UTILIZING THE EXCHANGE TRADED FUND MARKET

UTILIZING THE EXCHANGE TRADED FUND MARKET

Timing Is Everything

It is said that timing is everything. In my life, I certainly have found this to be true. I remember my early navy days and how just four short months changed my life. I joined the navy with the ex- press purpose of entering Underwater Demolition (UDT) and then move on to SEAL Team I. Out of Boot Camp, I was told I had to first go to my duty station, Naval Air Squadron VP31, and then apply for Underwater Demolition. I did so and was accepted. For- tunately for me, I was stationed just down the road from the UDT training school while I waited for the next class to start. Since I was a Red Cross Water Safety Instructor, the squadron personnel department placed me in Air-Crew Training. They had been wait- ing for a Water Safety Instructor to come through for months by then. I was immediately placed in the Deep Sea Survival Instruc- tors group. My duties were to teach pilots, who were heading to Vietnam, how to survive in the ocean if they had to abandon their plane over the ocean.

As an enlisted man, the position as a Deep Water Survival In- structor was as good as it could get. So, when my Underwater De- molition Class was about to begin, I decided to postpone the class

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296 The Point and Figure Methodology—A Complete Analysis Tool

for the second half of my enlistment if the Squadron would allow me to stay in my survival instructor position. The Squadron was perfectly happy to have me stay on so the die was cast. I simply put on hold my desire to become a U.S. Navy SEAL until my last two years of enlistment. Well, all good things must come to an end, and my first two years of shore duty were rapidly expiring. I had a choice—go to sea or go back to Underwater Demolition Class. I chose UDT/SEAL training.

I was accepted to class again after spending three months get- ting in shape for the entrance test a second time. I ran into a little administrative wrinkle though. Since I waited for the second half of my enlistment to attend class, the navy required I extend my enlistment by four months to qualify for having two full years of naval duty following the end of training. Since I had made a com- mitment to go back to college at the end of my enlistment, I de- cided not to extend. As I look back in retrospect, this was a major turning point in my life. I was transferred to Vietnam on an Air- craft Carrier already positioned in the South China Sea. In fact, they flew me out to the ship on a mail plane. Experiencing an ar- rested landing on an aircraft carrier that was under full steam in the middle of an ocean is an experience I’ll never forget.

I spent the next two years both at sea and on shore in San Diego. When I was honorably discharged from the navy, I imme- diately went back to college. I’m sure, had I chosen UDT, I would not have gone back to college and would more than likely own a dive shop in some part of the world. It’s interesting how life is full of choices. I made the right choice for me and went back to col- lege, but at the same time I lost an opportunity to test myself that few others have. Soon after graduation and a short stint as a pro- duction supervisor at a winery, I found employment on Wall Street as a stockbroker at Merrill Lynch. One decision, not to ex- tend my enlistment for four months, profoundly affected how my life turned out. Timing is everything.

During World War II, the United States was cut off from rub- ber produced in Southeast Asia just as demand for the rubber was increasing significantly. Do you know what happened? We made synthetic rubber through a large national effort to both increase the output and quality of this rubber. Here is the clincher though. After the war, we went right back to natural rubber even though

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we had weaned ourselves off it by creating high quality, synthetic rubber. Why would we do that? It doesn’t make sense. We had al- ready broken away from the addiction to Southeast Asian rubber, but we went right back. The reason is simple; we just weren’t ready as a society for synthetic rubber. Many years later we gravi- tated back to synthetic rubber, but only when we were ready as a society to accept it. The war accelerated the process of substitu- tion beyond what was natural. After the war we settled back to the natural curve.

It’s like the technology gap. New technologies emerge while we fight tooth and nail to hold on to the old guard. I remember my company had to drag me away from WordPerfect to begin using Microsoft Word when the quality of Word was already supe- rior to WordPerfect. I wanted the old technology I was used to. Look at the resistance that electricity met when Thomas Edison first developed it. People cried about the demise of the candle in- dustry, not the acceptance of this new source of light. And, so it is with financial products. They have a time and a place and until the time is right, substitution for the new will be slow coming.

History of Exchange Traded Funds

I remember my first thoughts on securitizing a basket of stocks came from working with the PHLX Gold & Silver Index. I knew early on, before Exchange Traded Funds (ETFs) hit the market, their viability, as an investment vehicle, was undeniable. I re- member vividly my conversations at the time with Joseph Rizzello, head of product development and marketing at the Philadelphia Stock Exchange (PHLX). The Philadelphia Stock Ex- change is one of the most progressive and forward-thinking ex- changes in America. In 1983, the PHLX had just come out with a new product, options trading on indexes. It was truly a revolu- tionary idea developed by Joseph Rizzello who was then the head of marketing at the PHLX. Joseph was also one of he real thinkers on Wall Street. Much like the first commodity-based ETF was in gold, the first index options traded were on the PHLX Gold & Sil- ver Index (XAU). This was the first product of its kind where an investor could simply make an investment in an option on an

298 The Point and Figure Methodology—A Complete Analysis Tool

index of stocks in a particular sector, rather than having to focus on one stock itself.

At the time, the index was priced around the $600 level, and the options were naturally very expensive as well. That would be tantamount to trading options on a $600 stock. It hit me one day that the real product was not the options that traded on this index, but rather the ability to buy the index itself. Having been a stockbroker in the past, I knew exactly what would have made the most difference in my business, and it would have been the ability to buy the index, a basket of stocks with a common theme. What the PHLX needed to do was split the XAU 10-for-1, making it a $60 per share index and then securitize it. In other words, trade the XAU as a $60 stock, a stand-alone product. Then, add the options for those who were so inclined.

