XLE:XLF Broke Long Term Trend Line After I Ditched the Pair

I've ditched the long XLE / short XLF strategy one week ago and then XLE:XLF pair broke long term up trend line. It appears that my ETF ranking is also good at timing the market.

Good Time to Load Up the XLE/XLF Long Short Pair

Readers of my SeekingAlpha articles may be familiar with the simple long XLE / short XLF strategy I've been advocated for months. As the pair XLE:XLF is now on the long term up trend line, forming a double bottom and bouncing up, it may be a good time to load up the pair. Nonetheless this is a pure technical call trying to time the market.

Impression, Earnings Reports

It is one weeks into the earnings season and we have developed an impression that the economy is growing. But there is another crucial factor that will negatively impact the trajectory of the market, the Europe debt issue.

We focus our discussion on financials sector and energy sector, as we are long XLE and short XLF based on our ETF ranking system. There are a couple of high profile earnings reports from these two sectors, JPMorgan Chase last Thursday, Citigroup last Friday, and Halliburton today. The numbers are rosy: all of them beat EPS and revenue expectations. Moreover, both JPMorgan Chase and Citigroup’s business loans grew in the past three months ended in June. And Halliburton eyed surging demand and growing margins. All the facts point to a more active economy and GDP growth, and a higher price level of the stock market.

Nonetheless, banks are still under pressure in an unfriendly macro economic environment. Their stock prices moved lower in face of new unfavorable regulation policies, litigation costs, and low interest rates.

The most critical issue is the Europe debt issue. It is reported this morning that “Debt Anxiety Pushes Financials Down as Bank of America, Goldman Hit Lows”. Although the Europe debt issue is already aged in years, it appeared that there is still no convincing solution. The direction of the stock market will be determined by the outcome of the duel between a growth U.S. economy and a deteriorating Europe debt issue.

Gossip on Sector ETF Rankings - July 15, 2011

It appeared that our long XLE / short XLF strategy successfully hedged a volatile first week into the earnings seasons. For the week, S&P 500 (SPY) fell 2%, XLE was flat, and XLF fell 4%. Investors who would end up with a 4% gain even when the market was falling. Our prediction was based on the predictive power of our ETF ranking system, which is a novel fundamental approach that drives short term return.

Valuable Analyses from a Reader and a Fundamental-Weight Cloud Computing Portfolio

Poppedcollar, one of my readers on SeekingAlpha posted excellent comments to my latest article: "The Growth Perspective of the First Trust ISE Cloud Computing Index Fund, SKYY". He gave insightful analyses on the prospect of cloud computing and a couple of selected companies. I'd like to copy them over.

Personally, I think MSFT, GOOG, INTC, WDC and STX all provide very safe exposure to a bullish cloud computing environment. WDC and STX may seem like a bit of a stretch but I seriously doubt any company would run a cloud with SSD. It's too expensive and too unstable. Regardless, I see WDC and STX being undervalued in any environment that will arise. Desktop PC's are far from dead and will remain a staple of personal and business computing. Tablets and smartphones are just an addon.

MSFT is another company I see being profitable from any angle. Software is always useful and Microsoft dominants from this angle. Windows sales may drop (though this is due to PCs being upgraded less frequently, not that PCs are being less frequently used) but I think Microsoft will easily cover this in other areas including cloud computing.

Google also follows the same reasoning as Microsoft with some added speculative hope for social networking. Honestly, I've been tinkering in the Google+ beta and its fairly lackluster right now but a few easy fixes and it could be significantly better than Facebook. Google (unlike Facebook) might also have some opportunity to monetize social networking by being able to draw for information about consumers. Facebook has...well a profile. Google has gmail and Youtube accounts. Youtube finds recommended videos that fit things you watch. This produces good demographics for someone posting an ad and as such, ads on Google+ will have much better targetting ability and generate a justifiably higher price tag.

Intel simply dominates the processor market and I foresee it also doing well in other forms of computing (particularly clouds). They are the best of the best in servers and any gaming oriented machine.

I'd play the software/supply angle which also captures other markets. I think it also captures the market better than a business that offers a service that may or may not be related to cloud computing (IE If it can be run off a normal network, it really isn't cloud computing).

And below is my reply:

I've checked my ranking system for the ranks of those companies. The ranks are listed below. It appeared that MSFT, INTC, and WDC are good value pick as for now.

