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Did you ever just look at a list of stocks or ETFs, roll your eyes, and feel tempted to start shopping on line for a dartboard? That’s pretty much how I felt looking this week at the list produced by my ETF Pullback strategy (see Appendix below for details and performance information). Here’s the current list:

  • PowerShares DB Commodity (NYSEARCA:DBC)
  • WisdomTree International Real Estate (NYSEARCA:DRW)
  • iShares MSCI Switzerland (NYSEARCA:EWL)
  • Market Vectors Poland (NYSEARCA:PLND)
  • PowerShares S&P SmallCap Energy (NASDAQ:PSCE)

Here was last week’s list:

  • PowerShares DB Silver Fund (NYSEARCA:DBS)
  • CurrencyShares Swedish Krona (NYSEARCA:FXS)
  • Market Vectors Poland (PLND)
  • ETFS Silver Trust (NYSEARCA:SIVR)
  • iShares Silver Trust (NYSEARCA:SLV)

(I suppose this might be a good time to mention that if that dartboard approach is starting to intrigue you, the Winmau Blade III Bristle Dartboard is ranked 5-star by 64 reviewers on Amazon.com.)

For those who aren’t yet ready to go the dartboard route, I need to start by noting that the PowerShares DB commodity fund serves as a reminder of how we can’t always rely on the name of an ETF to cue us as to the factors likely to most heavily influence its performance. It appears to provide general commodities exposure. It does, indeed, touch on all the major categories. But about half the portfolio is energy with another 10% consisting of precious metals. If you’re interested in things like industrial metals, grains, softs, etc., this is not the best choice for you.

As to the energy exposure, I’m not sure how I feel this at present. The first time I looked at today’s headlines, it appeared that oil had finished correcting and was poised to recover a bit in response to reports of lower inventories. Barely an hour later, it appeared that oil would continue to fall given the prospect of ongoing economic sluggishness. Who can guess how many times conventional wisdom will change by the time the day, or the week I expect to hold these ETFs, passes.

That’s pretty much the world we’re living in right now. Express any opinion you want regarding the market. It doesn’t matter whether you’re bullish or bearish, or even why you feel as you do. No matter what you say, there are likely to be occasions when you’ll appear to have a perfect read, and other times when it will look as if you’ve lost your mind. Ultimately, the only truly valid forecast may be: I haven’t a clue.

Cluelessness sounds like a cop-out (especially in today’s market culture, where it’s become respectable to go hysterical when outcomes do not precisely match guidance or expectations), but actually, it may be the most sophisticated forecast one can offer.

Consider how forecasts are created. One way or another, the prognosticator looks at present-day conditions, looks to the past for scenarios where conditions were similar, notes how the market (or the economy or a company’s earnings, etc.) performed in subsequent periods, and presumes that precedent will hold. For example, an economist may note that past reductions in interest rates were typically followed by increased economic activity. As a result, forecasts of improved conditions will follow a new round of interest-rate reductions.

That’s pretty much how forecasting is done. Sometimes, the techniques for matching past conditions to subsequent outcomes are highly mathematical. Other times, the approaches are seat-of-the-pants. But one way or another, that’s basically what the forecasting process is about: evaluating the applicability of precedents. Sometimes, I wonder if market strategists would receive better training in a first-year law-school curriculum than they do in business school or in mathematics or economics classes.

That, essentially, explains why prognosticators today are so perplexed. We do not have suitable precedents from which to draw. For a long time, we could assume deficit spending would stimulate economic activity. Now, we know that’s not necessarily so. For a long time, we could assume interest-rate reductions would stimulate economic activity. Now, we know that’s not necessarily so. For a long time, we knew the U.S. drove the world’s economic engine. Now, we have to figure out what to make of the EuroZone and all its problems. For a long time, we could assume higher resources costs would act as a causal factor that inhibits economic activity. Now, we have to consider that higher resource costs represent the other side of the chicken-and-egg riddle, the effect of economic activity rather than a cause.

Ultimately, all of our forecasting models, whether mathematical or seat-of-the-pants may be of questionable utility right now because we have to analyze too many unprecedented factors. To some extent, we always have to cope with novelty (that’s why forecasting can never be an exact science). The question involves degree. Today, the novel factors aren’t just a few more things to toss onto the table. They’re dominant.

This becomes a bit less troublesome when we consider individual stocks. Company-specific drivers (bottom-up factors) tend to be narrower and still more amenable to precedent analysis. But the macro factors are a mess. So now, more than ever, it’s crucial that those looking at individual equities understand that the only legitimate conclusions are outperform, underperform or match the market. (Numeric price targets depend heavily on market movement and, hence, the unprecedented macro factors.)

With ETFs, however, we move from bottom-up to top-down, which brings the breakdown in precedent to the fore. This is probably why my pullback model has lately tended to match the market in the last month or so (following some painful episodes earlier on) almost regardless of whether it seemed, before the fact, to be correctly or incorrectly positioned relative to traditional market “playbooks.”

This week’s portfolio looks to largely violate those playbooks. Global economic activity would not seem likely to justify bullishness toward energy and I’m not sure real estate markets, even outside the U.S. and in the developing world (an area in which the Wisdom Tree International Fund is now adding exposure) are ready to recover. Poland and Switzerland are, at least, outside the scope of current European worries, so that’s something upon which I can hang my hat. But as to the rest, I might just as well stick with pure technical analysis since the fundamental precedent-based playbooks haven’t been covering themselves with glory. (And I will, indeed, stick with technical analysis here since there is one precedent I absolutely must respect: Based on the way I aim a baseball, I wouldn’t dare try throwing sharp objects such as darts!)

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. (Click charts to enlarge)

Figure 1


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.

Figure 3


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.

Disclosure: I am long DBC, DRW, EWL, PLND, PSCE.

Source: ETF Pullback Choices: Respecting Dartboards and Clueless Forecasters