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May 04, 2008

The "Recession Trade" Is Over
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 May 2, 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.

Agricultural (DBA) - 10.2%
Brazil (EWZ) - 11.3%
Swiss Franc (FXF) - 8.6%
Gold Miners (GDX) - 8.3%
Gold (GLD) - 10.6%
Treasuries 7-10 Yrs (IEF) - 8.7%
Silver (SLV) - 8.8%
Steel (SLX) - 10.2%
Natural Gas (UNG) - 10.9%
Oil (USO) - 12.7%
Cash ($$CASH) - -0.2%

Returns

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

Equity: $98,234.50
Gain, Past 4 Weeks: 0.13%
Gain, Year to Date: -3.21%
Gain, Since Inception on 11/19/2007: -1.64%

The following ETFs in the Rotational portfolio paid dividends or distributions in the past four weeks: IEF and FXF. Payments are included in the stated returns.

Total dividends = $35.40 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. In previous posts, the methodology had an element of "forced allocation" to different asset classes, that is, provided that momentum is positive, one issue from each asset class will be held, with the remainder of positions allocated to the issues with the most momentum, regardless of asset class. My backtesting has revealed that the system will perform better, albeit with higher volatility, if this element of "forced allocation" is removed. Therefore, starting with this post, the Rotational system will hold 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.

If the table is truncated in your browser, click on it to view it in its own pane. Depending on your browser, you may have to click again to view it in full size.

Tracking

Shares of IEF, GDX, GLD, and FXF will be sold, market at open on Monday. The proceeds, minus the negative cash, comprise 36.0% of portfolio weight, and will be used to buy shares of XME, OIH, MOO, and IEZ based on the closing price on May 2. 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.

In last month's review of the Rotational system, I wrote

The current trends are consistent with the theme of a U.S.-led "economic slowdown" with high inflation, and the "recession trade" has been in effect for a few months so far. The changes in momentum are suggestive, to me, that the "recession trade" has played itself out, and will start to unwind soon.

Indeed, it seems that is happening.

Bonds, as an asset class on average, have maintained some momentum, but there is a significant churning going on. The largest negative changes in momentum have occurred in Treasuries, indicating that the flight to quality/fear of risk has been waning. If you review my personal trade notes from March, I had considered a discretionary long on high-yield corporates (HYG) to be a potential winner, and that looks like it was a good idea.

Momentum is still clearly on the side of the commodities markets, but the negative change in momentum for this class is the largest of any class. Only commodities and foreign currencies have dropped momentum this month. Inside the commodities complex, precious metals and agriculturals have dropped the most in momentum (although momentum is still positive, just much weaker); energy is still strong and strengthening.

Currencies competing against the dollar are the other class that dropped momentum, although as a whole they still have positive momentum on my timeframe – just not nearly as much. The two biggest changes in momentum occurred in the Mexican Peso and the DBV "carry trade" tracker. This is significant! Strength in the Peso implies that Mexico's biggest trading partner (the United States) is expected to continue consumption and importation of goods, meaning it's a vote of confidence for the U.S. economy. When the "carry trade" makes a significant bottom, such as the one on Monday March 17, it clearly implies the flight from risk is over and that a pursuit of yield may soon return. If you review my personal trade notes from March, I had considered discretionary longs on the Mexican Peso (FXM) and Australian Dollar (FXA) to be potential winners, and the Peso idea would have worked out nicely.

Of the asset classes with significant increases in momentum, the foreign stock markets are the second strongest gainers, and actually switched from negative to positive momentum in aggregate. Brazil is getting all the press, but China, Hong Kong, and Korea seem to have bottomed, and U.S. trading partners like Mexico, Canada, and Taiwan are strong (see currency notes for implications). If emerging market stocks are bottoming, it represents (again!) an end to the flight from risk and a renewed pursuit of yield.

In the month since my last review, every single domestic industry tracked, except for two, has gained in momentum. The two non-gainers? Gold miners and health care providers. The biggest gainers are energy, materials, construction, transports, internet, networking, and semiconductors. Many of these classes don't have positive momentum (yet), but that they are showing momentum gains implies (again!) that market participants are betting on the worst being over. Significantly, gold miners and health care providers, the momentum losers, are those that one would expect to be winners in an inflationary economic downturn, so their loss is the "economy's" gain.

REITs are the biggest gainers in terms of momentum, although as a class they still show negative momentum overall in my timeframe. The biggest gainers in REITs are the retail and industrial/office classes, which (yet again!) shows the confidence that "big money" has in the worst being behind us.

It appears that the "Recession Trade" is OVER.

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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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