‘ Risk On ‘ For Some ETFs

Kevin Grewal
updated | Author's Website

by Gary Gordon, posted at Seeking Alpha  

According to the folks at Fidelity Investments, the average frequency of a 10% market correction is once per year. However, we have not seen a pullback of this magnitude over the last 12 months (7/6/10-7/5/11), and we have yet to see it occur in 2011.

In March, the Middle East uprisings coupled with Japan’s devastating earthquake certainly had the potential to trigger a traditional stock market correction. Still, it didn’t happen. In fact, U.S. equities hit multi-year highs by the last day of April.

Sovereign debt risks combined with hideous “soft patch” numbers on the U.S. economy ushered in a May-June swoon. However, the last trading week of June recovered most of the 7% losses with the strongest price rally for U.S. stocks in 2 years.

Clearly, risk may be back in vogue for the moment. On the other hand, a debt ceiling debacle, weaker-than-anticipated earnings and/or woeful unemployment numbers could send investors back to the safety of cash.

That said, it may be critical to outline a more precise meaning for the ubiquitous term, “risk on.” The absence of a traditional market correction for an entire year makes this easy to do; that is, which stock ETFs prevailed in the uninterrupted 12-month period of bullishness (i.e., sans traditional -10% period) circa 7/6/2010-7/5/2011?

“Risk-On” ETFs In A 12-Month Period Without A Correction 
       
      1-Year Approx %
       
First Trust Global Copper (CU)   81.8%
Global X Silver Miners (SIL)   75.8%
iShares DJ Oil Equipment and Services (IEZ)  73.0%
SPDR Oil Gas Exploration Production (XOP)  60.0%
Market Vectors Coal (KOL)   59.2%
First Trust Internet (FDN)   56.8%
SPDR Energy Select SPDR (XLE)   56.4%
SPDR Retail (XRT)    55.6%
First Trust Consumer Discretionary (FXD)  54.2%
Market Vectors Agribusiness (MOO)  50.3%
       
SPDR S&P 500 (SPY)    32.8%

The results may not come as a major surprise, especially for those who believe that wealth is transitioning from old world sovereignties to emerging ones. If the global industrial cycle is perceived to be thriving, “risk on” begins with stock ETFs that represent the mining/exploration of natural resources – oil, gas, coal, copper, silver. Not far behind… the business of food production.

Energy and Materials are economic segments with huge ties to the economic growth of the world at large. It follows that “Risk On” ETFs are cyclical sector funds, and they also include discretionary consumption (e.g., retailers, leisure, etc.) as well as the hottest technologies (e.g., cloud computing, Internet, etc.).

The challenge that investors face, however, is recognizing the high probability for a traditional market correction. Again, a “10% pullback” tends to happen once in a 12-month period and/or within a calendar year, increasing the odds that the 2nd half of 2011 will witness a faith-shaking occurrence.

Which ETFs are more likely to take a hit during those faith-shaking occurrences? 

 The very same ETF representatives for mining and exploration. In fact, First Trust Global Copper (CU), Global X Silver Miners (SIL) and Market Vectors Coal (KOL) experienced negative returns over the last 6 months!

In my estimation, the best time to get into “Risk On” ETFs is after the broader market pulls back 10% from its highs. That’s not to insist that we won’t see a summer of cyclical stock success. Perhaps the mini-pullbacks in March and May-June will end the fear of a global slowdown.

Nevertheless, until a 10% corrective period instills enough panic, I’m more apt to invest equally in defense and offense. How might one accomplish that aim? Consider Retail HOLDRs (RTH) instead of SPDR Retail (XRT). And consider Country ETFs that benefit from global economic growth, but are less dependent on worldwide demand for natural resources. Note: Malaysia (EWM) often comes to mind.

You may also like: