Which Market Area Has Momentum?

03/30/2017 4:47 pm EST

Focus: ETFS

Jackie Ann Patterson

Author, Truth About ETF Rotation

The returns of the US stock funds are clustered close together, while the two international funds have lesser returns, asserts Jackie Ann Patterson. When the trend changes, the ranking changes, and prompts investors and traders to consider changes in their asset allocations.

Several studies have shown momentum to be a credible investment tactic. Stocks and Exchange Traded Funds (ETFs) that have gone up in the recent past have often been the ones that continue to climb. For example, Jagdeesh and Titman demonstrated in the Journal of Finance March 1993 that “strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods.”

A simple way to identify which instruments have the most momentum is to calculate the Rate of Change or RoC. This is just the percentage change over time. Taking the ending price minus the starting price and then dividing by the starting price is the typical way to calculate RoC. Multiply by 100 to see the resulting RoC in percentage form.

ETFs Which Track Key Markets

We can assemble a selection of ETFs to represent key areas of the global markets for both stocks and bonds.

For US large-cap stocks, the S&P 500 is the undisputed choice on indices.  The SPDR S&P 500 ETF (SPY) is typically the ETF with the highest volume.  The iShares Core S&P 500 (IVV) also tracks the S&P 500 and trades commission-free at a few brokers.

For US small-cap stocks, three different indices represent the space.  The Russell 2000 is probably the most popular as the iShares Russell 2000 (IWM) ranks among the top ETFs by volume. 

For International Developed Markets Stocks, the iShares MSCI EAFE (EFA) exchange traded fund tracks the MSCI EAFE index. 

International Emerging Markets Stocks are tracked by the iShares MSCI Emerging Markets (EEM) ETF.  Note that with this index fund, we can invest in markets worldwide without taking the time to become familiar with their languages and stock exchanges.

US bonds are represented by the Barclays US Aggregate Bond Index, which is tracked by the iShares Core US Aggregate Bond (AGG) exchange traded fund.  This bond index has a duration of five to ten years which makes it less speculative than long bonds, and more lively than short-term notes.  It also features a mix of corporate and Treasury bonds.

Long-dated US Treasury Bonds are tracked by the iShares 20+ Year Treasury Bond Fund (TLT). These financial instruments were chosen as a vehicle to provide stimulus to the US economy during the 2008 credit crisis.

ProShares Short S&P500 (SH) is an inverse S&P 500 fund. The intent of an inverse fund is to provide a daily return that is opposite the daily return of the underlying index.  So, if the S&P 500 goes down -1% on the day, SH goes up +1%. Obviously, it doesn’t make sense to hold SH in the same portfolio as SPY or IVV. However, it could be a useful to rotate into an inverse fund to have the potential of profit when the market goes down.

Ranking the ETFs

As an example, this graph shows the percentage change over roughly the past six months for the set of ETFs discussed above.

chart

We can see at a glance that the stock funds have been earning positive returns while the bond funds and the inverse funds have posted losses.  The returns of the US stock funds are clustered close together, while the two international funds have lesser returns. This is the current snapshot.  When the trend changes, the ranking changes, and prompts investors and traders to consider changes in their asset allocations.

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