We set out today to create a global balanced portfolio using 16 ETFs picked from the circa 200 available on the FinGraphs.com platform. Our investment horizon is the next 3 to 6 months, or until mid 2015. Accordingly to illustrate our selection process, we will use Mosaics of our Weekly charts. These offer a perspective over the next Quarters. Although to some degree we have considered size, liquidity and management fees, our main selection criteria will be market positioning (relative trends and price potential) as well as composition (e.g. concentrated ETF or broader based ETF).
Our first decision is to consider the denomination currency of our portfolio. We have chosen USD, as most of our ETF coverage in USD denominated. Over the last few months, we have reiterated many times our USD bullishness versus other major currencies. Our Weekly charts below on the Dollar Index (DXY), EUR/USD, GBP/USD and USD/JPY although a bit extended (DXY and USD/JPY labelled “I up done”), are still in favour of the Dollar over the next few Quarters.
Hence, any investment denominated in another currency will most probably have to be hedged for currency risk. We will mention the possibility to use hedged currency ETFs where they are available, in the market and on our FinGraphs.com platform.
Betting on a cyclical upturn:
2014 was mostly a defensive year: stocks were modestly up and the US economy improved, yet defensive sectors such as Staples, Healthcare and Utilities widely out-performed, especially in the second half of the year. If you have followed our latest contributions, you will know that we are still widely positive on US equities. Furthermore, following an unconvincing January, we believe that the cyclical upturn has started to gather momentum in February.
The charts below tend to confirm this view:
• Chart1 : Growth should continue to accelerate vs value (the IWM iShares S&P500 Growth ETF vs the IVE iShares S&P500 Value ETF is in an Impulsive up move with more upside potential),
• Chart 2: Consumer Discretionary (the XLY select sector SPDR ETF), a typical early cycle mover, has started to resume its uptrend vs SPY (the S&P500 SPDR ETF) following a correction down during 2014. It is on the brink of turning positive again
• Chart 3: Technology (the XLK select sector SPDR ETF), another early cycle mover, is approaching the upper boundary of our corrective targets up vs SPY (“C up” or the grey target oval). It could soon turn impulsive up, opening the way to much greater out-performance.
• Chart 4: in the 4th Quarter of 2014, mid caps (MDY, the SPDR Midcap Trust Series I) have started to catch up vs SPY following a very negative 2014. They are now only slightly bearish to neutral (Bear Trend, but no targets). S a matter of completeness, we have also considered the IWM iShares Russell 2000 ETF (not shown). However, it is still in an Impulsive downtrend vs SPY, and hence it is still too early to consider it in terms of risk/reward.
So, growth should outperform value, cyclicals could accelerate and mid caps are making a come-back. As mentioned above, we also believe that the SPY (the S&P500 SPDR ETF) should continue up over the next few months. One solution would be to use SPY as the core ETF in our US Equity portfolio and complement it with MDY (the SPDR Midcap Trust Series I) to achieve more dynamism. That said, our selection process really wants to concentrate on the ETFs that offer the best positioning and for now MDY is only neutral, at best, vs SPY. An alternative would be to replace SPY, which is based on the capitalization weighted S&P500, by one of its equal weighted surrogates. We have chosen RSP (the Guggenheim Equal Weight ETF). It offers in one instrument a balanced exposure between large and mid caps. It is also well positioned on a relative basis vs as we can see in the following relative strength Investor’s View chart combination.
RSP vs SPY – Investor’s View (a combination of a Weekly, Daily and Hourly chart):
The Weekly (left hand chart) and Daily (middle chart) are still heading up, respectively over the next few Quarters and Months. The Hourly (right hand chart) is in a mere consolidation for now, which may be already over (“C Down done”).
Hence, we will choose RSP as the first element of our ETF portfolio (the Guggenheim S&P Equal Weight ETF). It is an important one as it will serve as the core of our US Equity exposure.
US sector focus: looking for vectors of growth
We have benchmarked the major US sectors vs SPY (most sector ETFs are cap weighted; SPY is hence better suited for like to like comparison than RSP). As we are betting on a cyclical upturn, we will generally avoid Defensive Sectors such Consumer Staples (the XLP select sector SPDR ETF) and Utilities (the XLU select sector SPDR ETF). These corrected up in 2014, but are now resuming their downtrend vs SPY. We will also exclude Financials (the XLF select sector SPDR ETF) which has been slightly down vs SPY over the last 2 years, a downtrend which lately appears to be accelerating. Finally, we will also stay away for now from sectors which typically start to outperform later on in the cycle, namely Industrials (the XLI select sector SPDR ETF), Materials (the XLB select sector SPDR ETF) and Energy (the XLE select sector SPDR ETF). Anyway, all three are still in downtrends on our Weekly charts vs SPY.
