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My ETF pullback strategy (see appendix below for details and performance information), updated a day early this week based on vacation travel tomorrow, has heavy silver exposure, supplemented by a dash of exposure to other precious metals and European real estate. Here’s the current list:

  • PowerShares DB Precious Metal (NYSEARCA:DBP)
  • PowerShares DB Silver Fund (NYSEARCA:DBS)
  • iShares FTSE EPRA/NAREIT Dev (NASDAQ:IFEU)
  • ETFS Silver Trust (NYSEARCA:SIVR)
  • iShares Silver Trust (NYSEARCA:SLV)

Here was last week’s 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)

Obviously, when we see precious metals, we start wondering about global tensions, inflation and other kinds of uncertainties. Silver has more industrial use than gold, but given the current price levels, even after the mid-year correction, uncertainty rather than GDP is more likely to drive future price trends, for better or worse.

Inflation is not an issue today, but it remains a back-burner concern as the U.S. continues to struggle with deficits and the need to find solutions. Whether QE2 helped or whether a QE3 might be constructive are irrelevant questions now. Merits aside, political disdain for easing is extreme (as the Fed full well knows) and inflation watchers are likely to remain on edge simply knowing that easing has occurred and that current indications that it ended can always be reconsidered later on. Meanwhile, global tension remains an issue even though the Middle East has receded a bit from the headlines, but I’m not sure it will drive precious metals much in the near term. (When in human history have we ever really and truly enjoyed global peace? The issue isn’t the existence of tensions. It’s whether current tensions are significantly worse than usual and at the moment, I’m not sure they are.)

I think uncertainty over developments in Europe are likely to emerge as the main driver of precious metals, with bigger-picture concerns likely to eventually overwhelm the headline de jure: Greece.

A week ago, I discussed the process of forecasting and explained why an admission of cluelessness might actually be the most poignant honest thing any prognosticator could say nowadays, when the precedents that need to be evaluated to create a forecast range mainly from non-existent to useless. We’re seeing a dramatic example of this right now, in Europe generally and for the moment.

The Greek Parliament just passed a package of austerity measures deemed by many to be necessary for its financial rescue. At first glance, this hardly seems unprecedented and it seems like the developed world can exhale. We’ve seen many instances in years past where debt-plagued countries, especially in Asia and Latin America, have found it necessary to tighten their belts in order to solidify national finances. And life went on, in many cases, better than before. But this situation is different. Really! Greece isn’t just any country. It is part of a supposedly (and hopefully) strong union with other countries, a confederation that dreams of becoming an economic force to rival the United States and now China.

In the last sentence, note my use of the word “confederation.” That was quite deliberate since ultimately Europe is being forced to face the sort of issues we faced after gaining independence from Britain in the late 1700s, as we progressed from the Articles of Confederation (which gave primacy to state sovereignty) to the federal-leaning U.S. Constitution. The former British colonies always recognized the need for some sort of union, but had much to consider and debate when it came to the details of how far that union would go. As it turned out, we opted for more union rather than less, and strengthened the role of a federal government.

The details of the controversies are not identical, but Europe today is, essentially, wrestling with the same big questions. It is well understood that some sort of cooperation is needed. That’s long standing. Even before the euro currency union, it had the Common Market. Pretty much everybody has long agreed that in the modern world, given the state of technology, communication, travel and so forth, it’s not practical of desirable for each sovereign state to stand as an isolated self-contained society (that’s not even practical for the U.S. or China even with our respective economies of scale relative to European nations).

It was thought previously that adding a common currency to the common market would suffice. We’re now having cause to wonder if that’s really so. How far can a group of countries go in the direction of economic union without adding political union?

We’re seeing with Greece the consequences of a country trying to do its own thing in terms of fiscal and social policy while attempting to maintain monetary ties to others. It fell flat. Greece is now facing up to the need to move its fiscal and social policies closer to those of the mainstream, or at least to the dominant eurozone nations if it is to remain in the union. Nominally, it retains its own political sovereignty. But to the average Greek citizen, it may feel a lot like a considerable degree of nationwide policy-making has been yielded to the likes of Germany and France. It’ll be interesting to see how that plays out as austerity takes hold on a day-to-day basis.

Greece is by no means alone. We’ve still got Portugal, Ireland, Spain and perhaps Italy waiting on deck. How much de facto sovereignty will those countries have to effectively yield in order to remain in the currency union? How far can the process go without prompting mass tensions?

To a U.S. observer, it may seem as if a U.S.E. (United States of Europe) is ultimately what’s needed. Don’t count on that happening in this generation, but a lot could occur that would make it look or feel like a U.S.E. exists. Consider the debate between lavish social spending versus fiscal austerity. We argue vigorously about that in the U.S. But at least all voices, mainstream Republicans, Tea-Party Republicans, centrist Democrats, leftist Democrats, etc. are all from the U.S. and after however much screaming, shouting, protesting, cursing, arguing, and debating we do, the outcome will ultimately be determined within the U.S. Greek citizens can’t say likewise. Citizens of Portugal, Ireland, Spain and Italy seem to be heading in that direction as well.

It is still way too early to tell which path Europe will ultimately follow; whether it will opt for further integration or fracture. At first glance, it may seem that the history of the United States would serve as an important precedent, one that points in the direction of the emergence of a U.S.E. On closer examination, however, the precedent looks weak.

The 13 former British colonies were just that: British. They were united by a common language, a common culture, a common set of social customs and expectations, and a common political heritage including much that came to inspire the specifics of the Declaration of Independence. No such commonalities exist among the nations of Europe. They differ in terms of language, history, culture, political sensibilities, and so forth. Notwithstanding a violent revolution, the United States of America clearly and directly evolved from Britain. A United States of Europe would have to come together from a mish-mash of vastly different components. As easy as it may be for commentators today to wax poetic about political integration, we really have no idea if it can be achieved to any meaningful degree any time soon.

So even if Greece opted for austerity today and can now start to restructure its debt, we cannot rest easy. It remains to be seen how such nationwide submission will play out over time among the Greek population, and how it will play out among other financially-strapped European nations. And we have no real basis for predicting an outcome. Many will express expert opinions. Ultimately, though, none will amount to anything more than hopes and guesses.

On one level, the dollar may slip against the euro, which should provide a short-term prop for precious metals prices. The bigger picture, however, may come from continuing pulling and tugging at the nature of the present European confederation of nations and its future. As challenging as things may seem in Egypt, Syria, Libya, etc. at least nobody is questioning the ongoing existence of those nations. In Europe, however, the existence and nature of national sovereignty itself is coming under the microscope. That is the kind of uncertainty upon which a precious metals bull might hang his hat.

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 selected 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.

Figure 1

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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

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

Figure 3

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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.

Source: ETF Pullback Choices: Is There a Silver Lining for Europe?