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Tom Lydon is editor and publisher of ETF Trends, a website with daily news and commentary about the fast-changing trends in the exchange traded fund (ETF) industry. Mr. Lydon is also president of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net worth individuals. He has been involved in money management for more than 25 years.

Mr. Lydon began his career with Fidelity Investments and was a founding member of Charles Schwab's Institutional Advisory Board. He serves on the Board of Directors for U.S. Global Investors, Inc. and Rydex | SGI; and is also on the Pacific Investment Management Co., LLC (PIMCO) Advisory Board for RIAs. In early 2010, Mr. Lydon helped create the CNBC Model ETF Portfolios. Mr. Lydon is the author of The ETF Trend Following Playbook, as well as iMoney: Profitable Exchange-Traded Fund Strategies for Every Investor.

Seeking Alpha's Jonathan Liss recently spoke with Mr. Lydon to find out how he planned to position his clients in 2011 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming year:

Seeking Alpha (SA): Despite predictions of a dip in equities amid slow global growth in 2010, stocks were clearly the better choice than bonds in 2010, especially in Q4 where bonds sold off almost across the board whereas the S&P 500 has risen roughly 10% (through 12/30). You are a famous trend-follower Tom - will that continue in 2011? How are you planning to position clients with a longer-term horizon in 2011 in terms of an equities/bond mix?

Tom Lydon (TL): In 2011, we’re going to continue to stick to our trend following strategy to help us spot and take advantage of potential long-term fundamentally sound opportunities, whether they’re in stocks, bonds, commodities or currencies. After a choppy first three quarters for equities, the fourth quarter performance and stronger economic environment bodes well for a positive start for 2011. Bonds are under pressure which could be the marking of the bond bubble bursting that many on Wall Street have been anticipating.

Three of our key 2011 allocations are:

1. Buy Small-Cap U.S. Equities

  • Small caps are on fire this year, up 25% year-to-date, vs. 13% for large-caps
  • Small caps historically tend to outperform large-caps during economic recoveries
  • Smaller cap companies can more easily ramp up production and adjust to changing economic conditions
  • U.S. small caps are putting a fork in the notion that overseas is the only place where the opportunities lie
  • As a result of these factors, we are currently long Schwab U.S. Small Cap (NYSEARCA:SCHA)

SA: When did you first enter this position in client portfolios?

TL: On Sept. 28, 2010.

[Editor's note: SCHA is up nearly 17.9% since 9/28 vs. a gain of just 10.1% for the S&P 500.]

TL: 2. How to Profit from the Bursting of the Bond Bubble

  • Investors have enjoyed safe-haven in Treasuries; yields were pushed to almost nothing
  • QE2, the Bush tax cut extension and strong corporate earnings make stocks more attractive and puts pressure on yields
  • As the economy improves, the risk that the Fed will raise rates increases
  • Treasury yields rising in the last several weeks; may be the beginning of the bond bubble bursting
  • ProShares UltraShort 20+ Treasury (NYSEARCA:TBT) moves up 2x when Treasury prices fall - we're currently long.

SA: How long will you hold TBT for at a time? Is it a trade you're entering in and out of? Since it's leveraged, aren't you concerned about compounding when holding for more than a couple of days?

TL: We understand the compounding issue, but we're not concerned. The main reason we own it for clients is to protect other positions against a rising rate environment. We'll hold it as long as It stays above its long-term trend line.

TL: 3. Forget Gold – Look at Miners

  • Base metals are on fire and in heavy demand – China and other emerging markets need copper, aluminum and other base metals to build up their infrastructures
  • Copper prices have been soaring this year – China’s imports surged 37% last month alone
  • Miners poised to profit as both precious metals and base metals prices are at or near record highs. Even if prices stabilize, profitability is increasing dramatically.
  • We're long SPDR S&P Metals & Mining (NYSEARCA:XME) as a result of the fundamental case highlighted above

SA: Looking back at the year that just was, name one ETF investment that worked out particularly well and one that was a bust.

