Our current three positions are EFZ, TMF, and IFN. The stops and targets model is in 2/3rds a position of IFN, full position of EFZ, and a cash position (formerly TMF).
The MSCI World Index closed the week up -3.14%. The ETF Country Plus basic model ended the week down 1.21% while the Stops & Targets model ended the week basically flat down -0.08%. The ETF Country Plus basic strategy is up +17.91% year-to-date and the Stops & Targets strategy is up +11.58%. The benchmark, MSCI World Index, is down -0.81% year-to-date.
This Week’s Strategy Lesson: Anatomy of a Drawdown (Part 1)
Given the recent turmoil in the markets and the drawdown in our ETF trading systems over the last several weeks, we thought it would be useful to look at a few “case studies” of drawdowns and market corrections and try and understand better how the ETF models trade and react to them.
It is important to understand that the ETF models are strict rules based trading systems. A lot of careful thought and testing went into designing the system on the front end. And we continue to closely monitor the models. Once the rules were set and we liked how they functioned, the model took over and analyzes the information set we programmed into it, telling us exactly what trades to take and when to get in and out.
With this in mind, let’s peel the layers of a model and market drawdown. Our first example is from mid-2011. There are more than a couple similarities between this example and some of the things occurring in the markets recently.
The chart above shows the peak-to-trough drawdown for the ETF Complete model. During this period the model pulled back around 10.5% compared to the SPY only drawing down around 6.5% and snapping back faster than the model.
Coming into the April 29th high, the Complete model was up 12.5% for the year while the SPY was up around 8%. The model was exclusively postured long with some cash from profit taking. Over the next few months, the markets would deteriorate as concern about European debt levels grew to a fever pitch and a fiscal standoff in Congress ended with the S&P downgrading U.S. government debt.
The Global Macro model had the most turnover in this period, taking small losses on trades in USO, PBS, JO, TLT, and getting stopped out of XIV. The Country model had the second highest exposure taking losses in EWG, EWY, and giving back gains in SSO. Even the rotation into TMF (treasuries) went down at first. The Sector model had the least drawdown because it was in ~50% cash from profit taking in Energy and Technology through it was not immune to the drawdown in DRN and took a loss from a rotation into IBB.
It’s not uncommon during these drawdowns for the model to appear to be “grinding the clutch” as it attempts to find a gear. The model averages about one trade a week, but over this 10 week period we had almost double the usual with 19 trades. Many of these ended up being shorter trades caused by the model rotating into ETFs that had the highest TSI but on an absolute basis, the leaders were declining.
During this period, though, the laggards like precious metals and treasuries were gaining in relative strength and eventually overtook many of our traditional long ETFs. This story does have a happy ending for our model. If we zoom out a little and take a look at the equity curve over a six month period we can see how the new leaders faired relative to the broader market.
Here are charts of the three component models (Sector, Country, and Global Macro) parsed out:
The market’s quick recovery in June turned out to be a fool’s rally as the fundamentals in Europe deteriorated the SPY swiftly declined to new recent lows. Meanwhile, the complete model rallied to new highs from gains in SLV, GLD, VXX, and TMF.
During the normal trading of the model, as with during drawdowns, it is common to have periods of underperformance. Theses can happen because of a couple trades going bad, having too much in cash, or the markets whipsawing around faster than the models can adapt. But in this instance, the models quickly made up that lost ground and claimed new highs.
Of course, this is only one instance of a drawdown and the outcome could have easily been different. If the market had regained a sure footing in July and the crises subsided, the Complete portfolio would likely have lagged behind the SPY for a while as it had a more cautionary portfolio stance.
Depending on the composition of our positions and the severity of a pullback, the model might respond with anything from no position changes to completely reversing to a neutral or short stance.
Next week we will look at a couple more case studies to learn more about how our trend strength system responds to shifts in the market.
The Current Condition of the Model
For the country model, we are in EFZ, IFN, and TMF. In the basic model, the gains in India basically offset the losses in EFZ, while in the basic model TMF gave back some of its gains netting in a negative week.
The model remains defensively postured with EFZ and TMF giving short or alternative exposure.
Stay tuned to daily updates for any position changes.
Here is a summary of the weekly performance of all the ETFs that the strategy monitors:
Best wishes for your trading,
James Kimball
Trader & Analyst
MarketGauge