This process by elimination leaves us with three sectors, which we will focus on: Consumer Discretionary (the XLY select sector SPDR ETF) and Technology (the XLK select sector SPDR ETF), both early cycle movers and Healthcare (the XLV select sector SPDR ETF), which although considered as defensive, is showing strong resilience in its outperformance (outperformed in all of the last 4 years). XLV benefits for a strong underlying secular trend, i.e. an ageing population, and is also widely exposed to the very dynamic bio-technology sector.
In this sector, we have chosen to focus on IYC, the iShares U.S. Consumer Service ETF. It focuses on cyclical consumer related stocks, mostly, but not only, in the Consumer Discretionary sector (also includes stocks from the Staples, Industrials, Healthcare and Technology sectors). It is a very broad based ETF with circa 190 holdings. Hence, it offers more diversification that its pure Consumer Discretionary peers and over the last couple of years has offered better returns with less volatility.
In the first chart below, we first benchmark IYC vs XLY (the Consumer Discretionary select sector SPDR ETF) and confirm that IYC should continue to outperform over the next few Quarters (still some potential in terms of targets; in addition the Risk Index of this relative chart is not Overbought yet). In the second chart, we benchmark the more broad based growth ETF IVW (iShares S&P500 Growth ETF) vs IYC. On this relative basis, although IVW has reached a certain level of exhaustion down vs IYC (“I down done”), its trend is still negative. Hence, in the early stages of this cyclical recovery, IYC still seems to be the better choice. We will use it as the second element of our ETF portfolio. It will serve as the main proxy for the cyclical upturn.
The last two charts above review two segments of the Consumer Discretionary space, benchmarking them vs IYC to assess if they could add additional value to the portfolio. While Homebuilders (the XHB Homebuilders SPDR ETF) are still in an impulsive downtrend vs IYC, Retail (the RTH Market Vectors Retail ETF) is aggressively outperforming and should continue to do so. We will include it as the third element of our ETF portfolio as it provides an additional kick in the cyclical weighting of our portfolio.
As we mentioned above, XLK (the Technology select sector SPDR ETF) is on the verge of breaking out above corrective targets into impulsive territory vs SPY (above the grey oval in our first chart below). That said, in our second chart, it is still widely underperforming vs the tech heavy Invesco Powershares QQQ which includes the largest 100 non-financial companies listed on the NASDAQ Stock Exchange. We will hence favour QQQ over XLK as the fourth element of our ETF portfolio to gain exposure to the technology sector.
In the last two charts above, we also single out the semi-conductor segment using SMH (the Market Vectors Semiconductor ETF). It should continue to outperform XLK over the next few Quarters and is corrective up vs QQQ with a Risk Index which is not yet Overbought. We will include it as the fifth element of our ETF portfolio as we believe it brings exposure to a highly innovative segment of the hardware side of the technology sector.
We believe this sector is a hybrid and as such brings great value. It is traditionally considered as being defensive and will provide a hedge to our cyclical bias if it is proven wrong. It also capitalises on the aging of the population, a strong secular trend. It is also widely exposed to the very innovative bio-technology sector. In a few words, it mirrors growth and innovation with a defensive tilt.
The first chart below highlights the remaining potential of XLV (the Healthcare select sector SPDR ETF) vs SPY. The second would however lead us to favour a more broad-based Healthcare ETF: VHT (the Vanguard Healthcare ETF). It has outperformed XLV over the last couple of years and should continue to do so (targets up not fulfilled yet, Risk Index not yet Overbought). As it happens, it is also outperforming QQQ (our third chart). We will include VHT as the sixth element of our ETF portfolio allowing us to gain a broad exposure to the “hybrid” Healthcare sector.
The seventh element of our ETF portfolio would be IBB (the iShares NASDAQ biotechnology ETF) adding further skew towards this innovative Healthcare segment.
Other US segments worth exploring:
Although we have dismissed their broader sector, some further segments might be worth exploring. The 4 charts below compare their relative performance vs the SPY. On the last three, one would have to identify the relevant ETFs to match these, if they exist. We highlight these segments as a matter of interest only and will not include them in our ETF portfolio: ITA (the iShares U.S. Aerospace & Defense ETF) which is close to breaking to news high vs SPY following last year’s correction, the Speciality Chemicals segments which linearly outperforms SPY, the Oil & Gas Refining, Marketing & Transportation segment, which vs SPY could have finished a two years long consolidation pattern and the XBD Broker Dealer index which shows further relative upside potential despite the January Swiss National Bank induced hick-up (think FXCM).
This concludes our US equity exposure selection for which we have chosen the following 7 ETFs: RSP, IYC, RTH, QQQ, SMH, VHT and IBB. We will now turn to international equity markets.