TL: We trimmed down money market and Treasury positions for clients this year and overweighed our fixed income allocation to corporate bond ETFs. SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK) was one ETF that worked out great for us. It has returned more than 13% this year while providing a very attractive yield (9.7% currently). This has been a great year for corporate debt, and it’s getting even more appealing as defaults decline and balance sheets improve.

The disappointment in 2010 was the trendless condition of U.S. equity markets in the first three quarters. Our trend following plan has helped us participate in long-term up-trends while helping to avoid the lion’s share of the two big bear markets in the last ten years. This year however, major U.S. equity indexes like the S&P 500 (SPDR S&P 500 (NYSEARCA:SPY)) crossed above and below its 200-day moving average many times creating numerous whipsaws. Fortunately, markets appear to be more firmly trending this quarter.

SA: If you believe the case for U.S. equities is bullish in 2011, why not ignore the short-term trends and go long anyway? Which funds did you use for the equities allocation portion of client portfolios in 2010?

TL: You can never be 100% sure with the markets - they always change. We believe in having an exit strategy instead. We held multiple U.S. and international equity positions earlier in the year that resulted in gains or losses as most declined below their 200-day moving average at some point.

SA: Are we likely to see a continued sell-off in fixed income investments into 2011? Where can income investors turn for safety while still getting a reasonable yield?

TL: Investors have enjoyed a safe-haven in Treasuries, pushing the yields to almost nothing. QE2, the Bush tax cut extension and strong corporate earnings make stocks more attractive and puts pressure on yields. As the economy improves, the risk increases that the Federal Reserve will raise rates. When that happens, investors who went for long-term Treasury or municipal debt in search of reasonable yields are going to have their principal at risk. Treasury yields rising in the last several weeks may be the beginning of the bond bubble bursting. This scenario got a lot of attention in 2010, and we expect it to come to fruition in 2011.

For both safety and yields, investors might want to consider these ETFs if we see a bond bubble burst:

  • Utilities or a general dividend-paying ETF, since the climate is becoming very favorable for corporations to reinstate, raise or implement dividends. PowerShares Dividend Achievers (NYSEARCA:PEY) is kicking off a 6.6% yield on top of returning more than 16% this year, for example.
  • Corporations are in a solid position with nearly $2 trillion in cash and default rates on corporate debt have fallen to two-year lows. Corporate bond ETFs could continue to offer high relative yields while maintaining principal even in a rising interest rate environment. SPDR Barclays Capital High Yield (JNK) should continue to be an appealing pick (currently yielding 9.7%) as well as iShares Investment Grade Corporate Bond (NYSEARCA:LQD) (currently yielding 4.8%).
  • Short Treasury ETFs; ProShares UltraShort 20+ Treasury (TBT) moves up 2x when Treasury prices fall and the Direxion Daily 30-Year Treasury Bear 3x Shares (NYSEARCA:TMV) which moves up 3x when Treasury prices fall.

SA: In which sectors do you expect strength in 2011 and beyond? Where do you expect particular weakness? What factors are key in coming to your investment thesis?

TL: There are a few sectors in which we expect strength next year and beyond:

  • Retail - Holiday sales account for about 40-50% of revenue profit for retailers. Strategies are complicated this season, as retailers look for ways to lure consumers and move retail ETFs. As consumer confidence increases, look for retailers to heighten profitability in 2011. You can play this sector with the SPDR S&P Retail ETF (NYSEARCA:XRT).
  • Basic Materials – There are few industries fueling global economic growth more directly than basic materials. Everything from chemicals to coal, aluminum to potash are produced/harvested by the companies that make up the iShares Dow Jones Basic Materials (NYSEARCA:IYM), which we are currently long in client portfolios.
  • Financials – As the economy continues to recover, U.S. banks have enjoyed resurgence to profitability. Expect banks to get back to lending in 2011 and if we do see a spike in interest rates, banks will be poised to benefit by lending at higher rates as well. You can play this sector via the SPDR Financial Select Sector ETF (NYSEARCA:XLF).

