Stay ahead of the herd with relative strength rebalancing

Chris Rowe
0 Comments|December 24, 2013

A Note From the Editorial Director: Readers have been clamoring for guidance on conducting their own analysis of market trends. So today we’re introducing Technical Tuesday, a weekly feature from our friend Chris Rowe that offers just that. A hugely successful investor and Wall Street money manager, Chris is the perfect person to simplify the technical side of equity investing.

Are there particular technical subjects you’d like Chris to tackle in a future column? Tell us at mailbag@investmentu.com.
- Andrew Snyder

With only one week left in 2013, it’s clear the U.S. stock market has had a huge year. The S&P 500 is up 27% while the Russell 2000 and the small caps it tracks are up 38%.

The biggest winners in a market like this are those who are relatively hands-off. And my absolute favorite hands-off strategy is one that requires only a quick look in the rearview mirror just four times each year.

If you’re interested in learning the strategy and exactly how you can use it then read on…

Relative Strength Rebalancing

It’s a simple strategy, really. Relative strength rebalancing is a form of sector investing that helps us stay ahead of the average market performance. The strategy is simply to exit the sector ETFs that are not among the top performers each quarter while buying those that are.

What are the “top performers”? Well, I like to look to the top 10%.

The screen that I set up in about 30 seconds from etfscreen.com has 134 ETFs listed, so we’re interested in the top 13 or 14. From there, you’ll select five or six that you most want to own.

Eliminate the short funds and the leveraged funds in the pull-down menu on the top left of the screen.
 


Then eliminate ETFs that trade fewer than 100,000 shares per day.
 
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Be sure to sort the list in order of performance for the last three months. Click the down arrow on the seventh column from the left (circled in black). It says “Rtn-3mo.”



I also don’t want to be in any ETF that has more than 25% weighting in any one stock.

It’s easy to screen these out. Go to Yahoo Finance and enter the symbol, then click “Holdings” on the left. If you do that with the top performer, iShares US Broker-Dealers  (NYSE: AIA, Stock Forum), for example, you’ll see that its top weighted holding represents 9.24% of the ETF. So iShares US Broker-Dealers is a good candidate for our portfolio.

In addition to IAI, you can see that banking, pharmaceuticals and aerospace were among the best performers. (Natural gas is up there too, but the ETFs in this sector turn out to be commodity-based. Since we are constructing a stock-based portfolio here, it makes sense to eliminate those ETFs as potential holdings.)

A Simple Plan

Those of you with sharp eyes will also notice that these top 14 ETFs were among the top performers over the past six and 12 months. In fact, the group’s average return so far this year is 48%!

There’s a very good reason for this: When institutions take positions, they’re very large… to the point that they’re buying into them for months and then taking more months to unwind when it’s time to exit.

That’s how we can answer the question: “What gives you confidence that, just because an ETF was a top performer in the last three months, it’s likely to outperform for the next three months?” Nothing is certain, but understanding how these institutional investors impact a given sector, ETF or stock gives you some good perspective.

Relative strength rebalancing is by far the simplest way to beat the market’s returns over time. Don’t shy away from the strategy if it fails in the first couple of quarters. Relative strength strategies outperform the market over time. I’ve seen hundreds of studies proving this fact.

It pays to diversify, even when you’re trading ETFs. In other words, it makes sense to own at least three sectors.

Look for Technical Tuesday every week. And if there are particular subjects you’d like me to look at, tell me about them here: mailbag@investmentu.com.
Tags: ETF

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