ETF and Mutual Fund Techniques 202

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Feature

ETFs Not Just for Buy and Hold!

by Ken Long

In my studies of complexity and uncertainty, I have seen that simple, robust systems can have a competitive advantage over those that are complex and narrowly focused.  The trade-off in performance usually is a result of an over-engineered process or a very narrowly defined system that is optimized for a specific set of conditions. While specialization has its uses, organizations and people tend to stretch their special tool beyond the region of fit to try to make it adapt for a new and slightly different environment.  There often comes a time when they stretch too much and the specialized process fails.  In practice, it is easier to modify a simple, robust process for a new set of circumstances, probably because it has fewer moving parts and the implications of the changes are easier to grasp, forecast and manage.

When it comes to trading ETFs, what I observe is that the more specialized an ETF is, the more volatile it behaves when the environmental conditions change (i.e., the market changes its mind!).  One of the challenges for investors and traders, then, is to find a set of ETFs that is diverse enough to offer an edge, but small enough to be manageable.  A smaller set of �core� ETFs in a system is easier to scale up in response to new market conditions than it is to reduce a larger, broader set.  There are management studies that show too many choices can hinder the decision-making process. Marketing science reports similar consumer behavior patterns.

The good news is that there are now sets of ETFs that allow you to examine your market from a number of different view points. You can examine the real estate sector ETFs to look for an edge along the lines of commercial vs. personal, US vs. international, country-specific vs. regional, homebuilders vs. commodity suppliers, and commercial mortgage brokers vs. residential brokers.

You can examine commodity ETFs for individual commodities or baskets of representatives from commodity groups, or various blends of all commodities or those that are tied to particular index formulas and at various levels of leverage or aggressiveness. The choices available simply for the agricultural commodities boggle the mind.

Business sector traders can examine the world market model from a functional perspective and look for an edge in particular sectors based on where a country, region or the world is in the business cycle, or based on the Fed lending policy changes.  You can look on a global basis or within the  US market.  You can compare a global business sector to the corresponding  US sector to look for a pair trade opportunity or to see the effects of policy and/or currency trends on rates of return.

I use ETFs not only as tradable instruments but as the components of an analytical system to gain insight into worldwide trends. I am attracted to simple ideas that allow me to combine my analysis with tradability in a single entity.

A concern in any trading model (ETF or otherwise) is finding the value-add. In a recent feedback experiment, I examined one of my systems that looks for an edge in two areas: 1) using market condition to guide my exposure to the market, and 2) ETF selection to achieve out performance against the broad market.

Last month, I completed a test for a swing system that trades ETFs, based on momentum and quality. I wanted to see if the system added value through (1) the selection of ETFs vs. the broad market and (2) the timing component of being out of the market when the system classifies the market condition unfavorable. I had more than 100 trade signals over an 18 month period.

To testing the system�s performance against an equivalent buy and hold from the start of the time period, I looked at gains, losses, and maximum drawdowns. I ran the System Quality Number^SM on both systems and concluded that the ETF selection plus timing was favorable.

I then took the same trades using SPY, instead of the various indicated ETFs, buying and selling on the same days at the open as the ETF signals directed.  I compared that to the SPY buy and hold and found the timing component added value.

Comparing the SPY trades to the ETF trades, I found the ETF selection added value above and beyond the value of the timing.

 I found this to be a very useful and interesting exercise to examine the different edges the system was designed to have. It was a simple test, easy to set up in a spreadsheet, and should be an interesting case study in our upcoming ETF workshops.

A recent ETF workshop attendee just completed an independent test of the mechanical set-up and execution rules of a short-term opportunity trading system in WealthLab. He looked at thousands of trades in a variety of markets and in different sets of ETFs and large cap stocks. The initial results are very encouraging and will guide additional research to examine how to refine exits, position sizing and asset allocation to tweak performance while retaining robustness.  The informal community of Tortoise-style traders that is beginning to emerge will look at this study in our chat room and discussion boards. We�ll look at this dialogue and the study in our ETF 202 workshop in May. 