SA: What are your expectations for commodities, the dollar and precious metals in 2011 and beyond? Will we finally start to see some real inflation in the coming year?

TL: We should see continued strength in commodities in 2011 and beyond, including precious and base metals. The world’s countries are getting wealthier and more demanding, and that demand has in many cases stretched supplies thin and raised prices – just look at what happened with sugar, coffee and wheat this year! This could continue to be an issue in the New Year.

Metals may also see more gains, especially in the hybrid metals (those that have uses across multiple areas) used widely in industry – silver, platinum, copper and steel may all see gains as emerging markets build up their infrastructures and domestic ones revamp theirs.

Real inflation may become a factor next year, too. The Fed has pumped billions into the economy, and sooner or later, inflation is the result investors have been anticipating.

SA: At what point would you consider moving into TIPS? Or is there a different way you plan on playing the inflation trend when it finally arrives?

TL: Commodities are a much better way to play inflation. We currently have no plans to invest in TIPS.

SA: Let's move on to some specific issues that will affect equity returns in 2011 and beyond. In November the Fed implemented another round of QE. Will we get a third round of fiscal stimulus in 2011? Which sectors/asset classes do you think are ideal to play the Fed's actions?

TL: If the economic recovery remains weak and joblessness doesn’t start coming down, we could be looking at another round of stimulus, though the Fed will want to give the current stimulus plan a chance to do its job. At this point, I think the Fed has done its job and the economic conditions should continue to improve going into 2011.

Since the Fed implemented QEII, yields on bonds have gone up – the opposite of the intended effect. If those yields start coming back down, one benefit will be looser credit, which could help encourage more consumer spending. Retail ETFs are one of the easiest ways to play this, and the First Trust Consumer AlphaDEX (NYSEARCA:FXD) has been one of the top retail-focused ETFs this year.

Another way to play the Fed’s moves is to jump ship on the U.S. bond market entirely and look overseas. Emerging market debt has really come into favor this year. PowerShares Emerging Markets Sovereign Debt (NYSEARCA:PCY) is up 4.5% this year and yields 5.87%.

SA: How does the incoming Republican House majority affect the economic outlook for the next two years? Is gridlock ultimately good or bad for equity returns?

TL: There’s no doubt that the extension of the Bush tax cuts gave an emotional boost to Americans going into the end of the year. The incoming majority should help to promote more of a pro-growth/less spending environment. The two parties are going to have to learn how to work together to come up with clear plans to boost the economy. Gridlock is ultimately bad for equity returns as cooperation in government can go a long way toward developing [investor] confidence.

We can hypothesize about the next two years but it all comes down to how investors and Americans in general feel about the economic environment and their personal situations. Consumers account for 70% of GDP; when investors start buying again and have the confidence to come back into the stock market, many past sins will be forgiven.

SA: How about the situation in the EU. Have you lightened up on European stock/bond exposure in client portfolios as a result of continuing contagion there? Are there any bright spots you'd focus on in terms of European equity allocation?

TL: Yes, we have been underweight in European exposure while this situation plays out. It seems every day, there’s a new country to be concerned about. But contrary to what many might believe, it’s not all bad in Europe. Investors who want exposure to the region could consider a non-euro economy, such as iShares MSCI Switzerland (NYSEARCA:EWL), which is up 11% this year, or iShares MSCI Sweden (NYSEARCA:EWD), which is up 30%. Eastern Europe hasn’t been too shabby, either; SPDR S&P Emerging Europe (NYSEARCA:GUR) is up nearly 13% this year.

SA: It sounds like you're avoiding entirely countries that are part of the Eurozone and have the ECB setting fiscal policy for them. Is this accurate?

TL: The Eurozone continues to underperform U.S. markets and other emerging markets. That's not to say we wouldn't consider those funds at some point, but we currently see better opportunities elsewhere.

