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ETF Periscope: Irrational Exuberance of a Bullish Persuasion

Posted on the 05 July 2011 by Phil's Stock World @philstockworld

Courtesy of Daniel Sckolnik, ETF Periscope

ETF Periscope: Irrational Exuberance of a Bullish Persuasion

by Daniel Sckolnik of ETF Persicope

Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies.” — Groucho Marx

ETF Periscope: Irrational Exuberance of a Bullish Persuasion
Wall Street had itself a little party, celebrating its best single week of point gains in over two years.

So what was the cause of the eye-popping 648-point gain in the Dow Jones Industrial Average (DJIA)? How to explain the 5.4% rise in an index that got pummeled as recently as last week, when it looked like the entire year’s gains were about to bite the dust?

What could possibly prompt the S&P 500 Index (SPX) to shoot up close to 70 points, ending up 5.6%? And, in regard to the SPX, has it finally managed to break free of the 1300 resistance level that has served as such a steely damper for the majority of the month of June?

Many questions, but the more important one may likely be this: What exactly was the catalyst that grabbed a strong downward trend and flipped it to the upside?

In terms of an obvious cause and effect, it may be said, as the tagline for a famous movie and Broadway play suggested, that Greece is the word. Certainly, the fear of that country defaulting on its debt was a large reason the equity markets took such a powerful hit over the last few month. Well, that fear seems to have been effectively dealt with as the current Greek government managed, just barely, to garner enough votes to pass the requisite austerity measures into law.  The result of this action was that the European Central Bank, with the full blessing and likely assistance of the International Monetary Fund, promised to bail out Greece, “lending” them enough cash to meet their debt obligations. Those debt obligations are to the risk-takers who purchased Greek bonds in search of high yields.

So at least for now, that fire as been put out. Yet it was also put out last year. Undoubtedly, there are few, not many, smart investors who expect this will end Greece’s debt problems. What it does do is buy some time, while the ECB and IMF figure out what form “plan B” might take.

Another apparent catalyst was that U.S. manufacturing improved in June, according to the closely watched Institute for Supply Management report released last Friday. The manufacturing index rose almost 2%, which apparently caught a large number of prognosticating economists by surprise.

Taken together, this pair of catalysts, along with sundry secondary causes, served to sufficiently goose the equity markets north by a whole lot of points.

So are we now back to trending Bullish on Wall Street?

Maybe. But there are certainly lots of reasons to expect the rally to be a short-lived one.

To begin with, the Thomson Reuters/University of Michigan consumer-sentiment survey fell almost 3% in May, not an insignificant number. It points to the discrepancies that remain strongly apparent between Wall Street and Main Street.

Another event that occurred last week was the end of Ben Bernanke’s fabulous efforts at stimulating the economy. QE2, which was the second round of quantitative easing, now has officially been terminated. It does seem as if this was factored into the markets already, which makes sense, as it was hardly a surprise to anyone with access to any sort of financial news over the last month.

But Wall Street might yet have strong withdrawal pains, particularly if the upcoming earnings season doesn’t prove as relatively strong as the first quarter of 2011 proved to be.

Speaking of countries defaulting on their debts, investors don’t seem to buy into the likelihood that Congress will actually allow the U.S. to default on theirs. The debt ceiling will get raised, or the U.S. will go from its top-level AAA ranking to the barrel-bottom D rating, courtesy of S&P. Apparently, the markets seem unconcerned with this possibility, convinced, for some odd reason, that Washington is run by grown-ups.

Another thing to keep a close eye on is the fact that the VIX (Chicago Board Options Exchange Market Volatility Index) touched on 15 in intraday trading last Friday. This is a level that, once hit, frequently proceeds in a quick ascent of 20% or more within a week or two. When the VIX is low, it means that implied volatility is down. When it goes up, it means volatility levels are up. A 20% rise would be clearly indicative of something of an unsettling nature, which would be reflected in the equity markets taking a substantial dive.

It will be interesting to see if the past week was the resumption of the recent up-trending market, or if it proves to be nothing more than a head fake made by Bears in Bulls’ clothing.

What the Periscope Sees

In my search for a clearer read on the markets, I often reference Sabrient’s ETFCast Rankings.  It consists of over 300 ETFs (exchange-traded funds) that are ranked and scored via 19 of Sabrient’s proprietary analytics, that, when taken together, offer a forward-looking take on the markets.

In spite of an impressive week, investors and traders alike would be wise to remember that the markets remain highly volatile, regardless of which way the trend actually happens to shift.

Therefore, continuing with a recent series of hedged pairs plays, here are four different ETFs that might prove effective, regardless of which way the markets decide to blow.

Among this week’s ETFCast Rankings with a high Outlook score, one of the rankings key analytics, is VGT (Vanguard Information Technology ETF). The fund employs a passive management or indexing investment approach designed to track the performance of the MSCI US Investable Market Information Technology Index, an index of stocks of large, medium, and small U.S. companies in the Information Technology Sector. The fund attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.

Also in the top 10% of the Outlook score is IYM (iShares Dow Jones U.S. Basic Materials 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 Dow Jones U.S. Basic Materials Index. The index measures the performance of the basic materials sector of the U.S. equity market, and includes companies in the following sectors: chemicals, forestry and paper, industrial materials (such as steel, metals and coal) and mining.

Down towards the bottom of the Outlook score is OIH (Oil Service HOLDRS Trust), an equity exchange-traded fund launched and managed by Merrill Lynch. The investment offers diversification in the oil service industry through a single, exchange-listed instrument. There are currently 18 companies included in the investment.

Another ETF with a low Outlook ranking is FDN (First Trust Dow Jones Internet Index Fund). FDN is an exchange-traded index fund which seeks investment results that correspond generally to the price and yield (before the fund’s fees and expenses) of an equity index called the Dow Jones Internet Composite Index. The fund will normally invest at least 90% of its total assets in common stocks that comprise the index. The fund, using an indexing investment approach, attempts to replicate, before expenses, the performance of the index.

You might consider going long VGT and IYM, and shorting OIH and FDN, creating the hedged pairs play. As an alternative, one could purchase near month, slightly out-of-the-money calls on VGT and IYM, and near month, slightly out-of-the-money puts on OIH and FDN.

ETF Periscope

Full disclosure:  The author does not personally hold any of the ETFs mentioned in this week’s “What the Periscope Sees.”

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.

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