• MSFT - 81.95
• GOOG - 57.05
• INTC - 86.70
• WDC - 79.11
• STX - 73.65

Actually another idea popped up while I'm writing this. We can create a fundamental-weight portfolio. The idea is buy low sell high. A company with higher rank is supposed to be "cheaper" than that with lower rank. So we want to load up more. The average rank of the market is 50. So the weight should be proportional to a company's rank minus 50. If its rank is less than 50, then it is expected to underperform the market and there is no reason to hold it.

Thus the weight of each company should be

• MSFT - 24.87%
• GOOG - 5.49%
• INTC - 28.57%
• WDC - 22.66%
• STX - 18.41%

The rank is updated each week (because price change will affect valuation and thus the ranks). So it's better we rebalance this portfolio each week. The concern is trading cost, which can be reduced by a longer rebalance period.

Gossip on Sector ETF Rankings - July 11, 2011

S&P 500 (SPY) fell 1.8% today in face of ugly news erupted this weekend. XLF fell 2.7% and XLE fell 2.4%. Thus our long XLE / short XLF strategy still returned a combined positive 0.3% when the market collapsed. It appears to be an effective strategy to protect from downside risks.

Gossip on Sector ETF Rankings - July 8, 2011

If the market close here, the S&P 500 would be flat compared to last weeks close. But our long XLE / short XLF strategy would return a combined more than 2% in one week. Just want to reiterate the following key points

• It is necessary to have a protection when economic outlook is not clear
• Although XLF led the snap back, it would underperform because financials' dire financial strength
• Despite a falling oil price, XLE will rise if economy recovers.

SKYY Will Be a Market Performer

The new cloud computing ETF SKYY is hot in media these days. Still its viability is questioned by some prestige investors. Indeed, according to our ETF ranking system, it will be a market performer despite all the buzz surrounding it.

The weight and rank of each stock in the portfolio is listed in the table above. Summing everything up, the rank of SKYY is 54.42, meaning in aggregation, SKYY is better than only 54% of stocks in the market. The rank put it at a level pretty much the same with the entire market in average. Based on the predictive power of our ETF ranking system, it is likely a market performer.

We also compared its theoretical performance to our cloud computing portfolio. Since June 13th, the inception date of our cloud computing portfolio, our portfolio rose 16%, while SKYY would have risen 10% if it was created on June 13th. Nonetheless SKYY's performance is better than the 5% return of S&P 500.

As Dana Blankenhorn figured, investors can find the best cloud computing stocks on their own.

Introducing Risk Appetite Spread

What is Risk Appetite Spread? Denote R(x) to be the fundamental rank of an ETF. Risk Appetite Spread is

((R(IWF) + R(IWO)) /2 + R(SLY)) / 2 - ((R(IWD) + R(IWN)) /2 + R(ELR)) / 2

Where (R(IWF) + R(IWO)) /2 represent the fundamental rank of growth stocks, R(SLY) represent that of small caps. The average of these two represent the fundamental rank of risky assets. (R(IWD) + R(IWN)) /2 represent the fundamental rank of value stocks, R(ELR) represent that of large caps. The average of these two represent the fundamental rank of safe assets. In theory a high RSA indicates that risk appetite is on and will add fuel to a bull market.

Read more on ETF Ranking and Fundamental Ranking.

Where is RAS? It is located to the lower right corner on my blog. Similar to Sector Rank Spread, RAS is calculated and updated every weekend.

Cloud Computing Portfolio Rose 2% in One Week, Four Times Market Return

Five trading days have passed since we published our cloud computing portfolio on SeekingAlpha: "Cloud Computing: Design a Portfolio for the Best, Normal and Worst". Because we were boasting that our ranking system is for short term, specifically one week return, it is a good time to have a check on the performance.

Comparing to Jun. 13th close price, the equal weighted portfolio rose 2%. In the same time, S&P 500 rose 0.5%. In our article we estimated that our cloud computing portfolio will beat the market by three times. It actually outperformed by four times. The extra return may be explained by the halo of cloud computing.

Money Flows to Energy and Materials

A recent Focus on Funds blog post on Barron's cited a piece of research from S&P equity research team saying that energy and materials have "experienced the largest money inflows as a percentage of total assets so far this year. "

In the second-quarter, [energy's] inflows were up 3% on the heels of a strong 8% inflow surge in the first-quarter.

Basic materials, the second most popular fund group in 2011, came in nearly 3 percentage points less in terms of net inflows.

