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By: Chris Rowe — October 15, 2013

Technical Tuesday: The Strategy That Beat The Market By Over 100%

Hopefully today's article will stay ingrained in your mind for the rest of your investing career. 

Some of my articles are just "good to know"s while others are KEY CONCEPTS that you must add to your permanent technical arsenal.  Today's is the latter, so I implore you to stick with me for two minutes.

With last Thursday's gain in stock prices -- the biggest one-day gain for 2013 -- we have to add another check to the bullish column.  Typically, when you see a huge one-day gain like that, it's a sign of things to come.  When you have a few moments, feel free to look at a chart of one of the major stock market averages (during any time frame) and look at what followed those massive one day advances. 

That said, we still can't ignore the major signs of market weakness we have also been seeing. 

That's why my strategy has been to have bullish positions on the strongest sectors and bearish positions on the weakest sectors.  Stay with me here...

On July 2nd, I wrote an article titled "These ETFs Will Lead the Next Rally".

That article discussed one of the most effective, yet simple, strategies in existence: "Relative Strength Rebalancing".  I showed you how to find out which sector ETFs outperformed over the last quarter, and I told you that they are likely to continue to outperform.  Let's see what happened over the following quarter compared to the general market.

Take a look at the performance below.  And please note that I did not cherry pick.  It's sad that I even feel I need to tell you that, but unfortunately I swim in the same pond as cherry picking fish (WOW, I said that so nicely). 

I simply took the first 5 ETFs from the list I showed you 3 months ago and calculated their individual returns as well as the average return.  Turns out it's more than double the S&P return for the 3 months that followed the publication of the article. 

In fact, I only calculated 3 months of data, but if I calculated from the time the article was written until right now, the ETFs outperformed the S&P 500 by even more. 

7/2 Price 10/2 Price Gain
QCLN $14.40 $16.75 16.31%
ITA $82.56 $92.73 12.31%
IAI $31.09 $33.00   6.14%
XPH $71.04 $78.32 10.24%
XSD $53.66 $57.99   8.07%

Average return of 5 ETFs 7/2 - 10/2:    10.61%
Return of S&P 500 in same time frame:  4.90%

The major point here, before I switch gears, is that you can beat the averages easily if you simply use Relative Strength Rebalancing.  This means checking the top performing sector ETFs each quarter and making sure you are in the top 10% of these ETFs.  When an ETF you own is no longer in the top 10%, exit that ETF and replace it with an ETF that is.  Simple. 

This isn't one man's opinion.  I've read several studies -- probably over 50 -- that prove this approach to be effective, even over the course of the last 100 years. 

So one question might be: How can this strategy remain effective over such a long period of time without everyone catching on, thus rendering the strategy ineffective? 

Because it's an uncomfortable strategy for people to use.  People feel too uncomfortable buying stocks or sectors with superior performance, because they are scared to death of buying at the top and feeling stupid.  Thus, if you employ this strategy, you will still be in the minority of the individual investor population, which is a good thing to be in the financial markets.

In the article I wrote 3 months ago I go into more detail, so check it out here.   And you can find a list of sector ETFs that I already entered filters for (you'll see them at the top of the page) at this link.  You'll notice I have them already sorted by 3-month performance for you.  PLEASE consider using this strategy.  And if it doesn't work in the first quarter, do not abandon it.  It works over the long haul. 

Now To Switch Gears - Let's Talk More Strategy and CURRENT MARKETS

What I mentioned above is only a slice of what goes into the strategy that I employ.  In fact, by using the Stock Replacement Strategy (using options contracts) combined with the position sizing technique I use, the gains are larger and with MUCH less risk.  Yes, that's possible.

In addition to that, I also take bearish positions in weak sectors in order to significantly reduce the "directional risk" of the general stock market.  I chose this strategy because, in today's market, I'm seeing conflicting signals to a degree I've never seen before -- both in practice (since 1995) and in the history of the markets that I've studied. 

(Granted, it's MUCH more difficult to go back in history and study the context and the combinations of all the various indicators than it was to study them all in real time.)

This is what I did during the summer of 2011's debt ceiling stand-off before the market collapsed.  That was only a few months after the TRUE bull market top (the bull market which began in November, 2008 for most stocks, but what you probably know as the bull market that began in March 2009, which is when the major market averages bottomed out).  The last bull market began in Nov 2008 - March 2009 and topped out in May of 2011. 

A bear market ensued for 5 1/2 months and bottomed out in October of 2011, which is when the current bull market began. 

Why do I bring this up?

Because it's important to understand how long a bull market has been in effect.  I told you I'm seeing strong signs of a long-term top, but also seeing long-term signs of strength.  That's why the RS strategy is so important right now.  

But the fact that I'm seeing strength, combined with the fact this bull market is younger than most people believe, is something you should consider as a check in the "bull argument" column. 

The current bull market is about 2 years old.  Not 4.5 years old as many believe. 

The current bull market is up 59% (from the October, 2011 low).

According to the Stock Traders Almanac, over the last 100 years:

  • The average bull market is 755 days (2.06 years) with an 85% gain.
  • The shortest was 61 days in 1932 with a 61% gain.
  • The longest was 8 years from October, 1990 to July, 1998 with a 295% gain.

I show you these statistics for historical perspective.  Don't read into them too much.  The point is that this bull market isn't a very mature bull market.  In fact, it's right in line with the average time frame if it tops out right now. 

Okay.  Let's see what the House Republican Leaders say in a few minutes.  I'm staying hedged!

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