Wednesday, December 21, 2011

Tactical Diversity Speedometer -- Defined

We are constantly developing clear and concise ways to communicate current levels of market risk to our subscribers. We understand that return of your capital is just as important as the return on your capital. So, we cannot stress enough how important it is to be aware of market Risks before making an investment decision.

As most of our subscribers are aware we completed an extensive development process which enhanced greatly our ETF models in 2010. Clearly, this work has paid off when one considers all of our outperforming ETF portfolios this past year versus the performance of the major indexes and when compared with other competing approaches!

One of the key observations during this systems development work was that when we ran the software models on the entire universe of Exchange Traded Funds during a healthy market period some 40 to 50 to several hundred ETFs would pass all of our screening criteria for Buys.  But when we ran the same software models as market volatility increased, the number of funds passing the screens would dwindle to a handful and occasionally to none. This means that out of our universe of close to 1,000 Exchange Traded Funds not one would pass our screening criteria during a high volatility or down market period. This is the sign of a very, very dangerous market. Whenever the number passing the Buy screens went from a high number to a very low number in a short period bad things often happened in the market.

Then, we went one significant step forward with this development and focused on how many Sectors were currently passing our buy considerations. Consequently, we decided to create a speedometer so to speak (we call it the Tactical Diversity Speedometer) to show you the percent of all Sectors that are passing all of our buying considerations and therefore how much risk there is the market.

An important note on how we define “Sectors”.  These groupings of ETFs are calculated by examining all the intercorrelations among the nearly 1,000 ETFs.  Then grouping together those with high intercorrelations and selecting a “representative” for the group.  These “representatives” then comprise a set of “relatively uncorrelated sectors”.  It’s these relatively uncorrelated sectors that we examine to see how many pass all of our Buying considerations! (This work is computational intensive and is carried out with proprietary algorithms developed by our firm.)

Our observations have been that when only a handful or these Sectors pass the screening criteria it’s time to get very, very conservative with your investment choices.  But when 20% or more Sectors pass the screening criteria the market is healthy and therefore it is safer to pursue riskier investments. And obviously, the higher the speed of the Speedometer the healthier the market is.

It doesn't strictly mean that when only a sector or two pass the buy filters that one cannot make money in the markets; it simply means that the markets are not robust when such a low number of Sectors are in a buy mode.

On the title "Tactical Diversity Speedometer" --- "Tactical" because it focuses on a relatively recent time-frame; "Diversity" because it analyses 'Relatively Uncorrelated Sectors", thus groups of ETFs which are statistically 'diverse' and "Speedometer" because we display the 'speed' or the 'health' of the overall market and discuss both the current speed and the rate of increase or decrease.

The Tactical Diversity Speedometer is a way for our readers and subscribers to see the current level of market risk at a quick glance!

Here are some visually striking examples:

Beginning of a Healthy Market

Super Healthy Market

Un-Healthy Market!