ETFs For The 'Third Scenario'

by: Gary Gordon

In 2013, Mondays have been noticeably superb for U.S. stock investors. Tuesdays have been even more spectacular; in fact, until a few weeks ago, the Dow closed higher on 20 consecutive occasions. However, what began as a siren song of riskless gains back in November could be shifting in pitch and tempo. The Dow has risen or fallen by 100 points or more for 5 straight sessions. What's more, over the last month, the SPDR Dow Jones Industrials (NYSEARCA:DIA) has oscillated an average of 1.25% between its highs and its lows; DIA wavered in an average range of just 0.75% from January to mid-May.

Consider what transpired on Monday, 6/17. When a Financial Times article suggested that the Federal Reserve would confirm an intention to slow its bond-purchasing program, the Dow rapidly shed 150 points. Shortly thereafter, the author of the piece explained via Twitter that he had merely expressed an opinion, and the benchmark recovered 75 to finish up 109 points.

Are we now at a point where any and all appetite for equities depends solely on what the U.S. central bank says about its future intentions? Fortunately or unfortunately… yes. Not only is the recent rise in the average daily trading range directly attributable to Chairman Bernanke's tapering comments back on May 22, but every other force that might move equity markets (e.g., corporate earnings, technical resistance/support, macroeconomics, etc.) takes a back seat to central bank chatter.

The increase in volatility has led many to reason that the Fed will clear the air on Wednesday, June 19. That is, one way or another, taper or no taper, Bernanke will provide us with greater clarity. Many also reason that a decision to slow down bond purchasing will be a near-term negative for stocks, whereas a firmer commitment to the current course of quantitative easing will be a near-term positive for the bulls.

But what if there is a third scenario? What if members of the committee prefer to see more economic data over the course of the summer before making an unambiguous commitment? What if Bernanke and others see value in the ambiguity? Isn't it possible that a definitive tapering message might send rates soaring and stocks tumbling? Isn't it possible that an unequivocal pledge to $85 billion per month might send rates back below 2% and stocks rocketing without resistance?

The more thought that I give the matter, the more I believe that we're going to get Greenspan-style "Fed Speak." After all, an uptick in market volatility may be far more desirable to voting members than unbridled risk-taking or a shockingly swift downward spiral.

It follows that the best exchange-traded funds for more Fed uncertainty (a la the "third scenario") will be those that are perceived as defensive, yet less rate-sensitive than utilities or real estate investment trusts. Consumer Staples, Pharma, Medical Devices, Aerospace/Defense — exchange-traded trackers in these arenas are best equipped for ongoing Federal Reserve vagueness.

5 Days of the Dow Trading Up Or Down 100+
5-Day Return
First Trust Consumer Staples (NYSEARCA:FXG) 1.8%
SPDR Pharmaceuticals (NYSEARCA:XPH) 1.5%
iShares Medical Devices (NYSEARCA:IHI) 0.7%
iShares DJ US Aerospace (NYSEARCA:ITA) 0.4%
iShares DJ Healthcare Providers (NYSEARCA:IHF) 0.4%
PowerShares Aerospace/Defense (NYSEARCA:PPA) 0.4%
SPDR Dow Jones Industrials (DIA) -0.3%

Going into Wednesday, I have my clients positioned for a bit of a setback. I raised cash in areas that have fallen below key trendlines and/or hit my stop-limit loss orders. That said, I feel that ongoing Fed-inspired volatility still bodes well for consumer defensive funds and health care ETFs like SPDR Select Health Care (NYSEARCA:XLV).