SA: Same question but for U.S. states like California and Illinois. Will a government bailout ultimately be necessary to backstop state debt as defaults pile up? Are muni bond funds something you're avoiding going into 2011, or do their significant tax benefits still outweigh the possible downside of one or more states defaulting?

TL: The debt situation in several states is very worrisome. On the one hand, defaults are rare because states have a number of tools at their disposal to raise the needed cash. On the other hand, there's a question as to how much higher taxes can go in troubled states. If state debts don’t get brought under control, it wouldn’t be surprising to see some kind of government intervention take place.

The yields in munis don’t necessarily outweigh the risks at this point; there are plenty of other safer places that are kicking off even better yields. However, PIMCO has made a great case for active ETFs with their PIMCO Intermediate Municipal Bond Strategy ETF (NYSEARCA:MUNI). The fund has been underweight in problem areas like California and avoided half of the principal declines experienced by other municipal bond funds and ETFs.

SA: The U.S. housing market seems to be in the midst of another prolonged leg down. How are you playing this via ETFs? Is the commercial real estate market a better bet going forward? How much weight are you giving to REIT funds in client portfolios?

TL: We don’t currently have any weight in REITs for clients, but this has been a very interesting area in 2010, given that it handily outpaced the broader market. SPDR Dow Jones REIT (NYSEARCA:RWR) is up more than 20% year-to-date, compared with the S&P 500, which is up nearly 13%. The fundamentals for REITs continue to improve – rents are going up, occupancies are rising and many REITs have raised their dividends.

The housing market could continue to struggle as unemployment remains high, so REITs might be an appealing option for investors looking for dividends and a segment of the real estate market that seems to be a little more stable.

SA: Finally, one of the great economic stories of our time is the emergence of China and, to a lesser extent, India as global economic powerhouses. How much weight do you recommend for emerging market ETFs in both stock and bond ETF allocations?

TL: Let me add Brazil into the mix as well. China, India and Brazil have all been stellar performers and poised to continue their growth into 2011. Many are calling for a pullback, even a bubble burst, but you can’t argue with the continued high single digit GDP growth in all three countries. We continue to be comfortable holding as much as a 30% allocation to emerging markets in stock portfolios. As in the U.S., look for small-caps to outperform large-caps in emerging markets.

  • The easiest way to get broad representation is via the two largest emerging market ETFs, iShares MSCI Emerging Index (NYSEARCA:EEM) and Vanguard Emerging Markets (NYSEARCA:VWO).
  • China: China has been pushing for and spending money on efficiency-related technologies and processes. This push led to many start-ups, i.e. small cap companies. Small caps in emerging markets are outperforming their larger counterparts. Small caps also give investors direct exposure to the local economy and the spending habits of emerging market consumers. The best way to play this economic trend is via iShares MSCI China Small Cap Index Fund (NYSEARCA:ECNS).
  • India: India is expected to surpass China one day in terms of growth and prosperity. With a young workforce that is relatively well-educated and English speaking, they have a good start. Also, India’s private companies aren’t dependent on state patronage the way that Chinese companies are. In fact, private company growth is primarily fueled by entrepreneurs and business investment. The government has also become proactive in addressing the debt bolstering capital markets. I recommend using the fundamentally weighted WisdomTree India Earnings Fund (NYSEARCA:EPI) to play India's growth.
  • Brazil: Brazil could be a standout economy in 2011. The country has a new leader who plans to keep the current successful economic policies in place, and the growing middle class is expected to continue their spending. That said, there’s still a growth opportunity – many Brazilians still lack adequate water, shelter and wages. Market Vectors Brazil Small-Cap (NYSEARCA:BRF) is a great play on the domestic economy.

SA: There are now a couple of choices for India Small Caps exposure (SCIF, SCIN). Why a fundamentally weighted fund with less than a 2% allocation to small caps at present?

TL: They simply haven't been performing as well as EPI, and EPI is also the largest India-focused ETF out there.

Full disclosure: Tom Lydon’s clients own TBT, XME, JNK, IYM and SCHA.

Source: Tom Lydon Makes the Case for Small Caps, Corporate Debt