Straight Talk on Cabot ETF Investing System

Straight Talk on Cabot ETF Investing System

Zillow.com

One Great Stock

Today I want to start by spending some time explaining the product we introduced 10 days ago.

It’s called Cabot ETF Investing System.

In short, it’s an advisory that combines industry-specific ETFs and market timing to beat the market, by an average of 10 percentage points every year. (In other words, if the S&P 500 gains 10%, this system gains 20%.)

I think that’s terrific–and exactly what many investors need–so I’m currently making this new publication available to Charter subscribers for just $87 a year.

But I’m trying not to make this a sales letter; I’m trying to make this an explaining letter.

So here goes.

ETFs, as more and more investors have learned in recent years, are like mutual funds. (The initials stand for exchange-traded fund.)

So they’re safer than individual stocks, because they’re diversified. But unlike most mutual funds, ETFs are not managed by highly paid professional investors. Instead, they’re passively managed–mainly by computers–so that they’re always exposed, in the right proportions, to the exact segment of the market they’re designed to duplicate.

You can buy an ETF that mimics the S&P 500, or an ETF that mimics the stock market of China, or an ETF that’s loaded with agriculture stocks. You can even buy an ETF that does the exact opposite of the S&P 500 … or twice the opposite of the S&P 500. There are more than 1300 ETFs to choose from.

Because these ETFs are not managed by expensive professionals, they’re very cost-effective investment vehicles. And unlike mutual funds, which only trade at the close of the day, they trade all day long, so you get exactly the price you expect when you place your order.

But how do you decide which ETF(s) to own?

That’s the hard part, and it’s the #1 reason we didn’t launch this ETF newsletter until now.

(Assumed is the fact that the goal is to beat the market. If all you want to do is equal the performance of the market, you can buy the S&P 500 SPDR (SPY) exchange-traded fund and be done with it.)

We looked at momentum-based trading systems (the root of our growth stock investing system), but couldn’t find any that work. (Years ago, we tried using momentum with mutual funds, with similar poor results.)

And we looked at systems based on fundamentals, but they were unreliable, too. Just as economists are ridiculously inept at predicting what the economy will do, investors are bad at guessing which sectors will do well.

But then Robin Carpenter, who had been involved in our investigative efforts, had an idea.

He combined the research of an expert quantitative analyst with one of Cabot’s market timing indicators, the Cabot Tides, and just like that, he had a winning system.

The quantitative analyst chooses sectors not by predicting what the economy will do but by looking at the past performance of specific stocks after historic periods that were economically similar to the present period, and then buying the sectors that own those stocks that did best after those periods.

To keep it simple, he focuses on these nine ETFs.

Basic Materials Select Sector SPDR ETF (XLB)

Consumer Discretionary Select Sector SPDR ETF (XLY)

Consumer Staples Select Sector SPDR ETF (XLP)

Energy Select Sector SPDR ETF (XLE)

Financial Select Sector SPDR ETF (XLF)

Health Care Select Sector SPDR ETF (XLV)

Industrial Select Sector SPDR ETF (XLI)

Technology Select Sector SPDR ETF (XLK)

Utilities Select Sector SPDR ETF (XLU)

Typically, two or three of these sectors are rated Favored, though occasionally there may be four and occasionally just one. Some are rated Neutral and some are rated Unfavored.

To follow the system, you simply own the ones that are rated Favored … when the market environment is positive.

But sometimes, like today, the market environment is negative (that’s putting it mildly), and in those periods, the system says you should NOT be invested. (For the record, the system has been saying that since August 2, which means followers of the system have avoided most of the market’s recent damage.)

In these periods, conservative followers of the system simply hold cash; that’s the Long-Only Strategy.

Aggressive followers of the system, use the Long & Short Strategy. They can do even better (while assuming more risk) by shorting the S&P 500 SPDR (SPY), and staying short until the market environment is once again positive.

The timing for these signals, as I mentioned earlier, comes from the Cabot Tides, our time-tested intermediate-term indicator. It’s not perfect–no system is–but it does ensure that you will be shielded from all major downtrends, and that you will benefit from all major uptrends.

Here’s the track record through September 9. It is, admittedly, theoretical, with the exception of the last few months that we’ve been practicing this in real time, but I think you’ll agree it’s rather compelling.

Cabot ETF Investing System performance

Now, since we introduced this, we’ve had some questions.
 
Many new subscribers to the service have asked if, instead of shorting the SPY, they could buy an inverse ETF, or buy puts on the SPY.

In both cases, Robin’s answer is that shorting the SPY provides a more reliable benefit.

Some have asked about using stops to protect profits.

Robin’s answer is that while stops can work, they are more suited to systems based on chart patterns, and not systems based on economic fundamentals.

One asked about the maximum drawdown of the system (the greatest decline from a peak).

Robin answered that the maximum drawdown was 21.1% for the Long-Only system; 29.4% for the Long-Short system and 55.2% for the S&P 500 (SPY).

Other readers asked whether it would be better to short the Unfavored sectors in a negative market environment, instead of shorting the S&P 500 (SPY).

Robin answered that shorting those other sectors is less reliable. Shorting the SPY is best in the long run.

You notice, of course, that all those questions are about using the system in negative markets, and no one asked how they might leverage the Favored sector picks in an uptrending market.

That tells me (as do other indicators) that there’s not much optimism out there … and as a practitioner of Contrary Opinion, I find that very encouraging.

