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September 21, 2008

Rotational Update
by Bill Rempel

Rotational combines component rotation and asset class rotation to hold a small basket of ETFs or ETNs, selecting the handful with the most momentum from a representative sampling of classes and components. Throughout this article, when I refer to momentum, I am referring to an exponentially smoothed measure based solely on price movement.

Information is as of the close on September 19, 2008.

Model Allocation

Based on beginning with a $100,000 portfolio at inception, these are the current weights and holdings. The initial target was a buy of 10% weights per position. See my previous post on this system. Sort is alpha order by ticker and weights are rounded to the tenth of a percent.

Environmental Services (EVX) 9.1% weight
Mexican Peso (FXM) 9.3% weight
Biotech (IBB) 9.4% weight
Health Care Equipment (IHI) 9.6% weight
Transports (IYT) 9.9% weight
Water (PHO) 9.2% weight
Residential REITs (REZ) 10.3% weight
Treasuries 1-3 Yrs (SHY) 9.8% weight
Software (SWH) 9.3% weight
Oil (USO) 13.7% weight

Cash 0.5% weight

Returns

Based on beginning with a $100,000 portfolio at inception.

Equity: $80,616.25
Gain, Past 4 Weeks: -3.88%
Gain, Year to Date: -20.67%
Gain, Since Inception on 11/19/2007: -19.38%

Two of the ETFs in the Rotational portfolio paid dividends or distributions in the past four weeks: FXM and SHY.

Total dividends = $67.15 on the tracking portfolio. This amount is included in the returns shown above, and will remain in cash until needed for a new purchase. Note, commissions are expensed at $10.00 per trade when accounting for returns.

Changes To Model Allocation

Rotational screens for momentum inside a list of ETFs and ETNs by asset class category. The system is holding the top 10 issues, ranked by momentum, regardless of which asset class they are in or how much momentum they have.

If this system were to be initiated today, the target allocation would be a buy for 10% weight holdings of the ten issues highlighted in gold or green in the table below. Items highlighted in gray are "sells" from the existing model portfolio. Note that SWH barely edges out FXM in terms of momentum.

Tracking

EVX, FXM, PHO, REZ, and USO will be sold, market at open on Monday. The proceeds, plus cash, comprise 52.1% of portfolio weight, and will be used to buy shares of EDV, IEF, MBB, RTH, and TLT, based on the closing prices on September 19, at 10.4% weight each. I will round down any fractions in the share calculation.

Commentary

Below, I present the change in rotational momentum from the last evaluation to the current one. It can be quite instructive.

Here is a table that shows the average momentum for the different issues in each asset class, at different evaluation dates from the inception of the program.

On a straight-weighted-average basis, all asset classes again have negative momentum. This is an exceedingly rare occurrence. The only classes that gained momentum - although still in the negative category - were bonds and REITs.

Bonds are one of the two classes that gained momentum over the last month, although they're still in negative territory, as they have been since the June update. The U.S. Treasuries are positive - and corporate and emerging market debt is at the bottom of the momentum scale. This can only reflect a re-emerging flight to safety over the last few months. The longer end of the Ts have the most momentum, and the emerging market debt has the least. Personally, I think that the longer duration Ts are setting up for a longer-term shorting opportunity, and that the riskier debt issues - like high yield corporates and emerging markets - are longer-term buys here, but the system doesn't track my personal opinions and that means the system is getting long Ts in a big way this month.

Commodities as a class moved last month from having the most momentum, to having the second-lowest momentum, and they are still there near the bottom this time. All of the commodity asset classes that I track fell in momentum this week, and Oil (tracked by the USO ETF) finally fell enough to close out that long trade, standing at about +11% over the last 10 months. At one point the gains were much higher, but it is a staple of this type of long-term trend-following (LTTF) system that gains are sometimes given back in order to avoid getting whipsawed on shorter pullbacks. As I wrote last month, I believe that the commodity bubble is popped, and the energy complex has seen a "blow-off top" that will constitute overhead resistance for any subsequent rallies.

In the April update, Rotational Portfolio is Overweight Commodities, and in my comment on that update, I detailed my reasoning for switching my personal trades from the Rotational system to one based solely on U.S.-traded stocks, Aggressive. My intuition was that the global macro trends would change and that other systems would start to outperform, since Rotational does poorly during shifts in trend. I had absolutely no idea it would shift so drastically, however. Over the next several months I'll be spending some testing time trying to mitigate the impact from future shifts of this nature, but one has to pick their poison, as I've not yet been able to provide protection against such pullbacks without suffering from whipsaws. Note that my intuition about the shift influenced the timing of my changeover, but regardless of timing, I still think that Aggressive is a better long-term system for my account, based on size of assets managed and risk-tolerance.

