A Look At Relative Strength In The ETF World

05/21/09 11:49:36 AM

by Donald W. Pendergast, Jr.

Keeping tabs on which industry groups and sectors are hot -- and those that are not -- is a sound way to build a solid foundation for your trading and investing decisions.

Security: HAO, KOL, IYT, IYR
Position: N/A

A mere six months ago, many were wondering just how low the global equity markets might go; fear and loathing were widespread and the permabears were sure that it was the Big One. Today, investors have all but forgotten the reports of gloom and doom (one wag once remarked that Elliott wave analysts had correctly called 38 of the past four recessions, but that's another story, and I do believe that Elliott wave analysis can be an excellent forecasting tool, notwithstanding) and economic chaos, instead choosing to focus on making the most of the 10-week-old bear market rally.

FIGURE 1: TOP SEVEN LONG-TERM RELATIVE STRENGTH ETFS. Emerging market, coal, steel and nuclear energy ETF's take up most of the top seven long-term relative strength slots.

Graphic provided by: MetaStock.

Using a simple MetaStock relative strength exploration, one that focuses on the three-, six-, and 12-month performance of a basket of 37 diverse exchange traded funds (made up of US stock industry groups, commodity-based stocks, and various global stock indexes), I was able to glean a useful picture of where the strength and weakness resides in the ETF universe.

Glancing at the exploration output, we learn that small-cap Chinese stocks (HAO) are on a tear, as are the stocks in the coal industry group (KOL). Taking third place is the steel industry group (SLX), followed by Vanguard's Emerging Markets (VWO) and Market Vectors Nuclear Energy (NLR). Lodged in the seventh position is FXI, the ETF that focuses on the largest and most liquid Chinese equities; interestingly, FXI has only half the relative strength rating of its small-cap Chinese cousin, HAO. Small-cap indexes were generally mauled worse than their large-cap counterparts during the 2007-09 market smash and are now beginning to make up some of those massive losses at a rate far exceeding that of their large-cap brethren. See Figure 1.

Perhaps you've also noticed the potential link between the simultaneous resurgence in the Chinese small-cap index and the coal and steel industry groups, just as I did. China has hundreds of coal-fired power plants (and many more scheduled for production) that eat up enormous amounts of coal, just as their steel industry does. Coincidence? Nah, no way. It's just another visual depiction of global economics in action, courtesy of a simple MetaStock exploration.

FIGURE 2: WEAK LONG-TERM PERFORMING ETFS. Meanwhile, despite impressive bear market rallies, the transportation, regional banking, and real estate ETFs display lackluster longer-term performance ratings. All could offer significant short selling opportunities in the weeks ahead.

Graphic provided by: MetaStock.

Glancing at the list of ETF underperformers (Figure 2), it is no surprise to see the Transportation (IYT), Regional Banks (IAT), and Real Estate (IYR) ETFs clinging to the bottom rungs of this particular 37-ETF exploration. Again, the global economic crisis of 2007-09 did quite a number on each of these particular industry groups; rising energy prices crippled the earnings potential of most transportation sector firms, even as the mortgage fiasco wiped out the profitability of many banks and real estate-related enterprises, too. While these three ETFs have enjoyed nice bear market rallies ranging from 18% to 52%, each one also has a ton of long-term overhead resistance to overcome if they are destined to eventually return to their former states of stock market glory.

Given that reality, IYT, IYR, and IAT may be excellent shorting and/or put option purchase candidates should the broad US market indexes begin a more substantial corrective move during the next few weeks. The Standard & Poor's 500, NASDAQ 100, and Russell 2000 indexes all feature very extended weekly price cycles and have already begun to roll over, so tracking the stocks (for suitable short setups) in the IYT, IYR, and IAT could be a great idea, given that such weak groups tend to remain weak for an indefinite period of time.

FIGURE 3: COAL ETF, DAILY. Although it's not necessarily the holy grail of trading methods, buying pullbacks against a major uptrend in strong relative strength stocks and ETFs is still a sound, low-risk trading strategy.

Graphic provided by: MetaStock.

How can we play some of these ETFs for a pullback against the trend move? Look at the Coal ETF (KOL) in Figure 3. Assuming it had high relative strength versus most other ETFs, then each time that the stochRSI dipped below and then above its lower signal line (see top of the chart) might have provided a reasonably low-risk long entry setup, particularly if the trendlines had begun to accelerate higher. Sure, there are a few whipsaws here and there, but by playing with your entry prices (putting half a position on at the stochRSI signal line crossover and then waiting for a minor pullback to the trendline to deploy the second half), you can usually minimize that risk.

Will KOL or HAO keep grinding higher? No one knows, but by keeping track of their relative strength rankings among a diverse group of global index, US industry group, and commodity-based stock ETFs, you'll be able to make an educated guess as to whether to plow your trading or investing capital into these or any other ETFs.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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