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). On Monday open, the model will be rotating out of EFZ into SSO.
The MSCI World Index closed the week up 2.63%. The ETF Country Plus basic model ended the week basically flat down -0.09% while the Stops & Targets model also ended the week flat down -0.08%. The ETF Country Plus basic strategy is up +17.81% year-to-date and the Stops & Targets strategy is up +11.56%. The benchmark, MSCI World Index, is up +5.0% year-to-date.
This Week’s Strategy Lesson: Anatomy of a Drawdown (Part 2)
Last week we examined one of the drawdowns in the model’s history. There have been a few like that throughout the almost 8 years of back-testing and live trading of the ETF systems. These drawdowns are characterized by a higher number of trades and a rotation into a more neutral or short stance depending on the severity of the drawdown and its correlation to the overall market.
This week we thought we would look at a different type of drawdown. The 2008 financial crises and the corresponding drawdown in the S&P 500 is the closest thing we have to a prolonged bear market in the period from January 2007 to present.
The SPY put in its peak on October 11th 2007. Over the next 512 days the market went down and put in its lowest low on March 6th 2009—a correction of over 55%. During this time the ETF Complete Portfolio was up over 20%, but not without some increased volatility.
The financial crisis of this period was caused by an implosion in the housing market compounded by risky sub-prime loans and complicated repackaged mortgage securities. In September and October 2008, concerns about bankruptcy in some of the largest financial institutions and the possible system-wide contagion a big bank failure could cause reached a fever pitch and market volatility exploded. We will examine how each ETF model weathered this storm.
ETF Sector Plus Stop & Targets
Starting as early as January, 2008, the Sector model started to get wind that something was amiss. It had a successful SDS trade that reached a first target in January before being stopped out. From January 2008 to July, the model had some successful trades in energy, and natural resources. A resurgence of SDS offset losses in transportation and biotech in August and September.
When the market finally capitulated in October, those losing positions went to cash and our SDS position rocketed up to a couple profit targets. We were stopped out on a trailing stop in mid-October and remained completely in cash through December. From there till March we had positions in Gold Miners and Bonds.
Overall the Sector model ended this period up a few percent, considerably better than the SPY which closed out down 55%. From this point the model began to get long and went on to put in a phenomenal year in 2009.
ETF Country Plus Stop & Targets
Coming into October 2007, the Country Stops & Targets model was lightly positioned having taken profits in the hot emerging market countries of Brazil, China, and India. Over the next several months we closed out these positions and the model rotated into positions in Mexico and Taiwan and even went partially to cash.
By July 2008, global markets had deteriorated enough that the model went into 2/3rds cash with the final portfolio position being filled by EFZ (short global developed markets). The model maintained in this cash plus short stance until the middle of March 2009 where China, South Korea, and India retook leadership. Overall, the model closed this period up almost 10%.
ETF Global Macro Plus Stop & Targets
The Global Macro model navigated this period to the highest return of the three models. In the first half of 2008, the model made money with a mix of energy, short indices, and positions in silver and gold. These types of positions tend to be of a higher volatility as evidenced from the big drop in April-March, but the model ultimately got the directionality right.
By August 2008, the model went fully “short” the markets taking positions in short S&P500 (SDS), short Nasdaq (QID), and short Emerging Markets (EUM). The Global Macro model has the most access to short instruments giving it a higher upside during a prolonged down move in the markets, but not without the higher volatility we mentioned earlier.
By late October 2008, the model had reached profit targets in all of its positions and had either been stopped out on trailing stops or fully exited on the final target. It remained in cash until January where it slowly started new positions in treasuries and commodities. The model ended this period up 54%, the polar opposite of the SPY.
Model Behavior
We saw similar trends in all three models. While the broader market was trending down, each had some degree of pullback and eventually rotated into positions that were able to hold ground or make money. The Global Macro model has the most ability to make money in prolonged bear markets due to its greater access to short and alternative ETFs but that bearish upside is tempered by higher volatility and the potential for larger negative swings when it gets the direction wrong.
Ultimately, the behavior of the models in adverse market conditions is driven by a number of factors.
Speed of drawdown: By design, the ETF models have some sticking power, so quick violent drops will tend to get positions stopped out and when they are followed by equally quick recoveries, the performance can lag. Quick drops and snapbacks of the severity we have seen in the last two weeks are not that common.
Size of drawdown: The larger the drawdown, the more likely that the model will be stopped out of positions or begin rotating to the new leaders. It takes a still larger move for the model to start putting us into short positions.
Relative Condition of Leading ETFs: During some corrections, we have strong leadership in alternative sectors or commodities (in addition to the short index ETFs), while in other corrections, everything goes down. How all the ETFs stack up in the TSI rankings during this transition can make a big difference.
Relative Condition of the Positions: At any given time, the model could theoretically be anywhere from 100% in cash to 100% invested. If the model’s holdings have already reached several profit targets, it will naturally have less exposure to the drawdown.
We hope this series has given all of our subscribers useful information about how the model handles different market conditions. The model often gives us great trades, but it is designed to be a portfolio that constantly accesses the market conditions and, according to its rules, responds accordingly. And from our testing, they have done a great job over any longer period of consideration.
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 continued to give back some of its gains. On Monday, the model will sell out of EFZ and rotate into SSO.
The model is shedding some of its defensive posture.
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