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My ETF pullback strategy (see appendix below for details and performance information) is looking for the market to take a breather following a nice bounce off what I had described as an oversold condition back on June 9. Here’s the current list:

  • CurrencyShares Swiss Franc (FXF)
  • PowerShares Preferred Portfolio (PGX)
  • SPDR Wells Fargo Prfd Stk ETF (PSK)
  • Rydex S&P Equal Weight Consumer (RHS)
  • SPDR Barclays Capital Short Term Corp. Bond (SCPB)

Here was last week’s list, which, like the ones just before it, looked somewhat aggressive:

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

(Note: Based on scheduling issues, I’m again updating the model on a Wednesday, a day earlier than usual.)

Over a long period, I might hesitate to describe a preferred-stock portfolio as being conservative. It would seem quite vulnerable to rising interest rates as well as credit risk (many issuers of preferred shares are financial firms). But for a week (the time horizon of this strategy), I can live with it. I’m also comfortable with one-week plays in corporate bonds, consumer stocks and the Swiss Franc.

Market timing seems to be the main risk here. The model I’m using suggests stocks are ready to take a break following what might be described as an oversold bounce.

In my June 9 article, I explained the Stochastic technical indicator and how it was suggesting a short-term oversold condition back then. As discussed there, indicator levels below 20 suggest the market is oversold while indicators above 80 indicate an overbought condition. Figure 1 shows where the Russell 2000 stands as of now.

Figure 1

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It’s not a mirror image of where we were in early June. Then was more an extreme level. So it’s hard for the level of conviction regarding the prospect of a pause today to be as strong as was a month-ago belief in rally. Even so, it does seem like trading out of the kinds of ETFs I’ve been in during recent weeks (mainly relating to precious metals, energy and general commodities) seems like a timely idea. In any case, considering the hammering I took with this strategy back in the spring, I’m more willing to expose myself to what statisticians refer to as a Type I error (being more conservative than necessary) than the Type II errors I was getting hit with earlier on (gearing up for good times when in fact, the market was faltering).

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 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 2 shows the result of a StockScreen123 back-test of the strategy from 3/31/01 through 12/30/10.

Figure 2

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Figure 3 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

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Figure 4, a screen shot from the FolioInvesting.com account I use to trade the strategy.

Figure 4

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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: Looking for a Breather