I knew in my heart that this had to be a fantastically success- ful product. It was as clear as a bell to me. I went to Joseph Rizzello, who was a close friend of mine. He concurred. It would be a huge undertaking to create a product like that. It would be expensive to accomplish and it was very forward thinking, maybe in fact, too forward thinking for the time.

Nothing happened with that idea for the XAU. But Joseph Rizzello and the PHLX did come out with a product called CIP, Cash Index Participation units, on the S&P 500 (SNP) and Dow Jones (BIG). These were theoretical baskets of stocks that acted like an index portfolio. You owned the unit in perpetuity and had cash-out provision once a quarter. If the cash-out provision was drifting away from the net asset value, those long the unit could ask for the net asset value of the unit. This prevented short sellers from manipulating the value of the unit. Because you owned the unit, when any components went ex-dividend, you would collect the dividend by debiting the short sellers and crediting those long the unit. The Cash Index Participation unit (CIP) could also be margined.

It was a fantastic product, but doomed from the start. I trav- eled all over the country with the PHLX holding seminars to packed houses. I mean packed houses of 500 to 600 brokers and professionals. The investment world wanted this product. But, it was doomed because the futures exchanges decided to sue for the product. They suggested that the product was a futures contract

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and should come under their purview. This lawsuit resulted in a famous ruling called the Easterbrook Decision. The judge ruled in favor of the futures exchanges. While this instrument had all the elements of a security, it also had an element of futurity. There- fore, the courts ruled in favor of the futures exchanges. The fu- tures exchanges, after winning the lawsuit, simply took the product and shelved it—“Dead on Arrival.”

That decision spurred the workings of the ETF that we now have in our arsenal of trading tools, but it came from an unlikely source. The Toronto Stock Exchange came to the PHLX to learn how the CIP was created. The Toronto Stock Exchange created the first ETF called TIPS (Toronto Index Participation Units), which traded on the Toronto Stock Exchange. Following the debut of the TIPS, the AMEX created the SPDRs (SPY) and now we have numerous vehicles to invest in that have the same char- acteristics as the CIP we first traveled the country marketing. Once again, timing was everything. Like the final development of synthetic rubber I discussed earlier, this time society was ready and willing to accept the product.

Today’s Exchange Traded Fund Market

The ETF market exploded in the late 1990s with the popularity of the SPDRs and the QQQs, representing the S&P 500 and the Nas- daq 100, respectively. Merrill Lynch then introduced the HOL- DRs and Barclay’s burst onto the scene with the most comprehensive listing of index-based, sector-based, and interna- tional ETFs named iShares. Sector Select SPDRs are available and other companies like Vanguard, well known for its vast mutual fund offerings, have been entering the scene. Since then we have seen more ETFs introduced including Powershares, which are more philosophy-based rather than index-based, and the most re- cent ETFs introduced have been commodity-based ETFs, more subsector ETFs as well as more equal weighted sectors.

Before we get into the ins and outs of using technical analysis to trade and invest in ETFs, let’s start out with some basics. There are a couple of different types of structures to the ETFs but the basic premise is this vehicle allows us to buy a package of stocks

300 The Point and Figure Methodology—A Complete Analysis Tool

as just one vehicle, much like a mutual fund. ETFs are different from mutual funds because ETFs do not trade at Net Asset Value (NAV). However, traders on the floor will arbitrage the stocks un- derlying the ETF if a price disparity develops. They are also differ- ent from mutual funds because they trade throughout the day. You can buy and sell anytime during the day using stop-loss or- ders and limits just like you would with a commodity or a stock. Also, like stocks, and commodities, ETFs can be sold short. Many ETFs have options allowing for other strategies like the covered write and other methods to gain long or short exposure. ETFs are also transparent. That is, most mutual funds do not list their cur- rent holdings and weightings (there are a couple of exceptions to that including the Rydex Funds). On any day, you could go to the web site of the ETF in question, and find the current holdings and the weighting. This is very important in the evaluation of the ETF as you will learn a little later in this chapter. Below we have listed some web sites you will find helpful in learning more about ETF structures and what’s available as you begin to use this prod- uct in your investments and trading:

www.ishares.com www.vanguard.com www.powershares.com www.rydexfunds.com www.currencyshares.com www.spdretfs.com www.holdrs.com www.ftportfolios.com www.proshares.com www.vaneck.com www.wisdomtree.com www.bldrsfunds.com

The ETF landscape is changing so quickly that we aren’t going to list every ETF available right now, but at our web site (www.dorseywright.com), we have the most comprehensive list of ETFs available with all of the Point and Figure technical analysis tools you see for stocks also applied to the ETF uni- verse. Part of the analysis is a series of worksheets with holdings

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for each ETF categorized by market asset class, sector, or inter- national area. This allows you to compare similar ETFs for nu- ances in their construction. In addition to the Point and Figure chart of each ETF, we also have available Relative Strength (RS) charts, technical fund scores for ETFs, the ability to create cus- tomized box size charts on ETFs, and you can search our data- base of ETFs based on technical criteria to quickly find exactly what you are looking for. DWA provides the most comprehen- sive “Productivity Tool” for ETF investing in the world on the Internet. We also do weekly reports for numerous ETF providers such as iShares, Vanguard, Rydex, State Street Global Advisors, and Powershares.

