Are Quant ETFs Prepared to Handle the Current Downturn?

 |  Includes: PIQ, PWC
by: IndexUniverse

Today I want to talk about market timing strategies ... or rather, about the failings of one particular market timing strategy and what that implies for the many quant-based ETFs out there.

I was reading The Wall Street Journal the other day and came across this article on the so-called "Fed Model." The Fed Model is a popular market-timing strategy that compares the forward yield on stocks with the yield on the 10-year U.S. Treasury. The model was created in the 1990s by Ed Yardeni, who found that it provided a good way to time the market.

Or at least it did in the 1990s. But for the past decade, it hasn't worked at all. In fact, Yardeni himself now calls it a "lousy indicator."

Why? Because the thing it relies on—forward earnings estimates—are often wrong. For instance, last summer, analysts were calling for a 7.7% rise in earnings for the S&P 500. In reality, S&P 500 earnings fell 3.3%. Analysts were too bullish and neglected to incorporate the rash of multibillion write-downs we've seen recently.

And here's what has me worried. At year-end 2007, analysts were calling for a 15.7% jump in 2008 S&P 500 earnings, according to Reuters Estimates. My guess is that those numbers are coming down, quickly. But is it quick enough?

When market directions change rapidly, and when estimates of economic growth switch, analyst estimates can lag behind... it takes the analysts a while to run the numbers, and often, people are reluctant to own up to how bad the situation is.

I wonder if this exposes the ETFs that incorporate forward analyst estimates to added risk. If the estimates lag in bear markets, does that make these models less effective? We haven't seen a bear market since these funds launched, so we don't really know.

Proponents of the funds, of course, would argue that their screening methodologies help them sidestep the worst of any pullback... and that traditional, market-cap-weighted ETFs will be more exposed to the downside.

It will be interesting to see who's right.

Written by Matthew Hougan