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Using Intermarket Analysis
With Exchange Traded Funds
Previously,
Matt Blackman explained how using intermarket analysis can help
traders survive the rocky waters of today's market. This time, he
suggests using intermarket analysis with exchange traded funds and
gain another advantage.
Intermarket
analysis describes the impact that different asset classes and
global markets exert upon one another. This topic has been discussed
in numerous trading books and articles, and says, in a nutshell,
that all global markets and asset classes are interconnected.
Although these relationships vary from market to market and change
over time, they cannot be ignored. I discussed this topic in my last
article, "The Market Thrivor's Secret Weapon."
How does
intermarket analysis work with, say, exchange traded funds (ETFs)?
It must work well, because the advantages of applying intermarket
analysis to ETFs have not escaped industry players like Darrell
Jobman, senior market analyst for
TradingEducation.com. According to
Jobman: "ETFs trade like stocks, giving investors an instrument with
which they are familiar to trade a broader equity market and
allowing them to emulate professional fund managers without having
to pay management fees. Combining an ETF with the use of intermarket
analysis allows the trader, no matter how small, to mimic what the
institutions are doing with the latest state-of-the-art trading
signals without having to pay the high fees traditionally associated
with this level of sophistication."
And as
Louis Mendelsohn, developer of VantagePoint Intermarket Analysis
Software, CEO of Market Technologies, and author, commented, "As
members of the stock index family, ETFs are heavily influenced by
what is happening in other markets and frequently provide good
trending situations, making them perfect candidates for intermarket
analysis by the technical trader with the right technology."
So it
sounds as if the two work well together. Like intermarket analysis,
it feels as though exchange traded funds (ETFs) have been around
forever, largely due to their tremendous growth since their
introduction in 1993 (see Figure 1). They grew more than 46% in
dollar asset terms between 2003 and 2004 alone, and there is little
evidence this incredible rate of growth will slow anytime soon.
Figure 1:
GLOBAL GROWTH IN EXCHANGE TRADED FUNDS. Chart showing the growth in
ETFs from three ETFs with $811 million in assets under management in
1993 growing more than 300 fold to 336 ETFs worth $309.8 billion in
2005. (Market Technologies, LLC; data provided by Morgan Stanley and
Bloomberg)
Why so
popular? What are they, anyway? Basically, ETFs are index mutual
funds that trade like stocks, offering the additional opportunity to
buy baskets of stocks. Like stocks, ETFs involve lower fees and have
no restrictions on how often they can be bought and sold. With
mutual fund restrictions and minimum holding periods in place, this
is a huge consideration. There are many benefits to using ETFs in
favor of mutual funds, particularly in terms of commissions;
commissions for ETFs are the same as for stocks when using a
discount broker — that is to say, negligible.
"TO THE MOON, ALICE..."
According to a recent Morgan Stanley study, 336 ETFs had a total of
$310 billion under management by the end of 2004, all under the
control of 40 managers on 29 global exchanges. The United States is
the dominant player with 152 funds totaling $228 billion, followed
by Europe (114 funds worth $34 billion) and Japan (15 funds worth
$30 billion). This is phenomenal growth considering the ETF's humble
beginnings just 12 years ago, when three funds were introduced with
assets of only $811 million. That's a growth rate of more than
300-fold in the number of ETFs, and nearly 400-fold in terms of
assets under management since then.
Between
2003 and 2004, ETF assets worldwide increased 46.1%. Assets
increased 51.1% in the US, 66.5% in Europe, and 9.7% in Japan. Since
1993, US ETF assets have grown from $460 million to more than $227
billion, an average growth rate of nearly 50% per year.
ETF ADVANTAGES
Skyrocketing assets and minimal commissions are just the beginning.
Let's look at the benefits of ETFs when compared to index mutual
funds and stocks.
1.
Lower fees.
The first big advantage is management fees.
Traditional mutual funds are actively managed while ETFs are
index-based and more passively managed. The result is that ETF
management expense ratios (MERs) are significantly lower.
2.
Lower taxes.
While mutual funds actively buy and sell stocks
during the year, securities in each ETF are changed far less often
so they generally have a lower tax cost due to lower capital-cost
distributions from lower amounts of realized capital gains.
3.
Real-time pricing.
Mutual funds are priced at the end of the trading day
while ETFs change in price as the securities they hold change
throughout the day. Thus, any given time throughout the trading day,
ETFs give a more accurate representation of value.
4.
Diversification.
A single stock puts all the investor's risk in one place. There is
no diversity. To replicate the safety of variety, the investor would
have to buy a basket of stocks, which is a more expensive
proposition, commission-wise. A single ETF achieves the same goal of
diversity with one simple transaction.
5.
Tight spreads.
Another ETF advantage over less-liquid stocks is the spread. Due to
generally higher liquidity in ETFs, the spread between bid and ask
is lower than all but the most traded issues such as Microsoft and
Dell.
6.
No uptick rule.
Anyone who has ever tried to short a stock knows that they can only
do so after it has moved up. If it is dropping, no can do, thanks to
the uptick rule. Shorting a stock at that moment increases risk.
