From the February 2009 issue of Research Magazine • Subscribe!

February 1, 2009

A New ETF Playbook

A listing of seven potential scenarios for 2009 and the best way to play them using ETFs.

What will become of stocks over the course of 2009? And how about the faltering U.S. economy? Is the housing market done correcting? Where are the attractive yields in this low interest-rate environment? These are among the most pressing financial questions we face right now.

While financial predictions by Wall Street's forecasters may vary somewhere between haunting to jubilant, it's impossible to know if any of them are right. Yet one thing you can do is to check your investment playbook to make sure you're using the right strategy for the right game (or market environment). I've listed seven potential scenarios for 2009 and the best way to play them using ETFs.

Reduced Spending Play

As 2008 holiday retail sales showed, companies in the consumer discretionary sector -- like Best Buy, Home Depot, Ford Motor and Coach -- are all feeling the pinch of reduced consumer spending. Unfortunately for retailers, putting up a sign that states "50% Off" isn't coaxing consumers into buying stuff. A weak job market coupled with frail home prices continues to dampen consumers' appetite to shop and spend money. But not all consumer sectors will fare poorly.

The Consumer Staples SPDR (XLP) contains defensive stocks like Proctor & Gamble, General Mills and Kraft Foods. This was also the best performing S&P 500 sector last year. Its staples are companies that can still churn out profits even during difficult times. Other defensive industry SPDRs are Utilities (XLU) and Health Care (XLV). Even during times of tight spending, people still need electricity and gas along with medical care.

Rebuilding Infrastructure Play

As you may have noticed, Barack Obama isn't shy about his ambitious plans to revive the ailing U.S. economy. Among his boldest plans is to revitalize America's decrepit roads, highways, schools and public structures with upwards of $1 trillion in government spending. All of these major reconstruction plans will require a few things: commodities, manual labor and lots of machinery.

Companies involved in engineering, construction equipment, cement manufacturing, mining and steel are likely to be key beneficiaries of any infrastructure legislation that gets passed into law. The Market Vectors Steel ETF (SLX), SPDRs Metals & Mining (XME) and the Industrial Select Sector SPDR (XLI) are funds that could get a positive jolt. Another fund to watch is the First Trust ISE Global Engineering and Construction ETF (FLM).

Rebounding Commodities Play

For the first half of 2008 those who listened to Jim Rogers and bought commodities were geniuses. During the second half of the year, they looked dumb. After hitting an all-time high of $147.27 on July 11th, 2008, the barrel price of crude oil reversed course and subsequently fell out of the sky. (I privately wonder if foreclosures on the palaces of oil sheiks are the next shoe to drop in the real estate market.)

If you believe that commodity prices will indeed rebound, look at diversified funds like the iShares S&P GSCI Commodity Index Trust (GSG) or the PowerShares DB Commodity Index Tracking Fund (DBC). By using futures contracts, each of these products contains exposure to crude oil, heating oil, corn, gold and wheat. Sticking with a diversified commodity ETF will also relieve you from the difficulty of trying to guess which particular commodity will take off. If you're especially aggressive about playing a repeat boom in commodities, see the ProShares Ultra DJ-AIG Commodity ETF (UCD). The fund attempts to double the daily upside performance of commodities. It's also a much safer bet, from a credit risk perspective, than ETNs with similar strategies.

Fiscal Instability Play

Roughly $8.5 trillion is the cost of the U.S. government's 2008 financial bailouts. Scary isn't it? And if that wasn't enough to chill your spine, according to the Treasury Department's website, national debt as of mid-December was $10.6 trillion. Not included in the federal budget is another nasty problem; the broken Social Security system. Who's going to bail out the U.S. government?

Surprising as it may seem, at some point, people may start questioning the "safety" of government paper. That could trigger selling in U.S. Treasuries and the dollar. So long as the government continues assuming trillion-dollar obligations as if they're nothing, confidence in the government repaying its mounting debt may wane. Has the government dug itself a financial hole too deep to escape? The clear beneficiary of such a nightmare scenario would be the SPDR Gold Trust (GLD) and assets not denominated in dollars. The Rydex CurrencyShares Euro Trust (FXE) could also benefit from any instability in the dollar.

Contrarian Play

While most short or inverse performing ETFs had a banner year in 2008, some did not. One such fund was the ProShares UltraShort Real Estate ETF (SRS). At face value one would've expected better performance for a fund that's designed to increase in value when real estate stocks fall. But most of the harshest damage in the real estate market was actually limited to residential housing and home building.

A market top in the commercial real estate market was probably best signified by the Blackstone Group's 2007 acquisition of Sam Zell's Equity Office Properties Trust for $38 billion. Since that time, cracks in the commercial property market, and especially the mall and retail operators segment, have increased. Many companies are overloaded with too much debt that can't be supported by spiraling earnings. (See once high-flyer General Growth Properties) Even worse, many of their best tenants, like Circuit City, Mervyns and Linens 'N Things, have gone bankrupt. If the REITS become even more unhinged than they did last year, SRS should rise.

Momentum Play

With the Dow off by a third from its 14,000 high, the short-term trend for stocks is down. Even though the Dow has less than 7 percent exposure to the horribly performing financial sector versus 13 percent for the S&P 500, it hasn't helped. Will the Dow revisit or break its low of 7,392.27?

If you believe more weakness is ahead for stocks, see the ProShares Short Dow 30 (DOG). The fund attempts to deliver opposite performance of the Dow Jones Industrial Average without using any leverage. If you want magnified performance, you can also use the Rydex Inverse 2x S&P 500 ETF (RSW). The fund is designed to deliver double the opposite daily performance of the S&P.

Income Play

The Federal Reserve's December interest rate cut is killing investors who are starved for yield but shy on taking risks. At the end of last year, shorter-term "riskless" U.S. Treasuries were yielding close to zero percent. Explain to your clients that the only safety in Treasuries anymore is the assurance of not getting a respectable return on their investment. This situation is forcing people to reconsider their income strategies.

Risk-averse clients looking for better yields should stick with high-grade debt. See the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD). For more aggressive-yield-oriented investors, equity ETFs that offer decent yields with the potential for price appreciation are the Vanguard High Dividend ETF (VYM) and the iShares S&P U.S. Preferred Stock Fund (PFF). VYM has a yield of around 4.62 percent and PFF is 11.52 percent.

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