Business Magazine

ETF Periscope: Emperor’s New Clothes, Wall St. Edition

Posted on the 08 August 2011 by Phil's Stock World @philstockworld

Courtesy of Daniel Sckolnik, ETF Periscope

“Apparently there is nothing that cannot happen today.” –  Mark Twain

ETF Periscope: Emperor’s New Clothes, Wall St. Edition
The U.S. equity market has just come off one of its worst weeks since March of 2008. It ended the week at a level lower than it found itself way back in January of this year, while giving serious indications that it may continue to head south.

Not to worry, though.

Even though the U.S. debt has just been historically downgraded a notch from AAA to AA+ over the weekend, it is certainly a possibility that the demotion has already been factored in by investors, and that the 5.6% drop experienced by the Dow Jones Industrial Average (DJIA) and the 7% shed by the benchmark S&P 500 Index (SPX) over the last week was the result of that sentiment.

But has it really been factored in?

Or are there additional elements that impacted the markets with enough force that the downgrade effect has yet to be completely absorbed?

Is it possible that, after the “sturm und drang” that has just ended in Washington over the debt ceiling debate, investors may now take a moment to wipe the blown smoke from their eyes and political prattle from their ears, only to realize that not a lot of the country’s financial issues have actually been resolved?

Is it possible that, in spite of the fact that Friday’s employment report revealed slightly better than expected numbers, investors may get the scary feeling that the U.S. seems to be a lot closer to yet another recession?

Several pieces of economic news emerged over the course of the week that surely contributed to investors’ negative perception. The Institute of Supply Management (ISM) reported a significant slowdown in U.S. factories. Even more damning, perhaps, was the news that the national Gross Domestic Product (GDP) grew at a severely anemic rate of less than 1% in the first half of 2011.

This hard data may have opened up some investors’ eyes to the possibility that in spite of many corporations reporting decent earnings so far this quarter, the national economy is really somewhat of a laggard.

Has the myth of a recovery been stripped away to reveal the fact that the emperor really is wearing no clothes?

Up until two weeks ago, you would have not been faulted to assume the recovery was proceeding apace, at least as far as Wall Street was concerned. In spite of the concerns that the European Union’s ongoing sovereign debt crisis invokes, the Dow seemed resilient enough to induce talk of when, not if, the year’s highs would be broken.  Would it be this week or next?

But that was two weeks and 1,200 Dow points ago. There may now be too many indications of a sour economy for the market to ignore.

This week could easily prove to be pivotal in terms of market direction for the year.

As is often the case, the clumsy dance between fear and greed will be amplified in this volatile market. Will those stocks and ETFs you’ve been waiting to buy once the price dropped to a relatively reasonable level still seem to be worth getting, now that they are finally at a reasonable level? If the answer is yes, then the market has corrected, and the trend should reverse. If the residue from the burns of the 2008 collapse remains, and retail investors get gun-shy, the correction could easily gain additional traction.

What the Periscope Sees

Sitting back with a cash position at volatile market moments like these is not necessarily a bad idea. Nevertheless, there are often opportunities to be mined at precisely these times. Assuming you have taken the necessary precautions in hedging your portfolio now might be a fine time to put on a “pairs” trade, one which offers some degree of profit while simultaneously limiting, to a certain degree, the loss of the investment.

The assumption is that a good pairs trade has a fair degree of hedging built into the mix.

Here is one particular pairs trade worth considering, using two ETFs from among the universe of Sabrient’s ETFCast Rankings for the purpose. These Rankings consist of over 300 ETFs (exchange-traded funds) that are ranked and scored via 19 of Sabrient’s proprietary analytics. Taken together, they offer a forward-looking take on the markets.

In considering this week’s Rankings, I searched first the high, then the low end of the list, looking to find both the weakest and strongest ETFs to pair together.

For the upside, I selected IAT (iShares Dow Jones U.S. Regional Banks Index Fund) from the Financial sector. It is an exchange-traded fund that seeks to invest its corpus in common stocks of companies that form the Dow Jones U.S. Select Regional Banks Index as per their weighting in the index and seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of that index.

Down towards the bottom of the Rankings, in the Telecommunications sector, I chose IYZ (iShares Dow Jones U.S. Telecommunications Sector Index Fund), a non-diversified exchange-traded fund that seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the telecommunications sector of the U.S. equity market, as represented by the Dow Jones U.S. Select Telecommunications Index.  The fund invests its corpus in common stocks of companies that form the Dow Jones U.S. Select Telecommunications Index as per their weighting in the index.

Go long IAT, and go short IYZ.

Back to Featured Articles on Logo Paperblog