2 ETFs to Play During the Financials' Fizzle

Includes: BAC, C, GS, JPM, MS, SEF, SKF, WFC, XLF
by: Wall Street Sector Selector

By John Nyaradi

The financial sector is obviously a significant factor in the global and U.S. economy as “money makes the world go ‘round” and the financials are the second largest sector in the Standard & Poor’s 500 after technology. The sector’s poor performance over recent months has been troubling, to say the least, as many analysts say that a convincing economic and investment recovery cannot be sustained without financial sector participation.

However, this all-important sector faces significant risks and problems, both at home and abroad, and these negatives cast a shadow over today’s tenuous economic landscape.

In Europe, the banking problems are well documented as the euro zone grapples with the threat of sovereign debt default and the devastating impact such an event or multiple events would have on banks across the continent.

This week promises another installment in the European drama as investors respond to last week’s “stress tests,” Spanish and Italian bond yields soar, and this Thursday’s emergency summit regarding Greece’s rescue promises to be a wild and wooly affair as the players struggle to avoid a continental “Lehman event.”

Lest we think that this is just a European problem, the threat of contagion is real, as major U.S. banks have exposure to European debt to the tune of billions of dollars. For example, Citigroup (NYSE:C) reported on Friday that it has $13 billion in exposure to Portugal, Italy, Ireland, Greece and Spain, or PIIGS (see: Citigroup makes progress on bad loans).

On the home front, major U.S. banks hold significant positions in U.S. Treasury debt and a default or downgrade here would almost certainly create additional negatives for financial sector performance. The top five banks in the United States (Citigroup, Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and J.P. Morgan Chase (NYSE:JPM)) have billions in exposure to the U.S. Treasury market and so are large stakeholders in the outcome of the U.S. debt ceiling debate. (See JP Morgan, Goldman, Treasuries and default.)

On the consumer front, Friday’s significant drop in the June University of Michigan Consumer Sentiment gauge to 63.8 from 71.5 casts a deeper pall on the financial sector as retail banking and real estate continue to founder. To highlight that point, J.P. Morgan’s earnings announcement included a profit decline of more than 40% in its retail banking business; see J.P. Morgan profit rises 13%, tops target.

Finally, earnings reports last week for J.P. Morgan and Citigroup beat expectations, but both of the financial giants finished down on Friday and are down substantially year to date. Declining prices on better than expected earnings announcements are never a good or positive development.

We’ll see more earnings reports this week from big players including Wells Fargo (NYSE:WFC), Bank of America, Goldman Sachs and Morgan Stanley. While we very well could see positive reports, one must keep in mind that many of these behemoths still trade far below their pre-crisis highs. For example, Citigroup closed at $38.38 on Friday, compared to more than $500/share in the summer of 2007; Bank of America, trading at less than $10/share and down from its lofty peak in the mid-50s, today looks more like a small cap than a global giant.

As always, the charts tell the story:

In the charts of the three major banks above, we see a similar, disheartening picture. All three are below their 50-day and 200-day moving averages, indicating bear market status from a technical perspective, and the two widely watched averages have also formed a “death cross,” wherein the 50-day average has crossed below the 200-day. Furthermore, declines in the neighborhood of 15% from recent highs would qualify at least as significant corrections.

To no one’s surprise, the Financials Select SPDR ETF (NYSEARCA:XLF) exhibits similar patterns.

As the bear prowls this all-important corner of Wall Street, retail investors can also use ETFs to seek profits should this dismal trend continue. One can deploy put options on the Financials Select SPDR ETF and a technique I’ve found useful here is to buy put options that are “at” or “in the money,” and with expiration dates far in the future to partially mitigate the time decay inherent in options positions. This then becomes a trend-following position using an option instead of the underlying ETF that offers increased profit potential while keeping it simple, which option trading generally isn’t found to be.

A second technique suitable for cash accounts would be to simply “short” XLF. The ETF is widely traded and liquid and so this is a very valid strategy in today’s volatile markets.

Another possibility would be to use inverse ETFs in the financial sector, which are designed to increase in value as the underlying indexes decline. These inverse funds must be fully understood as they are designed to replicate the one day performance of the underlying index and so can develop significant tracking error that can work either for or against you.

Two of the most popular inverse ETFs are ProShares Short Financials (NYSEARCA:SEF) and Proshares UltraShort Financials (NYSEARCA:SKF)) which offers two times the inverse movement to the Dow Jones U.S. Financial Index and could be interesting for more aggressive investors.

One day, I’m quite certain that the financial sector will rise from the ashes like the mythical Phoenix ... the firebird that rises, reborn, to live forever. In fact, I believe that in future years the financials will be a “super sector” because, after all, money makes the world go 'round and the Federal Reserve and European Central Bank will move heaven and earth in an attempt to ensure that the “too big to fail” banks, in fact, don ‘t fail.

But the day of the Phoenix is not today. Instead, as we move into the lazy, hazy and sure to be crazy days of summer, opportunities abound even as the bear prowls the global economy and the crucial financial sector continues to struggle. Knowledgeable and disciplined investors need not despair, because through the flexibility and versatility of exchange-traded funds, we now have new weapons available to help us successfully navigate our uncertain and extraordinary times.