We recently started up a chat room for ETF swing traders who have been to the ETF workshop and were looking for a way to maintain contact with their network, refine their techniques and develop ideas in a controlled, productive and positive environment.  It combines the power of blogging with the deliberate discussions of discussion boards, fully supported with search and filter capability as well as the ability to share images and files in real time with the group. Although it�s only a couple of weeks old, it is already adding value to the participants. Contact me at �ken� at �tortoisecapital.com� if you are interested in what�s going on in there.

About the Author: Ken Long, a retired Lieutenant Colonel in the U.S. Army with a Master's Degree in System Development, is currently a professor of tactics and logistics at the Army's Command and General Staff College. He has developed the Tortoise Method of mutual fund switching, a trading system that takes about five minutes each week with a goal of outperforming the S&P 500 Index. 

Ken is the instructor of our upcoming  ETF 101 Techniques Workshop, our new ETF 202 Techniques Workshop and a co-presenter with Van at our Blueprint for Trading Success Workshop. Ken is founder of Tortoise Capital Management, www.tortoisecapital.com.

He is a trader and writes a daily and weekly market assessment for mutual funds and exchange traded funds. He is a proud husband, dad, and 
ju jitsu practitioner. 

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Trading Tip

MACD in Its Most Useful Form

by D.R. Barton, Jr.

Some tools in technical analysis are widely used because they are popular.  Others gain a following because they truly work.

Today we�ll look at an indicator that is both popular and useful.

Last week we took a look at the details of how the Moving Average Convergence-Divergence (MACD) indicator is constructed.  If you�d like to review that article you can find it by clicking here. 

I�m fortunate to get to talk trading with lots of folks in this business.  And a large number of them use some form of momentum divergence.  Let�s look at some examples of where I�ve used this technique in analysis and then talk about how divergences test positively as well.

In the summer of 2005, I made what many considered to be an outlandish call in crude oil, which was making yet another new all-time high.  In that article I said that technical and sentiment analysis would ��signal a near-term top for crude prices.�  Crude prices dropped 20% off of those intermediate highs.  One of the main tools I used for this forecast was the momentum divergence, combined with some sentiment indications.

MACD � Using Divergence As an Ally

In last week�s article, we talked about using MACD crossovers � and the fact that they don�t work that well.

Today, we�ll look another way to use MACD that does work.  Alexander Elder calls price divergence with the MACD, �the strongest signal in technical analysis.�  I can�t argue.

A MACD divergence is simply a place on a chart where prices make a new high or low and the MACD fails to also make a new high or low.  To see this visually, let�s look at the crude oil chart I used for calling an intermediate top.

Notice that oil was making new highs and the MACD signal line was dropping, as was the MACD-histogram. 

Which part of the MACD should you use to measure divergences: the signal line or the histogram?  Either can be used.   Elder uses the MACD-histogram in his book.  Others use the signal line.  Elder claims that using the MACD-histogram gives stronger though less frequent signals versus using the signal line.  I haven�t tested the difference mentioned by Elder, but anecdotally, I would agree with his assessment.

Now let�s look at a case where the MACD confirms or shows convergence with the price movement.  We�ll look at the Gold chart from back when the shiny stuff was just breaking out.

Here we see price powering up to a new multi-year high of $470 (shown by #1 on the chart).  But in this case, the MACD confirms the price movement by heading higher (#1, on the lower indicator), while we also see volatility (#2) expanding.

Avoid Costly Mistakes:  Don�t Use MACD in a Vacuum

There is one significant note of caution when using MACD divergences.  Since we are dealing with price extremes, I always like to look for one more piece of significant analysis to align with the MACD�s interpretation.  For example, for the crude oil analysis, I liked the fact that market sentiment (and emotion) were extremely high on oil (sentiment analysis is used as a contrary indicator at the extremes).  Additionally, we had a major news story (hurricane Katrina) that should have pushed prices much higher, but didn�t.  Combining these pieces of information gave a high probability that oil prices had reached a near-term top.

The same integrative analysis applied to gold.  I was not content to look at the fact that MACD confirmed the price direction.  I also looked at gold�s valuation versus other asset classes and concluded that gold remained fairly valued or even undervalued despite the run-up in price.