Exchange Traded Fund Evaluation: Know What Is Inside

With any ETF, the most important consideration when determin- ing whether to buy or sell, and how to manage a position, is to ex- amine the ETF chart you are purchasing or selling. Some ETFs have a long enough history to evaluate the chart itself but in those cases where there isn’t enough history on the chart of the ETF, we examine the underlying index. You see, every ETF is de- signed to track an index and generally the index will have at least three years worth of history, and in most cases many more. The job of the ETF provider is to make sure the ETF you purchase ac- tually replicates the performance of the index and they do a great job at it. For instance, the iShares COMEX Gold Trust (IAU) began trading in February 2005, so that’s as far back as our Point and Figure chart goes. However, the IAU is designed to track the price of London Gold Fixed PM whose symbol on the DWA web site is UKGOLD. To get a longer-term perspective on this ETF, it would be entirely appropriate to look at the chart of UKGOLD for guidance as well as the chart of the IAU.

Another question we often get is, “what is the best ETF to purchase when the Bullish Percent Index chart (our most impor- tant risk evaluator) reverses up?” The short answer to that ques- tion is that there is none. But I want to explain why. If you recall from Chapter 6 on the NYSE Bullish Percent, this type of indica- tor is a one stock—one vote indicator. This approach is different

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from the way indices are typically composed. There are three basic ways indices are composed. One method is to price weight. In price weighting, the higher the price of the stock, the more weight it carries. This is the way the Dow Jones Industrial Aver- age is priced. Another way to weight an index is by capitalization. That is, the larger capitalized the stock (shares outstanding times price), the more influence it has on the index. This is the most common way to weight indices and ETFs. With this type of weighting, just a handful of stocks can control the vast majority of an indices’ move. You will see this in our example in just a minute. Finally, we can weight an index equally. That is, each stock gets an equal vote. This is the way the DWA sector indica- tors and Bullish Percents are constructed. The universe of equal weighted ETFs is expanding. The first was an equal weighted index on the S&P 500 brought to the market by Rydex and the symbol is RSP. The way the RSP and the SPX moved from 2000 to 2006 was like the difference between day and night. The equal weighting effect on the RSP caused this index to significantly outperform the same S&P 500 index that was capitalization weighted. In other words, this divergence in performance points up the fact that in the market we sometimes have a bull market in stocks and sometimes have a bull market in indexes. The latter is generated by the capitalization weighting of the index.

In 1998, we were in a bull market in indexes. The top handful of stocks in the S&P 500 pulled the index to new highs while the smaller stocks that have little weight underlying this index were going down. Conversely, in 2000 the opposite happened. The small-cap stock university caught fire while the big stocks that typically push and pull the capitalization indexes turned cold as winter. This had the effect of making the market look like it was in a bear market but in fact more stocks were going up than down. This is why it pays to have an operating system in your head to understand the mechanics of the market. The Point and Figure method of analysis is the operating system that we have found most effective and easy to learn. Remember, in the stock market things aren’t always what they seem. This is especially true of the young media reporters who have been around Wall Street for only a few years since they graduated college with a de- gree in journalism. One more ETF I wanted to mention that was

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equal weighted is the First Trust Nasdaq 100 Equal Weighted In- dexSM Fund (QQEW). As we write this book, a number of sector ETFs are being introduced on an equal weighted basis. You know, it might be a good thing to securitize our whole DWA sector lineup because our Bullish Percent Indexes are all based on this universe. At present, most ETFs are capitalization weighted, and therefore it’s very important to analyze the chart of the ETF you are actually buying and then evaluate the top holdings of that ETF. You might find that the highest percent holdings in the ETF are in one stock. This would affect how you view that sector. A great example of this would be the drug sector. A look at the Dorsey, Wright & Associates Drug sector shows there are 151 stocks currently in this group. That means each buy or sell signal in the group can affect the Bullish Percent by about .67 percent. However, a look at the broad iShares Dow Jones Healthcare Index (IYH) shows an index very skewed toward just a couple of names. Pfizer (PFE) and Johnson & Johnson (JNJ) each have over a 10 per- cent weighting. If these two stocks were in a Bullish Percent Index with a 10 percent weighting a piece, and each were to move to a buy signal from a sell signal on its Point and Figure chart, that would mean the drug Bullish Percent could jump 20 percent in a day. Because of this fact, we use the DWA Bullish Percent chart to alert us to a change within a sector or market’s risk level, but we never just blindly buy a similar sector ETF, it must have good technical merits on its own.

What you find under the hood of the ETF is what will gener- ate the move. Learn to look under the hood when evaluating the investment merits of any ETF. In Figure 10.1, we compare the iShares Dow Jones Financial Service Sector (IYG), Vanguard Financials (VFH), and KBW Bank ETF (KBE). The top 10 hold- ings in the IYG and the KBE are both over 50 percent while in the VFH, the top 10 holdings account for only 38 percent so this one is more equally weighted. A closer inspection at the actual holdings and you’ll see that Citigroup (C) accounts for 7.66 per- cent of the movement in the VFH while accounting for 11.72 percent in the IYG. This doesn’t make one ETF better than an- other, but rather you just need to be aware of the weightings when considering how the ETF will fit into your overall invest- ment strategies.

304 The Point and Figure Methodology—A Complete Analysis Tool

Figure 10.1 Sample Financial ETF Comparison.

If C is one of the strongest stocks in the sector, then the IYG or the KBE would be a good choice for purchase as they have higher weightings in C. However, if C has a weak chart pattern compared to other financial stocks, the VFH would make more sense. Or, perhaps you have a large holding in C and wish to hedge that position by shorting an ETF. Then using the IYG would be the logical choice. This is also where RS tools can come into play, and RS charts could be made comparing the IYG, to the VFH to KBE, similar to the RS matrixes seen earlier in this book.

