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ETF Periscope: Traveling Sideways with Max Volatility

Posted on the 03 October 2011 by Phil's Stock World @philstockworld

ETF Periscope: Traveling Sideways with Max Volatility

“By three methods we may learn wisdom: first, by reflection, which is noblest; second, by imitation, which is easiest; and third by experience, which is the bitterest.” –  Confucius

ETF Periscope: Traveling Sideways with Max Volatility
Wall Street must be feeling on the beat-up side right now.

In spite of the fact that the Dow Jones Industrial Average (DJIA) ended up 1.3% for week, most investors probably felt more like victims of whiplash than victors.

The Dow dropped 240 points on Friday, which a lot of analysts attributed to “end-of-quarter” selling, which is fairly common. However, what was atypical of this particular end-of-quarter sell-off was the fierceness of the selling into the close.

Obviously, there are other factors at work here, and a quick look at the equity market’s recent numbers seem to indicate that deeper problems are at play.

The DJIA dropped 6% for the month, the fifth consecutive monthly loss, losing 12% on the quarter. Not only was it the fifth consecutive monthly loss, you’d have to go back all the way to March of 2009 to find a worse performing quarter.

The benchmark S&P 500 (SPX) lost 7.2% for the month of September, contributing sharply to the total loss of 14% on the quarter.

The Nasdaq Composite Index (COMP) performed equally poorly, dropping 6.4% for the month while diving over 12% on the quarter.

So Wall Street continues to soar and dive, as evidenced by the Dow traveling within a 1000-point range for the last several months.

The extreme volatility that is evident in the recent frequency of 200-plus-point moves in either direction would seem to indicate a lack of consensus among investors. What it does reveal is a reactionary mood, with both traders and investors pulling the sell trigger hard and fast, as if concerned something really nasty might have finally arrived.

On the other hand, once it seems clear that the floor hasn’t fallen out of the equity markets, prices of some fundamentally solid stocks lure buyers back in pretty quickly. However, looking at the charts of the major indexes, it can be seen that the highs are getting a little lower, even though the lows seem to have found a floor, at least for now.

Investor concerns that stand out the sharpest, like a fragmented car rushing at you in a scene from a 3-D movie, include the ongoing EU debt crisis and the ongoing malaise of the U.S. economy. China seems to have moved to the back burner as a source of worry for many investors at least for the time being, though that could shift as quickly as a Ferrari hitting a hairpin turn.  No, it’s the Western economies that are at the forefront of market action at the moment, and there is little reason to believe that resolutions to any of these problems shall arrive any time soon.

The EU caused some Bullish action last week when it appeared that the European Financial Stability Facility (EFSA), a company owned by Euro Area Member States, had given adequate assurances that the necessary bailouts to Greece would be made. However, that was not an actual solution, just a proposal. And like many proposals, a lot can happen between slipping the engagement ring on the bride’s finger and the actual wedding.

Case in point: Greece.

It doesn’t really matter what agreements Athens politicians are signing off on. If the populace decides the austerity belt is being pulled too tightly, they will probably just get a new set of elected officials that promise the polar opposite of what is being promised now by the current administration.

What is true about Greece and a population used to street protests can also be applied to Rome. Italy, which has the largest government debt among all of the PIIGS (Portugal, Italy, Ireland Greece and Spain), may also turn out to have a population that is unwilling to undertake the level of austerity that is required to offset a default.

It is this basic and very large disconnect that may be the largest cause of concern for bondholders of EU debt. The mounting fears by investors of default by one or more of the PIIGS may be justified, and there may come a point when whatever proposals and promises are made by the various EU leaders may simply be recognized as unachievable.

The U.S. economy, of course, has its own set of problems. The latest sentiment report, just marginally better then the last which saw a 3-year low, might indicate that consumers remain concerned that the recession never really went away as advertised. Ongoing unemployment rates which have bordered on double digits for a couple of years have to take a toll on the economy. Corporations may have more cash on hand than they have had in a while, but hoarding cash to stave off the problems that arise from a weakened economy may eventually prove to be a self-fulfilling prophecy.

Worth noting is the fact that Wall Street has a large set of detractors gathering outside its very own balcony. The “Occupy Wall Street” demonstrators, angry at how the economy is playing out, are unlikely to impact the market in any direct and significant way; they might be seen more as a thermometer indicating the temperature of consumer health, rather than some dramatic harbinger. Still, it could become the beginning of a movement that serves as the polar opposite of the Tea Party movement, which has managed to impact Congress in a fairly significant way and, indirectly, the U.S. economy itself.

In the current atmosphere of uncertainty on Wall Street, any reasonably cautious investor should certainly be figuring out how to hedge his or her portfolio. Each pursuit of that “gotta-have-it” stock that you’ve just been waiting to reach a reasonable price point should arguably be offset with some level of balance. Various versions of pair trades, where a long ETF is offset with a short ETF, might be considered a sound bet at this point.

Or, if your portfolio leans strongly to the Bullish side, a purchase of one of several ETFs that profits as the market drops, such as an inverse index ETF, is an idea worthy of serious exploration. These include SH (ProShares Short S&P 500), which tracks the S&P 500 Index, and RWM (ProShares Short Russell 2000), which tracks the Russell 2000 Index.

Note, please, that inverse index ETFs go up as the underlying index goes down, and vice-versa.

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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