With most ETFs, there is no such restriction, making them as easy to
short as index futures. In addition, there are no margin or
borrowing difficulties when shorting most ETFs.
7.
Unparallel liquidity.
Common (and preferred) stock has an established number of issued and
outstanding shares. More shares cannot be issued without going
through a lengthy and exhaustive process of filing with the
Securities and Exchange Commission (SEC) and notifying the public.
However, ETFs are valued based on the underlying index, sector, or
basket of stocks that they represent. This is an important
distinction. In common shares, the number of shares, issued and
outstanding, has a direct bearing on share value. The higher the
number of shares, the greater the public demand must be to maintain
price. Valuation in an exchange traded fund is a function of the
value of the underlying securities in the ETFs, not the number of
shares as with a common stock.
Grahame
Lyons of Barclays Global Investors considers it the task of the ETF
marketmaker/specialist to match supply with public demand and
increase the number of ETF shares as demand warrants. Barclays is
the advisor of the iShares ETFs in the US and works closely with the
specialists of each iShare to facilitate market liquidity. When
demand spikes, the specialist places an order with the ETF advisor
that creates more ETF shares to facilitate purchase at or very close
to the fund's net asset value (NAV). According to Lyons, if the
client wishes to sell and there is no matching buyer, the advisor
acts upon the specialist's direction and redeems the ETF shares at
NAV.
This is one
big reason why exchange traded funds have become such a popular
vehicle for institutions and professional money managers. Slippage
due to spreads is substantially reduced, and no matter how big a
block of shares the client needs, the sale will be accommodated
without seriously affecting value. In addition, there is less risk
of getting stuck holding a large position if the market starts to
move in the wrong direction.
DIAMONDS, QUBES, SPYDERS
Not
surprisingly, three of the more popular ETFs track the most popular
indexes: DIAMONDS, based on the Dow Jones Industrial Average ETF (DIA);
SPYDERS, based on the Standard & Poor's 500 Depositary Receipts ETF
(SPY); and QUBEs, based on the NASDAQ 100 ETF (QQQQ). Effectively,
these ETFs allow the trader or investor to buy shares in each index.
Unlike many indexes, ETFs also provide volume data, which means that
traders can continue to use their favorite volume techniques and
indicators when trading.
The daily
charts of these three major index ETFs can be seen in Figures 2
through 5, showing the simple 10-day simple moving average (SMA,
black line) with the 10-day predictive moving average (PMA, blue
line), based on inputs from nine other related markets.
Figure 2 is
a daily chart of the DIA, which shows the PMA based on the
intermarket effect of nine other markets, including the Dow Jones
Utilities Average, the NASDAQ 100 index, the S&P 500, the CRB index,
and the US dollar index. PMA's goal is to give the trader advance
warning of a change in direction. Instead of lagging the market, it
leads it. This technique works equally well for SPY and QQQQ.
Figure 2: DIAMONDS. Daily chart of the
Dow Jones Industrial Average ETF (DIA).
Compare the
DIA chart (Figure 2) with the one for QQQQ (Figure 3) and the one
for SPYDERS (Figure 4) to see a clear example of how different
securities affect one another.
Figure 3: QQQQ CASH. Daily chart of
the Nasdaq 100 Tracking Units ETF (QQQQ).
Figure 4:
SPY CASH. Daily chart of the Spyders (SPY) ETF.
These
relationships can be seen more clearly in Figure 5. NASDAQ often
leads the overall market. You can see that the high in mid-March
2005 in the QQQQ is much lower than the highs that occurred at the
same time in the DIA and SPY, providing negative divergence and
warning of pending market weakness.
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Figure 5: Charts of the Cubes, Spyders and Diamonds
overlaid. Note how the cubes tend to lead the other two and
the relationship among all three. |
This is
important when deciding when to buy a particular ETF. Because of the
emphasis on technology stocks, the Qs tend to do well at the bottom
of the cycle when the market is beginning its expansion phase. They
also do well in a rally, as evidenced in the rising market this
year.
Spyders,
while similar to the Diamonds, are composed of a higher number of
mid-cap companies compared to the DJIA's heavy reliance on large
caps. As you see from the charts of DIA and SPY, they exhibit
strength and weakness at different times. We also see that in the
case of the latest peak in early August 2005, the high for the SPY
was higher than in March. For the Qs, the March and August 2005
highs were roughly equal, but the high for DIA was lower in August.
This is a warning that large caps could be in for a period of
underperformance in the months ahead but best to wait for
confirmation in the way of a broken trend line or significant
support breach first.
LAST WORDS
Exchange
traded funds provide a number of benefits over index mutual funds
and stocks that, once understood, can be used to maximize returns.
Put ETFs together with intermarket analysis and you will have the
recipe for high-performance pie enjoyed by the very best
institutional players and money managers.
Matt
Blackman is a technical trader, author, reviewer, and regular
contributor to Stocks & Commodities and other trading publications
and investment/trading websites. He writes a weekly and monthly
market letter, is a Market Technicians Association (MTA) affiliate,
a Canadian Society of Technical Analysts (CSTA) member and is
enrolled in the Chartered Market Technicians (CMT) program. He is
also a consultant to Market Technologies. He can be reached at matt@tradesystemguru.com.
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