With respect to International ETFs, you will find that some countries are more skewed toward certain sectors than others. In Figure 10.2, we have highlighted just a couple international ETFs to show you how the movement of a particular sector can influence an international ETF. The iShares MSCI Switzerland Index Fund (EWL) is very heavily weighted in the pharmaceuti- cal sector, which has been an underperformer compared to other sectors, such as energy and basic materials. Both the iShares MSCI Austria Index Fund (EWO) and iShares MSCI Brazil Index Fund (EWZ) have weightings of about 20 percent and 50 percent, respectively, in these two groups while iShares MSCI Malaysia Index Fund (EWM) has no significant weighting in either of these groups. The returns from each of these ETFs reflect those sector weightings. From December 31, 2003, to March 31, 2006, Sweden and Malaysia were up 42 percent and

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* Top Ten Sector Weight

94.69%
* Note all data is through approximately 3/31/2006.

93.34%

99.82%

96.80%

iShares MSCI Switzerland Index Fund (EWL)

iShares MSCI Malaysia Index Fund (EWM)

iShares MSCI Austria Index Fund (EWO)

iShares MSCI Brazil Index Fund (EWZ)

Pharm. & Biotech Diversified Financial Food Bev & Tobacco Materials Insurance Consumer Durables Capital Goods Healthcare Eqp/Svc Banks Commercial Services

25.39% 16.14% 11.67% 11.44%

Banks Food Bev & Tobacco Consumer Services Utilities Transportation Telecom Services Capital Goods Diversified Financial Media Auto & Components

22.55% 12.53% 12.19% 10.97%

Energy Telecom Services Banks Materials Real Estate Capital Goods Utilities Transportation Insurance Diversified Financial

19.71% 15.48% 14.26% 13.61% 13.44%

Materials Energy Banks Telecom Services Utilities Food Bev & Tobacco Capital Goods Transportation Retailing Household Products

26.28% 24.79% 18.84%

8.67% 6.07% 5.49% 5.09% 2.78% 1.95%

9.66% 8.46% 8.43% 3.49% 2.55% 2.51%

9.12% 8.42% 2.74% 1.87% 1.17%

7.63% 7.00% 5.73% 3.00% 1.68% 1.02% 0.83%

Figure 10.2 Sample International ETF Comparison.

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16 percent, respectively, while Austria and Brazil were up 133 percent and 135 percent, respectively. You can’t forget to look under the hood of ETFs, both domestically and internationally. There are ways to logically and sensibly go about the invest- ment process. This does not guarantee profits but it does guar- antee you are doing the proper homework before you make a move and we have found that over time this is the key to out performance, plain and simple.

Exchange Traded Funds Trend Chart Evaluation

One of the first and foremost means of evaluating an ETF is just to look at its trend chart. Just like a stock, or any index, ETFs are plotted using intraday high and low prices. All of the same chart- ing rules apply—columns of X’s and O’s alternate, at least three X’s or O’s in a column, and so on. The only real change for an ETF chart is that we most often use a smaller box size since ETFs are baskets of stocks and they tend to move a little slower than indi- vidual names. Once an ETF gets into the $50 range or higher though, we find that often times a 1 point per box chart, the de- fault scale, works just fine. Again, one of the great things about the SmartChart function at www.dorseywright.com is the ability to make the boxes any size you want to create a chart with the volatility you desire.

As we have outlined in previous chapters of this book, we take a top down approach to investing. That is, we first evaluate the overall market to determine whether it is supporting higher prices or not. Or, which team is on the field? If the offensive team is on the field, as dictated by the Bullish Percents, we will generally look to initiate long positions as we are in a wealth accumulation mode. Conversely, if the defensive team is on the field, we will generally be employing plays that preserve wealth. Or to look at it another way, a rising or falling tide gen- erally carries boats. Once we have determined our outlook on the overall market, then we will look to sectors for opportuni- ties. Next, we go to our inventory. For more and more profes- sionals and investors, a significant portion of that inventory is the ETF universe. There are currently over 350 listed ETFs as

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we write this and more are coming to the market everyday so using an ETF universe, you can almost guarantee that you’ll have access to just about any area market segment. The final step of our game plan is to evaluate the individual security to be purchased using tools such as trend, chart pattern, and RS and then use the Point and Figure charts to manage the trade. What are we going to do if things go right and what are we going to do if things go wrong?

Let’s take a look at an example of how an ETF might just fit into your investment process. We’ll paint a picture from history and outline the landscape in April 2003. The NYSE Bullish Per- cent was reversing up to X’s at the 42 percent level. This put the offensive team back on the field with good field position. Next, if we reviewed the sectors, one which has emerged is the biotech sector. The DWA Biomedics/Genetics sector reversed up to X’s from below 30 percent, the optimum buy level. In addition, the sector’s RS was turning positive and the sector had a Favored sta- tus. All in all, the technical indicators were suggesting offense for both the market and the biotech sector. Now comes the time to evaluate whether to buy an individual name or the whole school of fish. A look at the Point and Figure chart of the iShares Nasdaq Biotech Sector (IBB) in April 2003 shows it violating the Bearish Resistance Line in March at 51 and subsequently going on to break a Triple Top at 53 in April (Figure 10.3). In planning the trade, we want to know what we will do if things go right and what we will do if things go wrong. So entering this trade, we would want to use a violation of the Bullish Support Line as our stop. Going into the trade, that stop or hedge point would be at 48.50. The IBB subsequently stayed above this support line until October when it violated it at 69.5. This would be our clue that the underlying supply and demand relationship was starting to shift in IBB and positions needed to have the risk managed in some fashion. Most ETFs are now getting options listed, too, so this opens a vast array of risk management tools from purchasing puts as protection against declines to selling calls and many more strategies that unfortunately we won’t have enough time to discuss in this book. We could probably devote a whole book to this new ETF product that is the most significant development I have seen in my financial career.

