates were a heck of a lot higher than they are today. So here again, don’t believe in past performance. With interest rates close to zero, as opposed to the mid- to high-teens of the early ‘80s, we could easily see stocks and bonds decline in tandem.

Bottom line: Probably the only true shelter from hard times is cash (even precious metals have risen so high as to raise the scepter or continued correction), although unfolding debt-limit-increase debates in Washington may even raise blood pressure among those who pursue this classic safest-possible strategy. Beyond cash, assuming one does want to maintain exposure to at-risk assets (as many do since few among us are so great at economic forecasting as to be confident we can know when to get back in), the kind of defensive ETF list produced by the model still seem like pretty good choices when hard times seem likely.

By the way, you may have noticed that the ETFs listed this week embrace some newer themes over and above consumer, large value, and income.

The PowerShares Dynamic and First Trust AlphaDEX ETFs are both designed to rely on proprietary models to outperform more passive versions of their respective strategies. The First Trust Morningstar ETF seeks not just yield but also attempts to model dividend consistency. And the Wisdom Tree fund is fundamentally weighted, meaning a stock’s proportion of the portfolio is based not on the size of its market capitalization but instead on the relative size of some other combination of factors, in this case, net income and cash dividends.

As one who works with models based on screening and ranking, the PowerShares and Frist Trust approaches definitely intrigue me. Naturally, I like the idea. So far, though, these so-called alpha-seeking ETFs have yet to consistently show better performance than their more passive peers. But it’s too early to fully judge the merits of these particular models, since many came out at the worst possible time, just before the late-decade crash. For what it’s worth, though, we have seen that during the worst of times, they did not cause any special damage (beyond that caused by the market as a whole).

I frankly still don’t know what to make of fundamental weighting. It’s definitely backed by aggressive public-relations, to some extent by Wisdom Tree, and especially by Robert Arnott, who has produced such indexes for a competing ETF family (RAFI). Any fundamental scheme will have more of a value tilt since one avoids the impact of surging stock prices by weighting on the basis of factors that don’t include share price. Simply put, fundamental weighting is a different, less market-sensitive, way to purse a bigger-is-better strategy. Like the alpha-seeking funds, however, many of these came out just before the crash, so we haven’t yet had a chance to fully evaluate them in a normal context.

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

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

As noted in recent weeks, the model has been on a cold streak as trends have come and gone with unusual rapidity. Volatility, noteworthy for being low early on, has really picked up of late as the model wrestled with commodity-related gyrations, the most recent of which has had an especially deleterious impact on performance.

It may be hard to see in this graph, but when I zero in on the last three weeks, the model has actually been modestly ahead of the market. But that last big slide was a whopper, and at some point, the model will need something comparable on the upside, at last on a relative, if not absolute basis. It’ll be interesting to see if this week’s decidedly defensive stance delivers at least some of that. This will depend on whether we experience more bad days such as what we saw as we entered June.

Source: ETF Pullback Choices: A Portfolio for Hard Times