Currencies competing against the dollar have fallen in momentum, moving further into the negative territory as a group, which they entered last month for the first time since I've been tracking this model portfolio. Only one currency, the Mexican Peso, is in positive territory. The Aussie Dollar, being commodity-based, is still the fastest faller. As it's become more obvious that the U.S. will rebound economically while malaise is starting to settle in across the pond, all of the European currencies are falling. The "carry trade" suffered again this past month, moving further into negative momentum.

Regarding the foreign stock markets, there's a "turnip truck" metaphor that applies ... and has already been overused. This is the worst-performing asset group in terms of momentum overall, but actually fell less this last four weeks than the commodities class did. All country indices are negative, and all fell in momentum, with the U.S. market (tracked by the SPY ETF) falling the least and having the highest momentum, i.e. having the closest to zero of all the negative measures. This may bode well for my thesis that the U.S. markets will outperform from here.

The domestic industry action is really entertaining. As an equal-weighted group, the domestic industry ETFs fell, but the action wasn't unanimous. Financials and consumer cyclicals gained healthy amounts, although they're still negative in overall momentum, and energy and materials shares fell the most. Several industry groups remain in positive momentum and are holdings in the system portfolio.

REITs are the other asset class, besides bonds, to have an increase in momentum this past month, for the second month in a row, although both groups had near-negligible increases and are still in negative territory, momentum-wise, although they are ahead of foreign markets, commodities, and the straight-weighted average of domestic industries. Only the international and residential REITs failed to gain momentum. Residential REITs didn't fall enough to be removed from the "buy" list, and the continued fall in international REITs plays well with the thesis of U.S.-based asset overperformance from here forward.

Rotational is a trend-following system that believes there's always a bull market somewhere, and in previous downturns this year, the portfolio has been able to ride it out OK because it was in "what was working." Not this time. This is the largest drawdown the system has generated in test or tracking. It's important to remember that, no matter how long any system's backtest, that its worst drawdown is always in front of it, just as its best performance is always in front of it. A backtest (or an actual trading return stream) is only a small sample from a larger heteroscedastic distribution, and as long as the recent results are within the same rough order of magnitude as the sample (they are), there's no evidence of "brokenness." In backtest, the system had a half-dozen drawdowns in the teens, and the current drawdown is 26.3% from peak equity, which is higher than, but comparable to, its backtested compounding rate and average annual return. It's potentially unnerving, yes, but not entirely outside of the expected range of results. The system doesn't change, however. It just executes, regardless of circumstance, and while it does tend to to suck wind at turning points, it makes up for it in the straightaways - because there's almost always something trending. We'll see if the current leaders, stay leaders.

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Bill Rempel
The Rempel Report

Disclaimer: Nothing at The Rempel Report, or any communication from The Rempel Report or its author, should be construed as personal advice, on investing or anything else, and at all times you are responsible for your own actions and you should perform your own due diligence. I'm not an investment professional, and you should probably consult with one, in addition to doing your own due diligence, before making any investment decisions.

I may have a beneficial position in any potential investment I mention. My positions in, and opinions of, those potential investments may change over time. I have no obligation to reveal those positions, and if I should reveal those positions, I am under no obligation to notify you, though this site or through any other means, if I change those positions.

While I do try to verify much of the data presented, I can make mistakes. I rely on third party vendors for data, and sometimes that data could be incorrect. Therefore, I cannot and will not be held liable for incorrect or erroneous data presented in text, table, chart, or other format. This is one more reason why you should consult with an investment professional, in addition to doing your own due diligence, before making any investment decisions.

Modeling is prone to error, and no statistical model is perfect. The output from statistical or predictive modeling should be viewed with skepticism.

Fundamental analysis is based on examinations of company filings such as income and cash flow statements, balance sheets, quarterly and annual filings, proxies, and other such items. Even though a company appears fundamentally sound today, that doesn't imply they actually are, or will remain, fundamentally sound. Fundamentals can change over time, and there is always the possibility that the company filed information that was either fraudulent or incorrect. I might make an oversight or error when examining company filings. In many cases, I will rely on a third party's presentation of filing data, such as a stock screening program's output, without actually reviewing the filings personally.

Technical analysis is based on the study of historical price, volume, and sentiment data over time. Past performance is no guarantee, and there are no certainties hidden in patterns, charts, indicators, or formulae.

FundaTechnical analysis involves those items which mix elements of Fundamental and Technical analysis, including valuation metrics such as the Price/Book or Price/Earnings ratios. Therefore all the warnings for both Fundamental and Technical analysis apply.

Take responsibility for your own actions. You should consult with an investment professional, in addition to doing your own due diligence, before making any investment decisions.

Copyright © 2005-2008 Bill Rempel

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