Europe - broad based exposure still premature:
For the purpose of this paper, on the equity side, we focus on exposure which can add value to a simple investment in SPY (the S&P500 SPDR ETF). We also tend to favour, market positions which are already in established uptrends in what we could label a “buy the dips strategy”. We believe they offer better perspectives in terms of risk / reward than plays that focus on countertrend snapbacks or “bottom fishing” strategies that try to anticipate larger trend reversal.
This is precisely why we are still shy on Europe. Below are 4 charts of reference European and European country indexes vs the SPY. You will notice that we have labelled the dividing symbol as “ * “ (i.e. a star) as these are not just relative charts which compare these indices vs SPY in USD denominated terms. These are actually price ratio, which ignore the currency effect. They correspond to a currency hedged ratio of these indices vs SPY.
As you can see, despite the strong move in anticipation of and following the announcement of the ECB quantitative easing program, these major European indices are still in a bearish downtrend vs SPY on a hedged ratio basis. The DAX may have turned neutral (Bear with no targets). Even so, it still falls short of the market position criteria we are looking for vs SPY.
When looking at Germany on a non-hedged relative strength basis (first chart below), it appears clear that although EWG (the iShares MSCI Germany ETF) has reached its downside targets vs SPY, it is still premature to call a reversal. We go on in the next three charts to highlights several sectors / market segments that may had value once the currency effect has been hedged out: the TecDAX market segment (the technology sector in the DAX broader Index) and the European Healthcare and Insurance sectors.
In the scope of this paper, we have mostly represented the viewpoint of a US based and USD denominated portfolio. We will hence not go into the details of the sectors in other regions. We will however make an exception and include the Tec Segment of the DAX Index as our eighth position in our portfolio of ETFs. One could use the EXS2 iShares TecDAX UCITS ETF to invest in this profile. We would highly recommend to hedge the currency risk out for now.
International equity exposure:
Similarly to what we have seen in Europe, the investment case for international equity exposure vs the SPY is still weak, especially in USD denominated terms. Yet, it is difficult to justify any broad based strategy without such exposure. This is especially true if we believe a cyclical upturn is underway: in such an environment, other equity markets should start benefiting from the US success story. We hence need to identify a global equity ETF to best serve our purpose for international diversification. We like EFA (the iShares MSCI EAFE ETF) which focuses on Large caps outside of North America. Although it probably still has some downside potential vs SPY (first chart below), it does show promising perspectives vs other large foreign equity ETFs.
• Chart 2: it has been correcting up since mid 2014 against IEV (the iShares Europe ETF), most probably on the back of Euro weakness. Yet, this relative chart is approaching corrective targets up (grey oval) with a Risk Index which is still quite low. We believe that on the back of further Euro weakness, EFA could turn impulsive up vs IEV over the next few quarters.
• Chart 3: in the second half of 2014 EFA has reached and held its corrective targets down vs EPP (iShares MSCI Pacific ex Japan ETF), it now seems to be resuming its uptrend and could soon turn positive again
• Chart 4: a situation similar to chart 3 for EFA vs EEM (the iShares MSCI Emerging Markets ETF)
Hence, although its positioning vs the SPY isn’t what we would want it to be yet (still in a downtrend), EFA seems to offer decent perspectives vs other regional / international ETFs. We will hence use it as our core ETF position for diversified equity exposure outside the US (our ninth position in our ETF portfolio).
To complete our international exposure, we focus on three markets which we believe can complement our EFA exposure, adding weight on countries which could offer some potential vs SPY. The first chart below looks at Japan on a currency non-hegded basis (the EWJ iShares MSCI Japan ETF). The second highlights the Nikkei 225 vs SPY on a hedged basis (the corresponding ETF is the DXJ Wisdom Tree Japan hedged Equity Fund: it is impacted by regular lump sum dividend payments so we prefer to use the Nikkei 225 to proxy the profile). Finally, we focus on China (the FXI China Large cap ETF) and India (the PIN Invesco Powershares India portfolio ETF).
EWJ is still negative for now, yet it is nearing exhaustion with its Impulsive targets down labelled “I down done”. The Nikkei 225 is in a strong uptrend vs SPY on a currency hedged ratio basis. FXI and PIN have bottomed out vs SPY and are now positioned in the early stages correction up (not ideal, but promising).
Versus EFA, on the charts below, all four are positioned in uptrends, with the later two showing strong remaining potential in their Impulsive moves up. Their inclusion alongside EFA in an international equity portfolio, would add marginal value to our international exposure over the next few quarters.
Finally, on the charts below, we look at EWJ, DXJ, FXI and PIN on an absolute USD denominated basis. All four are trending upwards and showing more potential.