One reader asked, “Why exclude ETFs from emerging markets, commodities, precious metals, etc?” The answer is that while those sectors may have big moves, we don’t have a system that allows us to invest in them with any confidence.

Others asked about using “leveraged” ETFs. I mentioned the double inverse S&P 500 ETF earlier, but there are many more, on both the long side and the short side. The answer here is that while use of these leveraged products can bring greater returns, it does so by adding risk, and if you happen to initiate such a program at precisely the wrong time, you might find yourself in a hole that’s very difficult to climb out of.

To sum up, there are numerous permutations of this system that you might be tempted to try, and some will work for a while. Right now, readers are focused on profiting from downside market action (I call that driving by looking in the rear-view mirror), but someday that will be the exact wrong thing to be focused on.

The important point to remember is that the system is sound, and in the long run it will work. Monkeying with it, like putting 20″ wheels on a Prius, may bring unintended consequences.

And if you have any more questions, let me know!

To give it a try, click here.

Moving on, if you’ve thought about buying or selling a house in recent years, you’ve probably visited Zillow.com, the company whose name combines “zillions” (of data points) with “pillow.” With sales, rental and tax data on more than 100 million homes in the U.S., the site is enormously helpful to both buyers and sellers.

Furthermore, like Google, Wikipedia, Yahoo and other great online resources, Zillow is free to casual users. The company’s revenues come mainly from realtors and other advertisers using the site to drum up business.

Zillow has grown revenues every year since 2006; it grossed $30 million in 2010. Furthermore, the second quarter of this year brought the firm’s first profitable quarter–and most assuredly not the last–as revenues soared 116% from the same quarter in the previous year.

Taking advantage of that milestone, Zillow went public on July 20, just as the broad market was topping.

Shares debuted at 20, zoomed to 60 that very day, and then tumbled, with the market, to a low of 23 … before climbing back to 38 two weeks ago.

But this is not a recommendation of Zillow (Z). Before I recommend the stock, I need to see more constructive chart action, as well as more liquidity,

This is, instead, a prelude to a discussion of a study released by Zillow last month, just three days before the IPO, and picked up by the Wall Street Journal, that suggests housing prices are cheap in Las Vegas and Detroit and almost back to “normal” in the U.S. as a whole. (If you infer from the timing of this study that Zillow might be trying to drum up some business of its own, you might be right.)

To draw this conclusion, Zillow hangs its hat on the fact that from 1985 through 1999, housing prices tracked income very closely, as these charts show.

Housing chart 

In Virginia Beach, Virginia, housing prices averaged 2.5 times local annual income through that “baseline” period. In Sacramento, California, they averaged 3.3 times local annual income. In Las Vegas, Nevada, they averaged 2.7 times local annual income. And in Detroit, Michigan, they averaged 2.1 times local annual income. Nationally, the average house sold for 2.9 times average annual income.

But in 2000, as the housing market began to overheat–I won’t waste your time repeating the reasons–housing prices began to climb above these averages, and they kept on climbing for roughly six years. Of course, you know what happened.

And now, more than five years into the decline of the housing market, Zillow is joining the chorus of voices suggesting this downtrend is near an end.

Well, I don’t think so, and my reasoning is this.

First, to construct a baseline from a 15-year sample is a bit shortsighted.

A quick look online reveals that in the decade before 1985, the national ratio was roughly 10% lower. Before that, data is murkier; the one constant is variability, thanks to market forces.

Second–and this is my strongest point–I know from experience that when charts fall from an overbought level, they don’t just return to “normal,” they typically fall to an oversold level.

So I think housing prices, on average, still have further to slide … and I’m not just saying 2% or 3%. I think housing prices will stay soft for as long as it takes for most Americans to stop thinking about houses as investments.

When that day comes, houses will be good investments again, but until that day–and I think it’s many years away–you’ll be safer if you simply think of your house as your home.

Turning to specific stocks, I will admit that this is a challenging time for me. The reason: the best charts today belong to conservative stocks, and I know from experience that once this negative environment has passed, those stocks will lose their allure.

So instead of using charts, I’m turning to Cabot Benjamin Graham Value Letter today to highlight a stock that’s attractive based on valuation.

It’s that well-known entertainment juggernaut Walt Disney Company (DIS), which is currently selling for 30% off its recent high.

Here’s what Cabot Benjamin Graham Value Letter editor Roy Ward wrote in his latest issue.

“The leading entertainment company operates a multitude of giant theme parks and resorts around the world, as well as many other operations including a cruise line, television networks and movie studios. Disney recently opened a new resort in Hawaii and is building a new resort in Shanghai, China. Expansion is also in the works at its ESPN network, Disney World in Orlando and Disneyland in California.

During the past 12 months, sales increased 5% and EPS rose 15%. We expect Disney to pick up the pace and produce sales and earnings increases of 9% and 23% respectively during the next 12 months. Expansion and recent rate hikes at the company’s parks and resorts will spur growth.

DIS shares are a bargain at 11.0 times our 12-month forward EPS estimate of $2.94. Larger box office sales and price increases could cause our estimates to be conservative. We believe the company’s share price will reach our Minimum Sell Price of 56.21 within the next one to two years.”

For the record, Roy advises buying anywhere under 36.41, which is his Maximum Buy Price. If you buy above that level, you lose your Margin of Safety. But if you buy below that level, and DIS climbs up to 56.21 within two years, that’s a tidy 54% profit.

For more details, click here.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Publisher
Cabot Wealth Advisory

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