Readers of my Sector ETF Ranking Articles at SeekingAlpha.com would know that my ETF ranking system continuously rank XLE and XLB to be the top two offensive sector ETFs since inception this May, matching the market consensus reflected by money flow. I believe this is a strong proof that fundamentals drive returns, even in short term.

ETF Ranking: Growth vs. Value

In an early post I showed that we can use ETF rankings to gain insight on where we are in a business cycle by mapping it to the Sector Rotation road map. I found another road map of Growth vs. Value on Interactive Investor's blog, of which I can make similar use.

The research was carried out by Morgan Stanley. It states that value stocks will outperform during early stage recovery and mid-stage bull market, growth stocks will outperform during mid-stage bull market to peak of bull market, then in bear market, balance sheet will outperform till the bottom. Although I'm not aware any ETFs representing balance sheet, there are value ETFs and growth ETFs. Because a highly ranked ETF will outperform the market, we can use this predictive power to learn where we are in the business cycle.

I select iShares growth and value ETFs: IWD, IWF, IWN, IWO. Their ranks are listed below:

• IWO, Russell 2000 Growth Index ETF: 63.19
• IWF, Russell 1000 Growth Index ETF: 58.54
• IWD, Russell 1000 Value Index ETF: 44.77
• IWN, Russell 2000 Value Index ETF: 42.21

Clearly growth is more fundamentally attractive than value at this moment. According to the chart, probably we are in the late stage of a bull market. This matches with the conclusion in our ETF ranking and sector rotation post.

To understand when we will be in a bear market, it would be handy to have an ETF represent balance sheet. If its rank is higher than growth ETFs, then highly likely we are at the beginning of a bear market. If you know a good balance sheet ETF, please let me know.

My Comment to Interactive Investor's Latest Blog Post

Below is my comment to Interactive Investor's latest blog post: "Mines flood Nifty Thrifty screen". The author worries that "if next year is a bad year for resource companies, it will be a bad year for the Nifty Thrifty", though I think this is just the normal Sector Rotation phenomenon. I think my comments is informative so I just repost it here.

* * *

Thanks for the post. I have similar experiences.

I also have a ranking system similar to Magic Formula. Roughly speaking, Magic Formula has two components: valuation and return on capital. I added one more: financial condition. I tweaked a little bit the formulas within valuation and return on capital, though.

Although I traded my ranking system for only a couple of months, I see the same thing you discussed here. One month ago, all the top names are mining companies, including RIO. But not anymore. I think some bad fundamental numbers entered the earnings reports during this earnings season. As a result, the ranks of top ranked mining companies dropped abruptly.

Nonetheless, I believe it is normal that certain sectors / industries are favored at certain phases of a business cycle. This is actually the well studied Sector Rotation phenomenon. I don't have predictive power so I worry less what's going to happen one year down the road. But I believe I'm in good hands as long as my ranking system tracks the fundamentals closely. If commodity price crashed in the future, the fundamental numbers will crash, too. My ranking system will reflect the changes and I'll exit the positions. In fact this already happened with my ranking system. As mentioned before, now the mining companies are not top ranked anymore and I don't have any of them in my portfolio.

One key point I'd like to mention is: How often do you update the ranks. I insisted to update the ranks every week with my ranking system. Fundamental numbers change slowly, but the changes are usually abrupt. For example, the rank of RIO dropped about 20% one month ago. I think if I don't update the ranks frequently, I'll miss big profit or get caught by big loss.

Another thing is I'm not sure which EY are you using. Some value investor will use 10 year average. But I'll use ttm number. For one, ttm is more popular so it's going to have bigger impact on price, at least in short term. For two, ttm is more sensitive to changes. There will be fluctuations, but I think it pays to follow the fluctuations in the long run.

Sector ETF Rankings Match with S&P Upgrades and Downgrades

A recent Barron's blog said that S&P rated energy sector to overweight, downgraded materials to market weight and financials to underweight. I mention this because it matches with our Sector ETF Rankings for the week, which put XLE at top, followed by XLB, and XLF at bottom.

Gossip on Sector ETF Rankings - May 17, 2011

Although I have only a few data points, I think I have some proof to show that ETF ranking does drive short term return, barring any fundamental changes.

For the week starting on May 9th, my ETF ranking put XLB slightly above XLE. And for the first two day of that week, XLB rose 2.31%, slightly higher than the 2.23% rise of XLE. But then both reversed their courses in the rest of the week. By Friday, XLB was down 1.78% for the week, a bigger one than the 1.35% drop of XLE for the week. My guess is that fundamentals deteriorated in materials sector duing that three days so XLB was down more severely for the week. Actually, if you pay attention to this week's Sector ETF ranking article, you'll find that we did see fundamentals deterioration in materials sector in the week before.

