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Talking About Exchange-Traded Funds

Cabot ETF expert Robin Carpenter explains his interest in market analysis and shares his thoughts on the current stock market.

Stock Market Video

Talking About Exchange-Traded Funds with Robin Carpenter

When Wisdom Fails Luck Helps

In Case You Missed It

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In this week’s Stock Market Video, Cabot China & Emerging Markets Report Editor Paul Goodwin says it hasn’t been a great week in the market, but it hasn’t quite hit new lows yet. It’s still a good idea to have your stocks on short leashes though. Featured stocks: NetEase (NTES), Monster Beverage (MNST), Cirrus Logic (CRUS) and PetSmart (PETM).

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Robin Carpenter has been analyzing the movements of the stock market since the 1970s, when he founded The Stock Market Laboratory to provide technical analysis to portfolio managers. Robin is also a pioneer of modern market analysis, having originated many statistical models such as moving beta, cross-sectional skew and dispersion, and developed investing strategies based on alpha hedging and market timing.

For more than two decades, Robin has run Carpenter Analytical Services in Hanover, New Hampshire, which provides statistical and analytical services to investment professionals. He joined the Cabot team in September 2011 with the launch of Cabot ETF Investing System. Today, Robin’s taken the time to chat with me about his interest in market analysis, the state of the current market and a little about exchange-traded funds.

Matt: How and when did you first become interested in market analysis?

Robin: When I was in high school, I was given a book, written by Joseph Granville, with the somewhat clumsy title “A Strategy of Daily Stock Market Timing for Maximum Profit.” I read that book (and a few others) several times. And so I began collecting market data and testing ideas. Unlike today, market data had to be compiled literally by hand, and calculations were mostly by slide rule and recorded on paper.

Doing all that by hand would seem unbearably tedious today, but back then it was just the way it was done. And by the way, it’s not a bad way to start. There’s something about actually crunching numbers the hard way--recording, computing, comparing, adjusting--that helps to internalize relationships. It’s slow, and it’s cumbersome, but it gets things inside your head in a way that slick software and instant computing doesn’t do so well.

Matt: What led you to exchange-traded funds as an investment method?

Robin: The first exchange-traded funds (ETFs) were substitutes for broad index mutual funds, with the added benefit of low fees and intra-day liquidity. They’re still that, but now there are specialized ETFs that focus on sectors, industries, commodities and alternative asset classes. It was this “slicing and dicing” that attracted me, not for investment at first, but as proxies for the indexes they track. They provide a fast, easy and cheap way to follow the ebbs and flows of the markets. If you want to measure how micro-cap stocks are doing, or value stocks, or maybe silver, or the U.S. dollar or other currencies, there’s an ETF (or several) tracking it. They give a quick, reliable read on what’s up, with updates available throughout the day. And it’s almost free.

A huge amount of market differentiation--what’s strong and what’s weak--is accounted for by sectors, industries or asset classes. If Utilities are strong, they’re all strong. (Well, almost all.) If regional banks are weak, they’re usually all weak. And it’s just a lot easier (for me, anyway) to assess prospects by type of business than to search for specific strengths or weaknesses in hundreds of individual companies.

Matt: How did you design the strategy of Cabot ETF Investing System?

Robin:

I learned of a sector selection model that has a solid record of outperforming the market, and that is based on quantitatively objective economic analyses. I did a thorough review of its selection performance--right down to daily fluctuations--and am persuaded that it’s valid and successful in identifying sectors that usually outperform the S&P 500, and with less volatility.

I realized that if the selection model were combined with good market timing, it could be the basis of a unique service. I had met Tim Lutts, president of Cabot, a few years earlier, and I remembered he said his subscribers have a high interest in ETFs. I knew Cabot had a timing model that is also quantitative and objective. So I met with Tim and we back-tested the selection and timing in combination. The tests were successful, so we designed Cabot ETF Investing System to meet that need.

Matt: What makes a particular sector “favored?”

Robin: The selection model is really pretty complicated. Unlike most sector models, we can’t say XYZ sector is Favored because of on particular factor, say, interest rates. Or because of inventories or employment data. In effect, the model generates a whole profile of economic factors and looks to see what sectors have excelled in the past when conditions were “like that.”

Matt: What’s the benefit of investing in sector ETFs versus other types of exchange-traded funds?

Robin: As I mentioned, there’s now a really full range of ETF types available. We still have the very broad index ETFs (like SPY tracking the S&P, or IWM tracking the Russell 2000). We have sectors (like the SPDR sector ETFs we use), and we have individual industries (like GDX for gold miners or IYT for transportation). The very broad indexes wouldn’t give us a basis for differentiation. The narrow industries might work OK over time, but the narrower the target, the higher the chance idiosyncratic surprises will occur. So the SPDR sectors balance those issues, giving sector specificity for differentiation, while each sector includes a limited range of industries that provides partial diversification within the genre.

Also, the SPDR sector ETFs are very liquid, so we always know we can get in or get out when a change is called for.

Matt: Is there a certain type of person who invests in ETFs instead of individual stocks?

Robin: Well, I don’t know that there’s a “type of person,” but there is a “type of objective.” Investors who find it easier to understand the economic dynamics of a whole class of securities like a sector or industry--and wish to gain or shed exposure to that class--are natural ETF users. Alternatively, an investor seeking broad exposure but who wants to manage the weightings (rather than just buy the SPDR S&P 500 (SPY) with its weightings) can do it with ETFs. (And there are even individual ETFs that offer S&P sectors in proportions different from the S&P weights.)

Matt: What do you think of the current market as it relates to ETFs?

Robin: We are now in a downtrend as defined by the Cabot Tides indicator. In a downtrend, most stocks go down, and almost all sectors go down. As a result, the Cabot ETF Investing System is holding cash. That’s how the System works. So right now we’re preserving buying power for the next Buy signal. When that signal comes, most ETFs will move higher with the averages. We hope and expect that the Cabot Favored ETF sectors will be stronger than average. But the market is a constant kaleidoscope and we’ll have to peer closely at that when the time comes.

Matt:

Thanks for taking the time to talk with me.

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When-Wisdom-Fails2

Here’s this week’s Contrary Opinion Button. Remember, you can always view all of the buttons by clicking here.

When Wisdom Fails Luck Helps

It’s true; sometimes an investor gets lucky. A company gets an unexpected takeover offer, or a competitor stumbles. But you don’t want to depend on luck. Do your homework, and try to be wise.

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In case you didn’t get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, there are links below to each issue.

Cabot Wealth Advisory 5/28/12 - For Energy Investments, Look North of the 48th Parallel

On Monday, Cabot Global Energy Investor Editor Lou Gagliardi discussed the decline of world oil production in traditional regions. Lou advised that energy investors look to Canada as part of the future because of that country’s abundant reserves of oil sands. Featured stocks: Suncor (SU), Meg Energy (MEG) and Cenovus (CVE).

Cabot Wealth Advisory 5/31/12 - Market Down, Invest Less: Market Up, Invest More

On Thursday, Cabot China & Emerging Markets Report Editor Paul Goodwin wrote about the preference for simple rules when it comes to investing. Paul then discussed his simple rule for making and keeping money in the market: When the market is up, invest more ... when it’s down, invest less. Featured stock: Boston Beer Company (SAM).

Happy Investing,

Matt Delman

Editor, Cabot Wealth Advisory

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