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Figure 10.3 iShares NASDAQ Biotechnology Index Fund. ETF Relative Strength

As you have gathered by now, RS is a very important tool in our work. It tells us where we should be and when we should be there. It smoothes out the rough edges of the buy and sell sig- nals and allows us to step back and see the big picture. When I think about relative strength, I recall the Zen story of an old man who accidentally falls into the river rapids leading to a high and dangerous waterfall. Onlookers feared for his life.

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Miraculously, he came out alive and unharmed downstream at the bottom of the falls. People were amazed he had lived and asked him how he managed to survive. The old man replied, “I accommodated myself to the water, not the water to me. With- out thinking, I allowed myself to be shaped by it. Plunging into the swirl, I came out with the swirl. This is how I survived.” You should allow yourself to accommodate to the market not the other way around.

If we just let the market tell us what it is doing and we adapt ourselves, we’ll come out fine. When we try to make the market accommodate us, that’s when the trouble begins. This is proba- bly where the old Wall Street adage, “the market can remain irra- tional much longer than we can remain solvent” comes from. Thinking back to 2000 in the equity markets, large-cap stocks were all the rage. It’s where all the money flowing into funds was going. But those well versed in reading the tides and currents of the river, that is understanding the Point and Figure work, knew that in February 2000, the small-cap stocks moved back in favor. Instead of trying to fight the current, go with it and change where you are investing. Since that change, to the end of the first quarter 2006, the S&P Small Cap 600 (SML) is up 88 percent while the S&P 500 (SPX) is down 7 percent. There are ETFs avail- able for both the small-cap and large-cap universe of stocks from a variety of different ETF providers. I once coined a phrase “never anticipate the anticipators.” Never forget this. Wall Street research is famous for anticipating the anticipators not to mention the news media.

Or, if you had wanted to buy large-cap stocks for whatever reason, it was best to purchase the S&P 500 on an equal weighted basis instead of a cap weighted basis. Again, the RS chart alerted us to this switch in May 2000. That move has meant the differ- ence between being profitable and unprofitable from May 2000 to March 2006 in large-cap stocks. And you know what? Most in- vestors and the media have no idea there is an S&P 500 equal weighted index that can be bought just like stock. The S&P 500 Equal Weighted Index is up 50 percent while the S&P 500 Cap Weighted Index is down 11 percent and ETFs are available on both weightings of the S&P 500. Is that not amazing? Both are S&P 500 indexes but one is up 50 percent and the other down 11 percent.

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Wouldn’t you want to be dealing with an advisor who was well versed in this? So in the Zen philosophy, trying to fight the water would make it much more difficult to survive the turbulence. You must accommodate yourself to the markets, not the other way around.

The same RS calculations that we perform on stocks and in- dexes can be applied to all ETFs, helping us to determine when the tide is coming in and when it is going out. Again, there are a couple of distinctions with a RS chart of an ETF. With a RS chart of an ETF, we look most closely at the column of the RS rather than the signal because these are baskets of stocks and move a bit slower than an individual name. An individual stock can move around, maneuver in and out of traffic like a sports car, while an ETF will keep moving with the traffic, like a big semi- truck. Let’s go back to the iShares Dow Jones Financial Services Sector (IYG) and look at its RS chart. On this RS chart we see that there are three columns going back to 1992. The RS charts of ETFs are designed to capture major trends and not each wiggle in a sector. In fact, in a sample study of 18 sector ETFs going back to 1992, the average length of time a sector ETF spent in either a column of X’s or O’s was 624 days at this writing. That’s just shy of two years so again you can see that the RS tool is longer term in nature and well suited for investors. Of course traders will also want to be aware of RS as the largest magnitude of movement usually comes from those areas with the best rela- tive strength. But back to our chart of the IYG; let’s examine each of these column changes in a bit more detail. The first col- umn of X’s is from December 30 1992 to October 6 1998. As long as this RS chart was in a column of X’s it suggests that we have an overweighted exposure to the financial services area of the market. During this time, the IYG was up 185.1 percent com- pared to only 137.4 percent for the iShares Total Market Index (IYY), our benchmark. The IYG subsequently moved into a col- umn of O’s for almost two years. During this time, the IYG per- formed just slightly worse than our benchmark, up 39 percent compared to the IYY’s return of 43.8 percent. When a RS chart reverses into O’s, it doesn’t mean the sector has to fall off a cliff and decline significantly. In fact, most often the sector does just what the IYG did—underperform slightly. But why would you

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want to be overweighted in a sector that has a high probability of slightly underperforming or even underperforming signifi- cantly? Once the RS chart of the IYG moved back into X’s on May 23, 2000, that told us we wanted to beef up our exposure to financials. Since this column of X’s has been in effect, the IYG is up 40.9 percent compared to the IYY’s return of −3.7 percent. Think about this for a second. What if you had moved money from ETFs that were starting to reverse into O’s in May 2000, mostly technology, and into those ETFs moving into X’s? (See Figure 10.4.)

Utilizing a universe of about 20 ETFs, we went back and did a case study on a sector rotation strategy using ETFs and specifi- cally the iShares universe. In our study, to be included in the port- folio, the RS chart had to be in a column of X’s. Then, the portfolio was equally weighted among those ETFs whose RS charts were in X’s. The only time the portfolio would be rebal- anced was when there was a change in relative strength. We wanted the market to tell us when to rebalance the portfolio, not just the calendar. So let’s say there were 10 sector ETF RS charts in X’s. Each ETF would receive a weighting of 10 percent. The portfolio would remain unchanged until there was an RS change.

Figure 10.4 iShares Dow Jones Financial Services Index (IYG) Relative Strength chart.