The same happened for the first two days of this week. My ETF ranking put XLE slightly above XLB for this week. By today's close, XLE is down 0.76% for the week, relatively better than the 1.53% drop of XLB. As the earnings season is approaching to its end, hopefully we won't see any fundamental changes for the rest of the week. And hopefully XLE will continue to outperform XLB in near future.

Sector Rank Spread Expanded Last Week

Previously I talked about that Sector Rank Spread indicates the tendency of money rotating among sectors, which will add fuels to the bull market. SRS expanded a little bit last week. Together with the surprising resilient employment number it implies that this bull market may still have legs.

ETF Ranking: My First SeekingAlpha Article And Valuable Comments

My first SeekingAlpha article is titled: "ETF Ranking: A New Fundamental Approach That Drives Short-Term Return". I'm not allowed to publish the same content on my blog. Just copy the first paragraph over.

ETF Ranking Favors XLE and Dislikes XLF for the Week

The ETF ranking is an extension of our newly designed stock ranking system that ranks every stock based on its valuation, financial condition, and return on capital. Although the ranking system is fundamental based, it actually drives short term return. We observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, if ranks range from 0 to 100.

People posted valuable comments following my article and I feel it would be good to copy some over. The discussion is mainly centered on growth vs. value. My take away is that

• Chasing trailing twelve months (ttm) growth number is too late to the game
• Projected growth number may be a better choice, but it's inherently difficult to evaluate the quality and credibility of the projected number
• Hence the best way to evaluate growth is to do it on a case-by-case basis. There may not be a good formula to represent growth, and hence it's difficult to integrate it into my fundamental ranking system.

It's just my take away and it's always debatable.

Below are the comments:

By the way, don't be so sure growth and value are antagonistic. Books, etc, make it seem that way and that's understandable; it's a lot easier to sell a book if it can be easily classified per a particular style so devotees of that style can recognize it as something that would be of interest to them. Actually, though, growth and value are much more aligned than many realize.

[Y]ou may want to work with PEG (the PE to growth ratio). For PE, I suggest using price divided by estimated EPS. For growth, use the consensus estimated long-term EPS growth rate. Many say a PEG should be equal to or less than 1.00. Actually, though, that's folklore. Realistically, PEGs below 2 tend to be reasonable. Now, here's the hard part. Critically evaluate the growth projection. That's important. Value errors usually come from latching onto a not-so-credible growth forecast.

If you work that way, you'll develop a strong sense of stock market value (one that is not at all antagonistic to growth).

I'm not talking about quality of growth; I'm talking about the credibility -- believability -- of the projections. A P/E of 25 on shares of a company with a projected 30% growth rate sounds great . . . unless you look more closely and decide that the 30% expectation is nonsense. The hard part is that there is no easy way to assess this; if there were, then everybody would be spot on in terms of stock valuation and there would be no opportunity for a value investor!

My Pet Project

ETF Ranking: Related Research

I was browsing on the web for related research on ETF ranking. My first impression is that this topic is overly crowded. Just look at how many Google ads associated to the keyword when you Google "ETF ranking".

Then I noticed that my blog post "ETF Ranking, Sector Rotation, And Business Cycle" is at the 6th place on Google. Not bad considering I've started this blog only a month ago.


OK, this is not the purpose of this post. The purpose is to give an overview on others' research on ETF ranking.

First, something about fundamental ranking.

Fluent investors may have noticed the similarity of my fundamental ranking system and Greenblatt’s magic formula. Although I didn’t know about magic formula when I started to work on my ranking system, I do agree with Greenblatt in many fronts. He suggests using magic formula on large groups of stocks, that’s why I settled with ETF ranking. He also commented that once applied to large groups of stocks, any differences between the various return on capital formulas will not have much effect on the performance. I'd like to use this as an excuse of not revealing my formulas.

Now on ETF ranking. It appears that many companies provide ETF ranking as a financial service to investors. Enumerating all service providers is not my purpose. I just try to enumerate all different approaches, and pick one representative website for each approach. And by no means the list is complete. I stopped at about page 4 on Google.

A little bit brag first: although there are many different approaches, none of them provides data to show the relation of their ranking system and short term return, at least I didn't see any public data. It appears that my ETF ranking is the only one that is designed for short term return and has data to show the strong statistical relation between ranks and short term return.

Enough for bragging.

