Many traders understand that international stocks can provide diversification to a portfolio but worry that in a bear market “all correlations go 1.” When traders say “all correlations go to 1” they mean that when U.S. stocks are in a bear market, all other global stock markets are also likely to be in a bear market. Correlations are a mathematical measure of the relationships between markets, or any two data series. Correlations range from -1.0 which indicates the two markets move exactly opposite to each other to +1.0 which indicates the markets being studied move in perfect lockstep. In previous bear markets, we have also seen commodities like gold and oil fall along with stocks. In other words, in a bear market the correlation of returns for normally diversified markets seems to rise, moving towards +1.0 which indicates the price moves are perfectly correlated.
This idea was tested and the results were published in a 2001 Journal of Finance article. In Extreme Correlation of International Equity Markets, Francois Longin and Bruno Solnik found that correlations do in fact increase in bear markets, but not in bull markets. This study confirms that traders should consider the long-term trend when developing trading strategies.
Currently, the long-term trend in U.S. stocks and many international markets is up, indicating we are in a bull market. According to that 2001 study, international stocks should provide diversification in this environment. Several successful strategies to benefit from ETFs that track international stock markets are fully disclosed in High Probability Trading for International ETFs. These strategies do not rely on momentum or other traditional indicators to identify buy candidates.
Some variations of these strategies have win rates of more than 80%. The table below shows the average performance for several variations of this strategy.
These strategies can also be applied to U.S. stocks. Test results using SPDR S&P 500 ETF (NYSE: SPY) show win rates of more than 90%.
Heading into Monday’s open, two international ETFs with PowerRatings of 8 are potential buys under the strategies detailed in High Probability Trading for International ETFs. iShares MSCI Emerging Markets Index Fund (NYSE: EEM) and iShares MSCI Thailand (NYSE: THD) should be considered potential buys.
PowerRatings are based on the relationship between price and the 5-day moving average (MA) of price. The further prices move away from the 5-day MA, the stronger the tendency to snap back becomes. PowerRatings uses the 5-day MA and several other components to identify high probability trade entry points. This strategy was thoroughly back tested and the history of over 4 million trades was analyzed.
We know from back testing that PowerRatings can be used as the basis of a trading strategy. Detailed back testing has confirmed that the higher the rating, the greater the one week historical gain has been for stocks and ETFs with that rating. For best results, enter trades on stocks with a PowerRatings of 8 or higher with a limit order 3-7% below the previous day’s closing price. Higher % limit entries have historically shown a greater percentage of winning trades but higher % limit orders also reduce the chance of trade execution.
As an example of a trading strategy that can be used, in the past, buying stocks with a rating of 8, on a 5% pullback the next day and selling after the stock closes above its 5-day simple moving average has been profitable 72% of the time with an average gain of 3.9%. Other entries and exits also show high winning percentages and large average gains.
All data is as of the end of day on 8/22/2014.