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This might be for one month or six months. Then, let’s say that an RS chart reversed into O’s. That position would be sold and each position reset back to a weighting of 11.1 percent now that there were only 9 members of the portfolio; kind of like resetting your trip odometer on each segment of a road trip. Over the 12 year test period; this portfolio has outperformed the broad market averages nicely. Through the first quarter of 2006, this sector rotation- based strategy is up 355 percent, while the IYY is up 210 percent, and the S&P 500 is up 185 percent.

Probably the most telling time of this portfolio is the 2000 market that put a damper on so many investors’ hopes of retiring early or having a better retirement than they ever hoped by being overweighted in technology and not having a sell discipline. In March 2000, the portfolio was 100 percent in technology in three ETFs—iShares Dow Jones Technology Sector (IYW), iShares Dow Jones Internet Sector (IYV), and the iShares Dow Jones Telecom Sector (IYZ). Over the next two months the portfolio completely transformed itself. The first to come out was the IYV, which had been in the portfolio since August 3, 1999. Then the financial and chemical sectors moved into the portfolio as their RS charts reversed up. Next, we saw the IYW come out of the portfolio on April 14, 2000, after having been in the portfolio since Septem- ber 25, 1998. The IYW was up 188 percent from the time it come into the portfolio to the time it came out. Then, two weeks later the IYZ’s RS chart reversed down into O’s, and that meant it come out of the portfolio. Over the following two-week period, sectors like utilities, real estate, financials, and healthcare were rotated into the portfolio. By May 2000, the portfolio had a 0 per- cent weighting in technology (Figure 10.5). iShares sponsors DWA to update this strategy each week on our professional web site along with a similar rotation strategy for international ETFs. You can clearly see what a powerful tool you have in RS and the virtually endless possibilities of how you can take this concept and create a managed portfolio strategy around it. And, you know, keeping it simple is usually best. There is nothing compli- cated about this strategy. Could you do things to optimize the portfolio? Sure. But even just a straightforward approach like this can help keep the odds of success in your favor.

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Figure 10.5 Conservative iShares Sector Manager—2000 Snapshot. Advanced ETF Relative Strength

The RS concept is so transferable and the comparisons you can do are almost unlimited, but I wanted to give you an idea of some of the ones we find especially helpful by first taking a look at the in- ternational markets. As we pointed out in Chapter 5, we can do an RS chart of the broad international markets to the U.S. mar- kets to help determine “where in the world” you want to invest. But just as we do more in-depth analysis of the U.S. markets, we can also do the same for international markets. There are cur- rently over 30 international ETFs listed on the U.S. exchanges and trading in U.S. dollars. On the international area of our web site, you’ll also find a complete list of all the international ETFs denominated in Euros but we’ll stick to the international ETFs

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listed on the U.S. exchanges for the purposes of this example. I highly recommend you get to know these international ETFs be- cause this broadens your horizons in investing globally. With today’s Internet, you can trade in any country you wish. I cur- rently have accounts open for online trading in Indonesia, Portu- gal, and Australia. My account at www.DIF.pt (change the language to English) allows me to trade all European stocks from one location and all ETFs from this location whether they are in- ternational or domestic. I hold U.S. Bonds as collateral for the ac- count simply as an added safety factor, but over the years I have not seen a real need for this. It is the best trading platform I have seen and you can execute our Sector Rotation Models on the site automatically even if you are an individual investor. Generally, our models are primarily for professionals who then invest in them on individual investors behalfs. Okay, let’s get back to the U.S. side of the equation. So let’s say that you’ve done an RS chart of the U.S. markets versus a broad international index like the MSCI EAFE Index and it suggests the international markets are favored over the U.S. markets. Okay, now what? Throughout the world, some areas are going to be stronger than others and the best way we’ve seen to determine the strength across the en- tire globe is through a simple RS chart.

Figure 10.6 is a comparison of the iShares Latin America 40 Index (ILF) to the iShares MSCI Japan Index (EWJ). When this chart is on a buy signal, it suggests the ILF should outperform the EWJ. Conversely, if this chart is on a sell signal, it would suggest that we would want to own Japan over Latin America. The RS chart of the ILF versus the EWJ moved to a buy signal on Novem- ber 19, 2002, and remains on that buy signal as we write this. It’s been three and a half years since that signal has been given and the ILF is up 257 percent while the EWJ is up 97 percent. Both have far exceeded the returns of the U.S. markets as the S&P 500 is only up 39 percent during the same time but clearly the ILF was a better place to be with your international allocation.

Taking this concept a step further, we can construct a DWA International Matrix (Figure 10.7 on p. 316) to give us a snapshot of strength in the international markets. This Matrix is essen- tially the culmination of a large arm wrestling tournament. In our

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Figure 10.6 iShares Latin America 40 Index (ILF) versus iShares MSCI Japan Index (EWJ).

tournament, every international country arm “wrestles” another country until every country has been wrestled. To determine the winner of the tournament, we merely count up the “wins” or RS buy signals for each country and then rank the countries with the one with the most wins at the top of the matrix. With about 30 international ETFs in the matrix, you want to focus your invest- ments in those that are outperforming at least half of the total

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Figure 10.7 iShares International ETF Matrix.

universe. Utilizing the International Matrix concept (you can’t imagine the computer power it takes to do this), we have con- ducted some studies creating a portfolio out of these principles. The portfolio holds five international ETFs in an equal weighted manner. An ETF can fall out of the portfolio by losing significant RS against the field. That ETF will be replaced, not rebalanced, with the next highest ranked ETF in the matrix not currently in the portfolio. The back test on this portfolio only dates to 2002 but the results are impressive with the portfolio returning 145 percent and the MSCI EAFE Index (EFA) up 62 percent and the S&P 500 (SPX) up 11 percent thru the first quarter 2006.

