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How New Year Investment Themes Will Play Out for ETFs

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Each New Year brings its own financial rhythm or what we call “market trends.” These are the movements in financial markets that will shape future winners and losers.

Ascertaining major trends before they become readily apparent to the rest of the world is a craft that makes successful investing such a challenge. Remembering history is helpful, but history won’t tell us how the future will necessarily happen.

Figuring out what will become this year’s major investment developments requires observation, respect for history, a keen understanding of world events and a fair dosage of gut instinct. Being ready for these themes through actionable ETF investments is how advisors can help their clients to profit.

Let’s examine what could turn out to be some of 2014’s biggest and most important investment themes.

Rates March Higher

The bond market bubble has popped and investors that piled into long-term bonds chasing yield are paying dearly. When bond yields rise, bond prices fall. And long-term bonds, because of their sensitivity to rising rates, have fallen the hardest. The iShares Barclays 20+Yr Treasury ETF (TLT) has declined 12.75% over the past two years.

There’s good reason to believe this trend will continue, especially as the Federal Reserve begins to scale back its $85 billion monthly purchases of U.S. Treasuries, also known as “quantitative easing” (QE). It’s doubtful foreigners will pick up the slack in Treasury bond purchases once the Fed exits. Interestingly, bond yields have still climbed despite the Fed’s continuation of QE.

Conversely, ETFs that gain from falling bond prices like the Direxion Daily 20+ Yr. Treasury Bear 3x Shares (TMV) and the ProShares UltraShort 2x 20+ Yr. Treasury ETF (TBT) have been strong gainers, rising between 27% to 37% over the past year. These funds use daily leverage of 300% and 200% and are designed to increase in value when bond prices fall.

More gains for TMV and TBT are ahead if the yield on 30-year U.S. Treasuries dances with 4%.

Metals Capitulate

Gold has historically had long periods of boom and bust. After peaking around $850/oz. in 1980, gold spent the next two decades doing nothing. That was the bust.

In 2000, gold began a long boom of 12 consecutive yearly gains—an impressive streak which came to an end in 2013. But this latest boom has been masked by a nasty bear market that began two years ago in precious metals.

Since 2011 peaks, the SPDR Gold Shares (GLD) has fallen more than 32% while the iShares Silver Trust (SLV) collapsed more than 53%. The technical trend remains down and only the ETFS Physical Palladium ETF (PALL) has avoided the carnage.

During the course of its 12-year bull market, gold prices fell more than 10% in value seven times and by more than 20% on three occasions. And if gold follows its historical pattern, the next long period of bust could be ahead. That should mean more outperformance for bear ETFs like the ProShares UltraShort Gold ETF (GLL) and the Direxion Daily Gold Miners Bear 3x Shares (DUST).

For patient investors, buying precious metals at rock bottom prices when the selling frenzy reaches fever pitch should make metals an attractive long-term investment.

Volatility Rebounds

The crisis era of the CBOE S&P 500 Volatility Index or “VIX” trading above 50 seems like ages ago. The VIX traded near its 52-week low of 11 on several occasions last year as the Dow Industrials and S&P 500 recorded all-time highs.

The past two years have been particularly difficult for volatility traders. VIX ETPs that go long volatility via futures contracts like the iPath S&P 500 VIX ST ETN (VXX) and the ProShares VIX Short-Term Futures ETF (VIXY) have lost almost 95% in value.

Conversely, investors who have shorted volatility have made a bundle. The VelocityShares Daily Inverse VIX ST ETN (XIV) has surged an incredible 533% since late 2011.

Aside from the brief spurts in volatility, there are plenty of reasons to believe the VIX will return to its historical mean or trading range in the high teens to low twenties. Like a sleeping giant, volatility awakens when most market participants least expect it, and it never goes away.

Higher stock market volatility will definitely be a major test for ETFs like the iShares MSCI USA Minimum Volatility ETF (USMV). Although this fairly new breed of volatility-killing ETFs has enamored advisors and investors alike, it’s important to remember these very funds were launched during a market environment of ultra-low volatility. How will they respond when market fear really heats up?

Deflation Beats Inflation

Although many market pundits have made bold predictions about runaway inflation, the weak performance of Treasury Inflations Protected Securities (TIPS) says it all. The iShares TIPS Bond ETF (TIP) declined 9.04% YTD.

Elsewhere, inflation has yet to rear its ugly head. Commodity prices measured by broadly diversified commodity ETPs like the Greenhaven Continuous Commodity Index ETF (GCC) have declined around 16% over the past two years. Instead of going up as many forecasters expected, even volatile energy prices for gasoline and oil have slid.

Likewise, consumer prices are contained. During the fourth quarter, core consumer prices minus food and energy rose just 1.7% from the previous year, according to the CPI figures published by the Labor Department. That’s still below the Fed’s annual inflation target of 2% and proof the Fed’s monetary stimulus has done little to spur higher inflation.

Inflation is always a threat, but deflation looms as a more immediate threat. This is particularly true for assets like stocks, which have increased in value at a relentless pace since 2009. The smart money is accumulating cash in preparation of lower prices. And the really brave money will be actively profiting from deflationary price action with inverse performing ETFs such as the ProShares Short S&P 500 ETF (SH) that are designed to increase in value when prices fall.