ETF Sector Plus Strategy Insights: Exogenous Shocks

Mish Schneider | March 8, 2014

This week we had a position change in the strategy. On Tuesday 3/4/2014 we sold out of TECL and initiated an equal weighted position in DRN at the market open. We closed out that trade up 15.8% from where the model entered TECL in December. Technology is still one of the leading sectors, but it was edged out of the top three. The new position, DRN (real estate) closed the week down 4.8% from where the strategy entered. This week the SPY churned in a “spinning top” market as it digested mixed economic news and geopolitical threats. The SPY ended the week up +1.05% while our ETF model held fairly flat down -.33%.


This Week’s Strategy Lesson: Exogenous Shocks.

These last couple weeks have been good examples of the potential effects of “exogenous” shocks or news events. When economists look at the economy or financial analysts values a company, they construct models that include a variety of factors.

For economists, it might be the employment rate and productivity. For financial analysts, they might look at a company’s growth rate or profit margin. The idea of creating models to value a company or economy is based on the idea that these variables interact with each other in meaningful ways and they change overtime in somewhat predictable ways.

We just had the Employment Situation report released Friday morning. Nonfarm payrolls were up 175,000 compared to a consensus estimate of 150,000. Economists put together models of where they thought this number was headed based on a variety of information, not the least of which is the recent trend in these numbers over the last few months. The number could come in high or low, but it generally falls within a range. It’s somewhat predictable.

Geopolitical events, on the other hand, are very hard to predict. It’s what an economist would call an “exogenous” event—something that occurs outside of our ability to make reasonably accurate predictions.

The events in Ukraine and the mounting tensions between Russia and NATO fit this bill. It is precisely the type of news that can cause investors to suddenly reevaluate their risk tolerance or exposure to markets. All week long, news stories and rumors of news stories have caused the market to occasionally zig and zag. Fortuneately, despite a jump in the VIX and several gap openings, the markets haven’t moved significantly up or down yet.

In the ETF Sector Plus Strategy, we hold diversified ETFs in the strongest sectors. The diversification protects us against exogenous shocks that can affect single stocks. And being in the strongest sectors can help mitigate us from shocks to the broader market—but we are not immune to them. That’s why it is important that you trade the model with position sizes that fit your unique level of risk tolerance. We believe that sticking with the model suggestions will provide a great long term investment return, but the performance during any given week can be subject to market fluctuations and shocks from unpredictable events.

Here is a summary of the weekly performance of all the ETFs that the strategy monitors:

PBW had a strong week and edged into the top three on Friday, however, DRN is sufficiently close to PBW that it has not triggered a position change yet.


Best wishes for your trading,
James Kimball
Trader & Analyst