1. XTF’s structural integrity. ETFs are ranked based on (a) Tracking error, (b) Efficiency: daily alpha before expenses, (c) Market Impact, (d) Concentration Risk, (e) Tax Efficiency: Capital Gains, (f) Expense Ratio, and (g) Bid-Ask Ratio. No doubt all of them are important for institutional investors. But by no means this is a fundamental based ranking and I'm certain there is less likely to be any relation to short term return.
2. NewConstruct.com. Admittedly their idea is similar with mine. They first rank stocks in the ETF's portfolio by their risk and reward, and then sum up to the rank of the ETF. Although I don't have additional information, my guess is the risk and reward should have at least some fundamental flavor. And the sum-of-parts approach is the same with mine. Nonetheless, there is no data show the relation to short term return.
3. Value line. An introduction is here. This is by far the closest one to mine. It is value based, which has to be fundamental. And it is sum-of-parts. However, their ranking system is designed for 6 months to 12 months holding, while mine is for 1 week rebalance. The introduction did say they have one year data to show the performance, though.
4. Sabrient’s SectorCast model. The rank consists of two parts: fundamental data and analyst's projection of company's future performance, such as forward P/E. The idea sounds brilliant, but I'd like to question the soundness of using analyst's projection. More often than not, analysts are just chasing public opinions. The performance data is not persuading. Actually the best ranked ETFs generated negative return while the market is rallying. Due to this, their model is evolving constantly. The risk is that they are just tweaking the model to fit the curve.
5. Ranks based on past 3 months or 6 months' performance. Such as ETFTable.com. The information is good for momentum or trend trader. Both are mysterious and certainly not based on fundamentals.
6. Ranks based on technicals such as 20 day moving average and 50 day moving average from masterdata.com. This is another way to express trend, and certainly not based on fundamentals.
7. Ranks based on number of new highs and new lows of constitutes from ETFinvestmentoutlook.com. Yet another way to describe the technical strength, and certainy not based on fundamentals.

Short Low Rank ETF Still Good Hedge

I spent a little bit more time to dig into the problem whether shorting lower ranked stocks or ETFs is a good hedging strategy. The data I got yesterday are on the bottom 20 stocks. If you still remember what I have discussed in my post on effectiveness of fundamental ranking, you will know that those stocks' ranks are below 1. They are not good hedge because they are garbages, and when the market turns from bear to bull, the rising tide lifted garbages a lot faster than those boats, i.e., stocks with higher ranks. Miserably you will see the market rallying while your portfolio falling if you short the garbages as a hedge.

But currently the sector ETF with the lowest rank is XLF. Its rank is around 20 as discussed in my post on ETF ranking. The question is whether rank 20 behaves like garbages or boats. If it is like boats, it may still server as good hedge.

In my post on effectiveness of fundamental ranking, I only calculated the estimated annualized return of the upper half of the spectrum: from rank 100 to rank 50. Using the same method, I calculated the return of the lower half. The result is shown in the chart below. Unlike the upper half where the best curve fit is 1/x^4, the lower half's best least square fit is a straight line.

On the chart each point represents a group of 100 stocks. The lowest 100 stocks, rank 0 to 3, still behave like boats. They are the worst performing stocks in the spectrum. So the garbage is only the lowest 20 stocks? To answer this question, I calculated the return of the lowest 50, 20, 10, and 5 stocks.

The bottom 50's return is lower than that of bottom 100. But bottom 20 is a lot higher, and it go up steeply all the way to bottom 5. So really the garbages are the bottom 20. No wonder I see such a bad performance when hedging with them.

Some key take away:

• The bottom 20 stocks behave like garbages, one should never touch them, no matter long or short.
• The market neutral strategy mentioned in ETF ranking would still be a good strategy if the shorted ETF's rank is above 15.
• One can short an ETF with low rank to hedge a portfolio with top k stocks, as long as the shorted ETF's rank is above 15. But that would be a little bit too complicated. In this case, short SPY may be a simpler hedge.

By the way, now you can subscribe to weekly ETF ranking update via email. You'll receive the highest ranked and lowest ranked offensive sector ETF every weekend. Go to the top right corner of my blog, enter your email address and click on "Subscribe". The "Subscribe" button will pop up a confirmation page hosted by tinyletter.com, a free service provider. You will also receive a confirmation email from TinyLetter (subscribe@tinyletter.com) titled as "Confirm your subscription to Weekly Update On ETF Ranking". You need to click on the link within to confirm your subscription.