ETF Update: True Sector Rotation?

Sector rotation is a matter of time frames.  The TV pundits use the term whenever the daily trade is to sell one group and buy another.  The news story is measured from one day to another.

The problem for investors, and perhaps even traders, is that these very short-term moves must be guessed in advance.  This is not very helpful for system traders.  One needs time to read a new signal.

The Fundamental Problem

Last week we enjoyed a day back in the classroom — a guest lecture invitation.  It is a good opportunity to think about one’s message.  What can one say to a group of very intelligent and eager young students?

Here was part of our message.

Many trading models take data from period “A” and forecast period “B”.  The time frame for these periods can range from seconds to months.  Each model gives a different answer.  In particular, fundamental analysis has a longer time frame.

It is important to find a system that fits one’s personal trading style.  We have had excellent trend-following models that did not work for traders?  Why not?  Their psychology was to “sell the rips and buy the dips.”  The model was designed to cash in when there was a big breakout.  The traders were out of the market in a big upside breakout, and some were even short.

Are we at the top of a range, or is the market breaking out?

The Current Market

Our own approach to sector rotation makes a 30-day forecast.  There is some smoothing of past data to improve the signal-to-noise ratio.  It identifies Trends, Cycles, and employs a bit of Anticipation.  Since we use a universe of ETF’s, we call it the TCA-ETF model.

We have done some sophisticated back testing so we know the best and worst circumstances for our approach.  The best runs come when sector strength moves from one group to another - -handing off the baton.

The worst conditions come when all sectors are correlated in a trading-range market.  This has been the situation for the early months of this year.

Knowing this makes us especially interested when new sectors show strength.  (For new readers, there is a more complete description of our methods and ratings at the end of the article.)

Featuring Basic Materials

Moving up rapidly in our sector ratings is  the Dow Jones U.S. Basic Materials Sector Index Fund (IYM).  This group is pretty concentrated with 40% of the holdings in five names that you know (DD, PX, NEM, FCX, and NUE) and 60% in the top ten.  The average price/cash flow is about 4 and the P/E is about 12.5.  These ratios reflect the current negative economic sentiment.  The beta is about 1.4.

Each week we do a search on the leading ETF guru’s to see if anyone else is highlighting a sector, but this one draws a blank.  It is a real play on an economic rebound, and few see that.  Here is the picture our model is picking up.

It is always interesting when the model highlights something unusual.  There is some support from the ECRI leading indicators, as noted here.

Meanwhile, the sectors featured in the last two weeks — financials and home builders - -have done well, but we are watching for new leadership.

Weekly TCA-ETF Rankings

Almost all of our sectors except the inverse ETF’s are now in the “buy” range, with high ratings for financials and many other groups.  It was an excellent week for the system, gaining over four percent (after a bad start) and beating the S&P by a point.

Based upon the model signals, we continue our official bullish position in the Ticker Sense Blogger Sentiment poll.

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