ETF Sector Plus Strategy Insights: Crossing the Zero Divide (Part 4)

James Kimball | August 3, 2015

The ETF Sector models actually outperformed their benchmark across the board. The Sector Conservative model is back to beating the market while the Moderate and Aggressive both continue to lag on the year.

The week all the major indexes gapped lower to open the week before slowly clawing back to even or a little ahead. The SPY and QQQ are back to a bullish phase. DIA and IWM remain in a warning stage. Next week, we have a number of major economic reports include the employment situation on Friday.

We recommend that you log into the website to see the current allocation for your model and any recent trade updates.

Summary of the Sector Models' Performance

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This Week’s Strategy Lesson: Crossing the Zero Divide (Part 4)
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This week we are going to wrap up this series. The major markets remain range-bound in this same large sideways trend they have been carving out over the last six-months. As we have been discussing, the average TSI of all the holdings dipped marginally negative recently and we have had a number of additional rotations related to this.

In the past weeks, we looked at fall 2008 and summer 2011, two out of a number of times in the last several years where the TSI went negative. We were specifically looking at how this would affect the model holdings and performance over these periods.

In both of the instances above, we saw higher position turnover and a large divergence between the performance of various portfolio holdings. However, in both of these instances, the market correction was deep enough that we were able to book profits from our short and alternative position rotations.
In this last instance, we are going to look at a more recent time where the market had a quick, violent drop but recovered just as fast.

The Fall of 2014

Last fall, the market was just coming off an unbelievable 2013 (SPY up around 26%) and rather robust first half of 2014 (SPY up around 9%). However, the market was showing some signs of slowing down and volatility making another grand entrance. In July, we saw a quick 5% drop followed by a rally to new highs in August and September, then an incredibly sharp 9% drawdown into October followed by an equally quick rally (topping off around +12%) to close out the year.

This type of violent drawdown followed by an equally quick bounce back can often play havoc on relative strength models. The pullback in October was just enough to hit some of our stops and trigger some defensive rotations. However, with the market leap-frogging into the recovery, those changes to the portfolio never had a chance to play out.

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The chart above shows the equity comparison for this period between the Sector Moderate model and the SPY. While the ending performance over this time frame was basically the same, the Sector Moderate had to weather a fairly substantial drawdown before recovering.

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The chart above shows the average TSI for the Sector Moderate since inception. We are looking specifically at time frame circled in red. The TSI made a v-shaped correction dipping negative briefly. The combination of the market selloff with the shake-up in the TSI rankings caused the higher volatility and drawdown.

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ILike the previously week’s analysis, I have zoomed into how each portfolio slot performed over this period. I have also overlaid the relative change in average TSI (grey line). We see a similar divergence between our best performing portfolio slot (in this case Slot 1 which was predominantly holding CURE over this period) and the worst performing portfolio slot (Slot 3 in blue).

The semiconductors sector (SMH and SOXL) had produced a number of great trades over the prior year and half. However, after the large price appreciation and growth in valuation, that sector started to manifest out-sized volatility. We actually got stopped out of our position in SOXL in early August, then had an unfortunately timed re-entry into semiconductors that also got stopped out.

At, what turned out to be the very bottom of the correction, the model rotated into a typically more defense position in TMF. However, with the quick correction, semiconductors returned to the lead and we rotated back into that sector and ended up clawing back to even over the next two months.

Due to the nature of this correction, the model experienced a larger drawdown than the market (the drawdown show is for Sector Moderate only, the Complete had a smaller overall drawdown due to added diversification). And while we eventually pulled-back even with the market performance over this period, it was not without experiencing some pain.

With the benefit of hindsight, we can look and see that the correction was brief and the ship righted itself fairly quickly. But, it goes without saying, that in real-time it is a lot harder to diagnose where the markets are going and trade with conviction during volatile periods like this one.

It’s not really possible or practical to have a trading system that can instantly respond to changes in market trends without itself getting whipped around. What we have attempted to do is design a system that strikes a balance between the competing pressures of trying to stick with a trend while also trying to identify new trends and decide when to rotate out of the old and into the new.

In our testing, the methodology we have decided upon worked well. In larger corrections, it will tend to get short and reach profit targets. In shallow corrections, we will tend to stay with the trade and “ride out the waves.”  It is really primarily the violent trend changes with no follow-thru that can cause us the biggest problems.

One part of trading (and sticking with) a system is understanding how it tends to work in different market conditions. That was, you can develop reasonable expectations and better understand the how and why of the position changes.

The Current Condition of the Model

Please visit the Model Portfolio section of the member area to see the ETF ranking for each of the three Sector models.

Stay tuned to the daily emails for any position changes and updates.

Best wishes for your trading, 

James Kimball