This portfolio is designed to point out RS across the world, and does not take into account absolute price declines. In other words, if the market goes down, this portfolio will likely move lower too but should outperform over the long term on a relative basis. In markets like April through June 2006, we found the high RS international ETFs were extremely volatile. We came into this

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period up 28 percent for the year. The decline in the world mar- kets was so severe we lost 25 percent of those gains in a heart- beat. Once the markets stabilized we shot back up 10 percent but what a ride that was. Over two trillion dollars of equity was lost worldwide during this period. The U. S. markets were just as volatile. When the plug is pulled on the world markets there is nowhere to hide. The strong RS snapped back fast however when the dust settled. So, to manage the absolute price risk, you’ll want to use things like the Bullish Percent and actual trend chart patterns to help manage that portion of the risk. Remember, RS is just that, relative. It does not speak toward absolute performance unless you are a delta neutral investor where you would go long one and short the other. International markets definitely have volatility. That ride I discussed earlier was like riding the bull “Bodacious” in a rodeo. That bull has put more professional bull riders in the hospital than all the other bulls combined. It’s not unusual to see these markets move 5 percent to 8 percent in just a week’s time. Professional DWA clients have access to the DWA International ETF Manager with weekly updates as iShares spon- sors this portfolio on the web site.

Yet another way to analyze the ETF market is versus the mu- tual fund market. In any given year, over 80 percent of the mutual fund managers don’t outperform the S&P 500. If that is the case, why should you pay for active management of that fund when you purchase an ETF for a much lower expense ratio? There are fund managers that can and do outperform their benchmarks and the extra fee is well worth it. Furthermore, those managers that outperform the indices change from year to year. A broad observa- tion about this type of outperformance is that when the bench- mark, small caps, growth, value, and so on is a leading asset class, the harder it is for the active manager to outperform his or her benchmark and you’re probably better off with the ETF. The re- verse is also true—when the benchmark is an underperformer to most asset classes, the greater likelihood you can find a manager who is in fact adding value. Let’s look at an example how you can use the RS tools to determine whether the active manager is worth the fee.

Phoenix Capital Growth (PHGRX) invests with a Domestic Growth style so we would want to do a RS chart of the PHGRX

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versus a Domestic Growth ETF like the iShares S&P 500 Growth Index Fund (IVW). If the RS chart were on a buy signal, it would tell us that the manager(s) of Phoenix Capital Growth were adding value over the index. If the RS chart were on a sell signal though, it would tell us that we would be better off in the index itself. By looking at the RS chart in Figure 10.8, we see that the RS chart is on a sell signal. That signal was given on March 27, 2001. Since that RS sell signal, the fund is down 20 percent while the IVW, its peer index, is only down 1.4 percent. If I wanted to invest in a large-cap growth fund that had a higher probability of outperforming the IVW I might look at something like the Amer- ican Funds New Economy (ANEFX). This RS chart moved to a buy signal on August 19, 2003 (see Figure 10.9). So let’s say that we like the American Funds family and this was our inventory we were working from. Prior to August 19, 2003, instead of purchas- ing the New Economy Fund, we were instead using the IVW for our domestic growth exposure. Once that RS chart moved to a buy signal, we would call up the New Economy fund from the farm team and substitute him on the field for the IVW, essentially putting him on the bench. Making that simple substitution on our mutual fund team, we enhanced our performance tremendously— the ANEFX is up 36.7 percent compared to the IVW only being up

Figure 10.8 Phoenix Capital Growth (PHGRX) versus iShares S&P 500 Growth Index Fund (IVW).

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Figure 10.9 American Funds New Economy (ANEFX) versus iShares S&P 500 Growth Index Fund (IVW).

12.7 percent. This is so interesting. I get goose bumps every time I think about these concepts we have created. DWA is all about adding value to the investment process and we have come a long way with our RS work.

Here’s another example in the small-cap growth area. As we have outlined before in this book, the small-cap area of the mar- ket has been the place to be since February 2000. Over the past six years, funds have been emerging and falling against its peer in the area, the iShares S&P Small-Cap 600 Growth Index Fund (IJT). On July 13, 2005, the Winslow Green Growth Fund (WGGFX) moved to a RS buy signal versus its peer group. That told us to expect this fund to begin to outperform the IJT. At the same time, the MFS New Discovery Fund (MNDAX) remained on a RS sell signal versus the IJT. So, if in July 2005 I was looking to add some small-cap growth exposure to my portfolio, I would prefer to buy the WGGFX over the IJT and certainly the IJT over the MNDAX. In the last 11 months, the WGGFX is up 8.4 per- cent, while the base index is up 3.55 percent, and the MNDAX, the weak RS chart, is only up 2.76 percent. These RS charts are extremely powerful for anyone using mutual funds and at our web site, you can easily click the “Peer RS” button and the chart is already done for you. As well, you can harness the power of

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technology and search our entire database of funds to cull out those with a particular peer RS characteristic. For professional using mutual funds and ETFs to populate their asset allocation strategy, this is a tool you cannot live without. It would be like trying to build a house without a hammer. It’s all there for you at the DWA web site.

What Does the Future Hold?