Hence, EWJ, DXJ, FXI or PIN could be great additions to our EFA “rest of the world” ETF. They may not all be ideally positioned yet vs SPY, but on an absolute basis, they should do no harm (all in Bullish trends). We will hence include DXJ as the tenth position in our ETF portfolio (we are still bullish on USD/JPY and prefer the currency hedged ETF to EWJ) and FXI and PIN as the eleventh and twelfth.
Other asset classes – bond allocation:
Let’s now turn to other asset classes. We have excluded commodities as they are still in impulsive downtrends both on an absolute and relative basis, probably until mid 2015 at least. We have also excluded Real-estate sector ETFs, which following a correction up vs the SPY in 2014, now seem to want to resume their downtrend. As for cash, it all depends on your liquidity requirements and your inclination to be fully invested or not. Now what about bonds?
The four charts below look at US Government Bonds and the yield curve. The first chart displays TLT (the iShares 20+ Year Treasury Bond ETF) on an absolute basis. It is still trending up and should continue to do so despite the recent correction (targets still show potential, the Risk Index is only entering the Overbought zone). In the second chart, TLT is presented vs the SPY. The pair is positioned in a weak uptrend (well below the grey oval corrective targets zone for now). We believe, it should shift back to a downtrend if our cyclical upturn materialises. Yet, this is not yet the case.
The last two charts above, look at swap rates on a 2 Year and 10 Year tenure. These highlight a flattening Yield Curve (rising short term rates, long term rates in a downtrend), a situation which historically has often preceded a period of recession. Hence, with TLT still positioned in an uptrend both on an absolute and relative basis and considering the flattening yield curve, one would certainly keep some exposure to TLT. If worse came to worse and our cyclical upturn failed to materialise, TLT could provide a great hedge to our strategy. We would hence include some TLT as the thirteenth position in our ETF portfolio.
Now, a bond portfolio needs more than long dated Government treasuries. We will hence choose a broader based bond ETF as our main ETF bond holding. We have chosen AGG (the iShares Core Total U.S Bond Market). Although it is still in a downtrend vs TLT (chart 1 below), it has reached its potential down and its Risk Index is Oversold. It is well diversified and has an average maturity of circa 4 years, which makes it less sensitive to a cyclical upturn than TLT. We will include it as the fourteenth position in our ETF portfolio.
In the second chart above, we compare LQD (the iShares iBoxx $ Investment Grade Corporate Bond ETF) with the government bond ETF with a similar duration (the IEF iShares 7-10 Year Treasury Bond ETF). Corporate bonds are certainly worth having if the cyclical upturn accelerates. The chart shows a correction down during 2014. Recently, the pair has reacted up. It could now be ready to resume its uptrend. We would hence add LQD as the fifteenth position in our ETF portfolios.
The next chart looks at HYG (the iShares iBoxx $ High Yield Corporate Bond ETF) vs LQD. It is still in a downtrend for now and its Risk Index is not yet Oversold. It is probably still too early to get back into High Yield. This would be especially true if the yield curve continues to flatten. We would hence exclude HYG from our selection.
Finally, in chart 4, we present EXHD (iShares Government Germany 5.5-10.5 ETF). Although a bit exhausted in terms of targets, we believe that the ECB bond buying program will sustain its continued progression. EXHD could add a welcome diversification to our predominantly US based bond portfolio. We will hence include it as the sixteenth element of our ETF portfolio. Obviously, we would elect to hedge its currency exposure for now.
Our 16 ETFs portfolio on an absolute basis:
The mosaic above presents the 16 ETFs we have selected as building blocks for our ETF portfolio. On an absolute basis, they are all in positive uptrends, except for EFA (which is USD denominated and hence impacted by the recent USD strength). Even so, EFA seems to have completed its correction down (it has reached its grey oval corrective target zone) and could now be ready to resume its uptrend. One could also hedge out part of its currency exposure.
As for the weighting of these different building blocks in a model portfolio, it will depend on how convincing you believe each part of our argumentation is in terms of adding positive value and diversification to your asset mix. It will also depend on your propensity to engage in pro-cyclical risk and more generally on your investor’s profile: Are you looking for a defensive, balanced or aggressive portfolio mix? Would you be ready to diversify your US holdings into a more international asset mix? How much bond market exposure would you want to retain to hedge the probability that the cyclical upturn my fail?
For more information on our methodology click here (http://www.fingraphs.com/#couponid-STKCHARTS14) and then view the Introduction slide-show and visit the ‘User Guide’ section on our website. Clicking that link also qualifies you for a 7 day demo and a 10% discount on our services if you choose to subscribe.
In wishing you a good start to your week,
Best regards, J-F Owczarczak (@fingraphs)