ETF Complete Strategy Insights: Momentum in the ETF Models (Part 3)

James Kimball | August 11, 2019

The ETF Complete model closed the week down -0.9% compared to the SPY which closed down -0.3%.

Markets had a volatile opening to the week after some fireworks about trade in the international sphere, however, things calmed down a little and the SPY closed back near Friday’s levels around the 50-Day moving average.

Stay tuned for the daily updates and log into the website to see holdings and additional performance data.

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This Week's Strategy Lesson: Momentum in the ETF Models (Part 3)

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This week we are going to wrap up this series on how momentum is used in the ETF models. We have already seen the statistical basis for favoring momentum and went into a little detail about how momentum is used in the models, but what is the real-world phenomenon that explains the effectiveness of momentum?

In economics, there are a variety of different system at work in different environments. There are self-balancing systems designed to keep something in equilibrium. Examples of this might be the sweat-chills system your body uses to cool down or heat up when its core temperature falls or rises, or the way FED policy attempts to provide a not too cool but not too hot environment in the economy. In contrast to this, momentum fits in the category of positive feedback or “virtuous cycle” systems.

A positive feedback system is one where there are fewer or no counter-acting forces to bring the system back into equilibrium. Without the counter balancing effects, an initial positive (or negative) shock can gain momentum and cause increasingly larger positive (or negative) effects. These positive “shocks,” when it comes to investing, can be anything from new technological advancements, demographic or consumer shifts, to improvements in business conditions or political reforms that open new markets.

Technology has been the great transforming feature of modern life. It only took a little more than 60 years to go from our first flight to landing on the moon. More recently, the computer revolution has been changing and re-shaping almost every industry. You don’t have to look any further than the growth in online shopping and e-commerce.

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E-commerce has been steadily growing at almost 20% a year. Retail is naturally growing every year, but a good portion of this growth is from more and more commerce migrating away from traditional brick & mortar stores to online shopping and home delivery. The annual growth rate will surely slow down over time, but there might still be considerable room to run as E-commerce only accounts for about 8% of all U.S. retail sales.

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Amazon is on the forefront of this shift in retail. The above chart plots the percent change in Amazon and XLK (Technology ETF) over the last few years. While Amazon is a retail company, their primary competitive advantage is driven by technology and an increasing part of their revenue is coming from their could-based web services.

Like a river flows downhill, capital flows to where it can get the highest return. As these trends develop and get stronger and attract the attention of outside investors, capital flows into these sectors or industries or countries. This is one of the reasons why a trend persistence or momentum model works.

Of course, the devil is in the details. Designing a profitable momentum system requires you to have the right methodology to identify trends early and a system of trading rules and money management that allows you the right amount of flexibility to stick with these trends. Our ETF models attempt to accomplish this through our proprietary trend strength measurement (TSI) and specific trading parameters that help us find and profit from momentum while avoiding some of the pitfalls and drawdowns typically seen during market corrections.