March 6, 2007: Momentum / Value / Risk
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On violent corrections and their aftermaths

After almost 8 months of uninterrupted "up-up and away" movement in the markets the inevitable counter movement has arrived. Chinese markets which led the way up "mini-crashed" by almost 10% in a single day (Feb 27, 2007) anything having to do with scary themes such as: "South East Asia" (Singapore, Malaysia), or "real estate" (including commercial REIT ETFs such as VNQ) or "financials" (even those with no almost no exposure to the sub-prime markets) followed sharply down. No part of the world was spared. It was a classic picture of a somewhat unreasonably widespread panic.

A period of straight 8 months of upward move is very unusual. That the correction was pretty violent, shouldn't surprise anyone who has been watching the behavior of the markets for some time. Big movements in either direction, tend to be followed by counter movements.

As you can see in the above chart, defensive ETFs like Utilities and Telecom are now dominating the right (strongest momentum) section This is a sign of great fear, which is actually bullish.

The pundits and talking heads have been arguing on CNBC and elsewhere on whether this is the start of a new trend or just a temporary setback.

The bear case relies on:

  • The overheating of the chinese markets, markets were up over 100% last year there. Valuations are too high. The speculative bubble there is obvious. I actually agree on this. I avoid the Chinese ETFs.
  • The subprime lending market is starting to show significant stress Many recent US homeowners assumed too much risk, took mortgages above their means. As their mortage rates adjust they can't pay.
  • A sharp inventory correction in the US and slowdown in GDP growth
  • A continuing slow down in earnings growth
  • Oil prices are again way up from their lows. Just like in May 2006.

The bull case relies on:

  • Stocks are still historically cheap. As cheap as they were in 1996-1997 before the big internet bubble started pulling the markets sharply up.
  • Investors still haven't gotten over the last bear market, a lot of money is still on the sidelines; not committed to the market.
  • Private equity activity at a record - companies are too valuable and are being taken private
  • Stock buy backs are at a record high - there's a scarcity of shares
  • The earnings-yield (inverted PE including accounting for dividends) on the S&P500 is way above the yield on the long term bond.

So who is right?

Is there anything we can do to try and predict our odds? Where are the markets going? What are the best ETFs to be invested in going forward?

At times like this, one of the things I learned to do is to listen to Ken Fisher. Ken has one of the best records on getting the big picture right. You can find two of his recent articles here (may require free registration):

I'm not sure whether to buy the housing boom argument (may be true in the Bay Area, where Google, Apple, and other booming companies keep hiring but not nationally), but I definitely agree with Ken's general bull case. I've seen a few bear markets, they never start with such bang and with so much scary talk as we experienced in the past few days. They also don't start when valuations and prospects are reasonable. Also, the up day following the biggest drop tells me there are enough buyers stepping in to take advantage of the opportunity. I'm betting on a short lived correction.

As we learned in the last May-June 2006 correction, this might well be an opportunity to buy what we wanted to buy anyway, just cheaper. To get more specific answers we turn to the raw data.

A roadmap

The first question is, assuming this correction is short lived, where are the markets going in the next few months?

Let's look back at the correction which started on May 10, 2006. The current correction was much sharper (so far) which tells me it will be even more short lived. Prolonged drops tend to be spread out in time, sharp corrections rebound faster. What happened after the bulk of the drop was over by the end of May 2006? A couple of scripts have the answer:

    $ etf-rank -D 20060530 -O fret1m | average

    $ etf-rank -D 20060530 -O fret3m | average
What this says is that starting from May 30, 2006 (not the bottom but well into the correction), ETFs on average went up sharply. How sharply? The rebound following the bulk of the last summer correction was: future 1-month average ETF return from that point onward was 1.58% and the future 3-month average ETF return was 4.37%.

The top 50 ETFs of course, fared even better with a 6.86% rebound:

    $ etf-rank -D 20060530 -O fret3m | sort -n | tail -50 | average

Keep overweighting value

But with the tools and the data we have, we can do better. Which ETFs went up the most following the May-June 2006 correction?

Let's look at valuations. Specifically: P/E ratios.

    $ etf-rank -D 20060530 -O pe,fret1m | correlation
    C(0,1):             -0.34820156

    $ etf-rank -D 20060530 -O pe,fret3m | correlation
    C(0,1):             -0.46623528
We can see that there was a negative correlation between the future returns of ETFs and their average PEs. In other words: high-PE stocks faired worse than low PE (value) stocks. Things might always be different, but the similarities between the two corrections are just too big to ignore and I expect this to repeat. To confirm I look for days where markets go up following a big drop to see which ETFs are doing better in the early stages of returning to normalcy. The best performing so far are the usual suspects.