Where is the future of ETFs? We think it is only going to continue to expand. Just as we were writing this book, the first inverse and leveraged ETFs have been introduced. I saw this coming in 1982 and, in my opinion, we are only in the first foot of a 26-mile marathon. DWA will be in the forefront of this product as we were in 1982 when I went to Joseph Rizzello at the PHLX with the idea of securitizing their indexes and trading them instead of the options. As well, currencies ETFs have just been introduced. These new ETF products really open a door to risk management for individual investors that previously was only open to insti- tutes. Cash management takes on a whole new meaning now. In fact, it can now become a profit center. The ETF product is cer- tainly a tremendous leap forward for our industry but it is the analysis of the product that will make them a viable alternative to an investor’s portfolio. Like investing in general, you must have an operating system firmly placed in your mind before any information about the investment process can effectively be eval- uated. It is the analysis we do in the ETFs that make an index something that is truly special and one of the most viable invest- ment tools one has today. With the Point and Figure methodol- ogy’s robust, adaptive nature, you will be armed with the tools you need to evaluate any ETFs on the market. For instance, we have developed a model based on RS for the currency ETFs as a way to manage the cash side of your asset allocation. Manage cash? You bet you can—now with flair. Just think about holding cash in Euro’s instead of dollars when the RS chart suggested you do so. You can now with ease thanks to Rydex’s efforts in bring- ing out ETF’s on currencies. We welcome all ETFs. The more the merrier for us and this form of analysis.

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According to the Wall Street Journal (June 14, 2006), the Dow Industrials are down 8 percent since May 10. And it’s not just the United States. Some of the strongest foreign markets have been knocked down much harder. For exam- ple, Brazil (−21.3 percent), India (−28.1 percent), and Russia (−29.0 percent) have all dropped much more sharply. What’s more, the correction has hap- pened relatively quickly, which tends to get investors especially nervous.

The irony of a correction in the market is that it can’t stop going down until everyone “knows” it’s going lower. The entire purpose of a correction is to shake out the weak holders. In this sense, a correction is a healthy part of the market cycle. You can’t make any money in a crowded trade, and Mr. Market knows that. So he will do whatever he needs to make in- vestors dump their shares. If investors are already nervous, Mr. Market knows that a 5 to 7 percent pullback will shake them out. If investors are supremely confident, Mr. Market realizes it will take a bear market to make the weak holders let go. Your goal is to hang on and not be shaken out.

Instead of facing a correction with dread, look at it as an opportunity. The Chinese sage, Fu His, wrote that “a situation only becomes favorable when one adapts to it.” Instead of using all of your energy resisting the sit- uation, look at it as an opportunity to display your risk management skills, and when it is over, as an opportunity to buy at lower levels.

Here’s the most important thing of all: Once you have a risk manage- ment plan in place, stay the course. Risk management can take many forms. It can be done with sector rotation, through raising cash, or hedg- ing, or a combination of these things. Other common methods of risk re- duction are diversification and strategic asset allocation. Decide what works for you, and then stick to it.

Risk management should not be done on the fly. The danger of not stick- ing to your preset risk management plan is well illustrated by the famous Dalbar studies on investor returns. Almost every advisor is familiar with the Dalbar study that shows how investors do not exactly optimize their returns by getting nervous and managing risk by emotion rather than a carefully thought-out plan. According to a story in Investment News (June 12, 2006), from 1986 to 2005, investors in the S&P would have realized a return of 11.9 percent annually, if they had just been able to sit on their hands. However, after analyzing fund flows, Dalbar was able to determine that the average in- vestor actually earned just 3.9 percent annually. In fact, investors have demonstrated, in aggregate, that they can’t even sit still when they already have a “risk management plan” in place. Dalbar suggests that asset alloca- tion funds, balanced funds, lifestyle, life cycle, and target date funds are all effective ways to make investors more disciplined. Yet the evidence doesn’t really bear them out on this count. The average asset allocation investor

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made only 3.3 percent annually, even worse than the 3.9 percent of the twitchy investors who were yanking their money in and out of the market. It’s apparent that asset allocation investors, despite going into funds that were more conservative and supposedly managed their risk to begin with, were still jerking around with their accounts trying to avoid losses!

It’s not that the market itself is beating their brains out—investors are doing it to themselves. And why is it happening? According to Dalbar, most investor mistakes are made in attempting to avoid loss! This is a per- fect example of the “karma boomerang” effect where having a fear of something can actually “cause” the feared consequence. Managing risk is a good idea, but believing you can somehow eliminate it—which is what in- vestors secretly desire—is nuts. Dalbar concludes that “actions driven by aversion to loss are the primary causes of losses among mutual fund in- vestors.” (my emphasis)

In other words, the more you fear risk and loss and try to run away from it, the more it will seek you out! There needs to be an explicit recog- nition that even with a risk management plan in place, whether through sector rotation, raising cash, hedging, or whatever, drawdowns are an in- evitable and healthy part of the market cycle. Face it—accept that you might lose some money in a correction. It happens. It’s not a big deal if you are managing your risk the way you had planned. It’s only a problem if the losses are uncontrolled and your emotions get involved.

Client education about risk and risk management is absolutely central to long-term investing success. In the market, risk is not a matter of being careful on an individual basis. Risk happens. If you’re in the market at all, you’re subject to it. The root cause of investor problems comes from not understanding what risk is, and specifically, not accepting what your risk is. Dalbar points out that a “good understanding of risk produces more prudent behavior.” This is true, but it will never happen in real life. Studies in psychology point out that human beings are not wired to take risk. Peo- ple take risk or put themselves in risky situations because they don’t think it is a risk. Investors (and people generally) are overconfident and imbued with a belief that “it won’t happen to me.” Ben Roethlisberger wasn’t plan- ning to bounce his face off a windshield. Instead, he thought, “if I’m care- ful, it won’t happen to me.” If he felt there was a risk, he would have certainly worn a helmet, or maybe even not been on a motorcycle in the first place. This is an example of not having a good understanding of risk, and not having any kind of risk management plan in place.

When the market corrects, implement your prearranged risk manage- ment plan. Recognize that corrections are healthy for the market and use the opportunity to display your skills. Handled properly, corrections might end up proving very beneficial for your business.