How do these two commodities stack up today?  Crude oil made a new high confirmed by MACD last week and gold is actually showing MACD divergence with its new highs.  However, in the case of the gold chart, we see gold taking a �three steps up, two back, three more up� approach to making new highs, and it is not holding any resistance levels or forming any meaningful double tops.  About the best that can be said is that there is a battle going on between those who think it is overbought and those who think gold prices are going to the moon.  With higher highs and higher lows being formed, it looks like the bulls are in control for now.  Clearly the $1,000 dollar per ounce level is pulling like a magnet. There is a very high probability that we�ll go to test that important psychological level before any serious pullbacks happen.

Lastly, we recently did some testing of a band system with and without momentum divergence.  And waiting for momentum divergence (in addition to a band touch) clearly strengthened the entry signal, making it more efficient.

MACD is very useful when used in its convergence-divergence role.  Combining it with other forms of analysis can enhance its reliability and lead to trading signals that you can use confidently.

Great Trading!

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV,  and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  �drbarton� at �iitm.com�. 

 

Melita's Inspirational Corner

Finding Fault

by Melita Hunt

Earlier today my four-year-old niece Charli was sitting on my lap and she told me �Aunty Letey, you have crackling near your eyes.� I reached up to my eye thinking that she saw something on my lash, while at the same time asking her what it was and she said �Little cracks, next to your eyes.� My sister calmly told me that she was referring to the wrinkles around my eyes and that I was obviously getting older.  Of course it was said out of the mouth of babes, perfectly innocent and pure, and simply an observation. My sister and I both had a good laugh about it.  I guess that my evening beauty regimen isn�t exactly working as well as I imagined it was!

It also brought me to today�s subject because it touches on how we think about ourselves and how we look. I have been spending a lot of time looking at old photos while I am over here at Mum�s. It�s an interesting phenomenon; I�ve noticed that the majority of the time when looking through the snaps, the guys will always joke about how good looking they are, while at the same time the women are picking themselves apart and saying how bad they look. 

And when photos are being taken I often hear people say �Don�t take the photo yet I�m not ready.� or the classic �I�m not photogenic.� or �Don�t put me in it, I�ll just ruin the photo.� What is this saying about you and how you think of yourself? And how many photos have you not been willing to be in? Perhaps you�ve been dragged into shots kicking and screaming, and then you implode, shrink, don�t smile or even worse, you frown. This just reinforces those beliefs that you are not photogenic, will ruin the photo and shouldn�t be in it. Vicious circle, huh?

So how often do you praise yourself about how you look in photos and how often do you put yourself down? And be careful here, if you joke about it, is it to cover up how you really feel?

I think that observing this behavior is a great way for you to stir up your beliefs and gauge your level of self-esteem. What are you teaching your children about self-esteem when you are not standing proud of who you are? Are you willing to just be yourself? If not, why not? Do you always need to look pristine and preened?

Take a good look at a set of old photos and current photos and really notice what you like and don�t like about yourself. It can be very telling! What do you really think about yourself? Are these beliefs forwarding or limiting?

I, for one, have changed my tune on this drastically. When the scare of cancer turned up in my life with the possibility of chemo, hair loss, skin disorders and the inevitable weight loss, I came to realize that all of those things are going away someday anyway. And now, looking at all of my past pictures, I am really enjoying them. They are pretty darn good, even the ones that seem horrific, like the curly perm when I was 18 years old.

Of course there are going to be the shots of horror, when someone has caught you in an unflattering pose, and I am not suggesting that you don�t take the time to look good in your photos, but don�t put yourself down if they aren�t particularly good. What belief needs to change inside of you so that you can be in photos, look at them all and just appreciate who you are? An imperfectly perfect human being, just like the rest of us.

So stand tall, jump in and light up the camera with your eyes and your smile. In years to come the photos you take now will be the ones that you will look back on favorably for many reasons.

And if you ever need reminding that today is as young as you�re ever going to be, just hang out with a four-year-old for a couple of days!

Melita Hunt is the CEO of the Van Tharp Institute. If you would like to keep up with Melita�s progress regarding her recently diagnosed lung cancer (she is a never-smoker). Please feel free to read her blog at www.myleftlung.com.

You can contact Melita at [email protected]

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