Keeping the correction in perspective

To keep this correction in perspective you may want to peek at a recent article by Birinyi associates showing all 5% or more declines in the present bull-run. There were 6 of them in 4.5 years, or about 1.33 corrections/year. What is remarkable is how regular they look: they are spaced pretty evenly 6-12 months apart.

The conclusion from all this is stay the course, don't panic. If you have the guts, now may be the best time to put some more money in solid value ETFs from around the world. This includes ETFs like the Wisdom Tree international ETFs (DIM, DOO, DLS, DFE), The Vanguard low cost Mid-Cap Value (VOE) and General Value (VTV). The Rydex deep value ETFs (RFV, RZV), the countries that still have reasonable valuations, (Germany: EWG, Belgium: EWK, Korea: EWY) or the broader European ETFs (EFV, VGK).

The ETF Screen

Enclosed is my recent favorite ETF screen favoring moderate momentum, value, and averting risk. [Some couutries are missing due to my data feed dropping PS and PB ratios on some of the international BGI ETFs.]

Good luck,
-- ariel

[note: dated material. March 6, 2007] Momentum, Value, Risk: 50 out of about 290 ETFs, best to good order.

Using mmvr ranking method on 20070306
Rank     Score  Ticker  Full Name
----     ------ ------  -------------------------------------------
1	 2.2242	TTH	Telecom HOLDRs
2	 2.0862	VAW	Vanguard Materials VIPERs
3	 2.0073	VPU	Vanguard Utilities VIPERs
4	 1.9425	EWG	iShares MSCI Germany Index
5	 1.9350	XLB	Materials Select Sector SPDR
6	 1.8639	VOX	Vanguard Telecom Services VIPERs
7	 1.7446	UTH	Utilities HOLDRs
8	 1.7245	RFV	Rydex S&P Midcap 400 Pure Value
9	 1.6740	DNL	WisdomTree Japan High-Yielding Equity
10	 1.6543	IDU	iShares Dow Jones US Utilities
11	 1.6392	XLU	Utilities Select Sector SPDR
12	 1.6124	IXP	iShares S&P Global Telecommunications
13	 1.6032	IWS	iShares Russell Midcap Value Index
14	 1.5476	JKI	iShares Morningstar Mid Value Index
15	 1.5474	VPL	Vanguard Pacific Stock VIPERs
16	 1.5446	VGK	Vanguard European Stock VIPERs
17	 1.5219	PWP	PowerShares Dynamic Mid Cap Value
18	 1.4926	ADRU	BLDRS Europe 100 ADR Index
19	 1.4914	EFV	iShares MSCI EAFE Value Index
20	 1.4811	IYZ	iShares Dow Jones US Telecom
21	 1.4764	PGJ	PowerShares Gldn Dragon Halter USX China
22	 1.4532	EZU	iShares MSCI EMU Index
23	 1.4221	EWK	iShares MSCI Belgium Index
24	 1.4106	EWM	iShares MSCI Malaysia Index
25	 1.4069	DLS	WisdomTree Intl SmallCap Dividend
26	 1.3962	EWS	iShares MSCI Singapore Index
27	 1.3057	DFE	WisdomTree Europe SmallCap Dividend
28	 1.3013	EWP	iShares MSCI Spain Index
29	 1.2963	EWA	iShares MSCI Australia Index
30	 1.2941	VTV	Vanguard Value VIPERs
31	 1.2935	PPA	PowerShares Aerospace & Defense
32	 1.2671	ADRD	BLDRS Developed Markets 100 ADR Index
33	 1.2647	EPP	iShares MSCI Pacific ex-Japan
34	 1.2498	VCR	Vanguard Consumer Discretionary VIPERs
35	 1.2428	DNH	WisdomTree Pacific ex-Japan Hi-Yld Eq
36	 1.2331	EWW	iShares MSCI Mexico Index
37	 1.2031	EFA	iShares MSCI EAFE Index
38	 1.1887	PUI	PowerShares Dynamic Utilities
39	 1.1864	IYM	iShares Dow Jones US Basic Materials
40	 1.1623	PMR	PowerShares Dynamic Retail
41	 1.1479	FXI	iShares FTSE/Xinhua China 25 Index
42	 1.1390	RPV	Rydex S&P 500 Pure Value
43	 1.1385	FEZ	streetTRACKS Dow Jones Euro STOXX 50
44	 1.1229	SDY	SPDR Dividend
45	 1.0614	EWO	iShares MSCI Austria Index
46	 1.0543	IWD	iShares Russell 1000 Value Index
47	 1.0528	PRF	PowerShares FTSE RAFI US 1000
48	 1.0369	DVY	iShares Dow Jones Select Dividend Index
49	 1.0350	XLY	Consumer Discretionary SPDR
50	 1.0303	EWQ	iShares MSCI France Index