Now is the Time for Inverse Sector ETFs

With what at first looked like a spasm in the market now displaying all the markings of a full-blown correction, it could be time to consider inverse sector ETFs.

ProShares has a slate of ultra ETFs that tracks eleven Dow Jones US indexes: Basic Materials, Consumer Goods, Consumer Services, Financials, Health Care, Real Estate, Industrials, Semiconductors, Oil & Gas, Technologies and Utilities. The ultra ETFs are meant to deliver 200% of the performance of the underlying index.

These ETFs come in two flavors: long and short (the short funds are often referred to as inverse). The short ETFs go up when the underlying index goes down. The long funds go up in concert with the underlying index.

If you are in the bear camp and believe we have further to go on the down side, this could be a good time to identify those sectors that are expected to be most under pressure in the coming weeks or months. In reviewing the charts this past week, there was a pretty consistent pattern: big drops starting Tuesday, moving averages violated, etc.

Those sectors that looked most interesting to me include Financials, Industrials, Basic Materials and Technology. A good candidate out of this sub-group might be Financials. With the turmoil in the mortgage lending industry, especially in the sub-prime market, and the unwinding of the Japanese yen carry trade there are some negative factors setting up that could keep the Financials from bouncing back. In addition, if the current downturn becomes more extended it could reduce investment banking and brokerage revenues which have been strong lately.

The following chart shows the Select Sector: Financial SPDR ETF (XLF) compared to its 65-day moving average and to the ProShares UltraShort Financials ETF (SKF).

Note that the 65-day MA for XLF has been clearly violated since the start of trading on Tuesday, 2/27. Note also that since 2/27, the UltraShort ETF has climbed over 10%. Of the sectors mentioned above, this chart is one of the most extreme.

The situations that have developed with the Select Sector: Technology SPDR (XLK) and the ProShares UltraShort Technology ETF (REW) and the Select Sector: Industrials SPDR (XLI) and the UltraShort Industrials (SIJ) look very, very similar to that of XLF and SKF.

The Select Sector: Basic Materials SPDR (XLB), however, has not broken down as badly as those mentoned above. Nevertheless, a bear could point to a number of troubling signs. Manufacturing in the U.S. has been struggling over the last few months and, as with technology companies, earnings forecasts are less than stellar. This would tend to impact Basic Materials as their customer base is saying they are not expecting business to be robust. In the case of Basic Materials, the chart is not so extreme as the one shown above for XLF. The 65-day MA has not yet been crossed but if it is, there would be time to catch the move early and potentially rack up a quick double-digit gain. Now might be the time to pay close attention to the ProShares UltraShort Basic Materials ETF (SMN).

If the Basic Materials trade looks good to you, you should also check out the situation developing with the iShares Dow Jones US Real Estate ETF (IYR) and the ProShares UltraShort Real Estate ETF (SRS). IYR had been trending strongly upward for several years until early in February when it finally began to weaken. This week's market drop just pushed it below its 65-day moving average and, with investors beginning to believe that real estate may not yet have seen the bottom, IYR could have further to go on the downside. As the following chart shows, this could be a good time to buy SRS.

For more information on the ProShares Funds click on the following links:
UltraShort Sector Funds and Ultra Sector Funds. These ETFs have only been available for about a month but they seem to have arrived just in time.

Disclosure: Author has no position in any of the above-mentioned securities.

Comments

[hotta fire]

"Disclosure: Author has no position in any of the above-mentioned securities."

Good thing... he would have lost a lot of money today buying those inverse ETFs he mentioned.

[Malkiel]

No, you need a day like today to be able to buy your short positions (which you would do if you are convinced that the overall market, or at least a chosen sector of it, is not trending up or is moving up and down). I like to keep it much simpler though, say by moving back and forth between a general market index ETF (like QLD ultralong for the Nasdaq) and its short equivalent (QID in this case). you buy the short as high as possible into the rally and sell it at the next convenient low, where you then simultaneously buy the long to ride back up. This is where volatility is your friend and flat or straightup trends are deadly. It's also where free trading in a tax-deferred account becomes a nice profit machine...

[Solution]

What's difference between shorting a fund and buying its inverse fund ? Isn't buying UltraShort the same as shorting double ? Does people suddently get smarter by buying inverse fund ? Don't understand.

[RossGreenspan]

The difference between shorting and buying the inverse is that many retirement accounts are restricted from short selling. The inverse ETFs act as shorts but are allowed in retirement accounts.

[TradeRadarOperator]

Malkiel is correct. Buying the inverse ETFs when they are down is just the old "buy low/sell high" concept. For example, I did initiate a position in QID but I did it several weeks ago. At that time QID was still making a bottom while the NASDAQ was riding high. I endured some pain until the NASDAQ finally dropped. And, of course, these funds will bounce around as much as the correpsonding long funds as there is plenty of volatility in both kinds of funds, expecially the Ultra versions.