Financial ETFs Are Banking On More Rate Cuts

Includes: IYF, KBE, UYG
by: Gary Gordon

Wall Street often overlooks it. Main Street often ignores it. Yet the Institute for Supply Management [ISM] Service Sector Report may just be the biggest key to Fed policy going forward.

The ISM's index fell to 54.8 from 55.8 in August, hitting the lowest reading since March of this year. the number was below expectations, giving those with high hopes for lower rates a jolt.

Yet this number was hardly anemic. In fact, anything over 50 implies expansion. And some have gone as far to say that the consumer side of the economy... housing woes and credit crisis in tow... is holding up just fine.

Shouldn't that bode well for consumer discretionary stocks? Would the S&P Consumer Discretionary Fund (NYSEARCA:XLY) be a worthy portfolio addition right now?

No it would not.

"Holding up" is not the same as a major resurgence. Moreover, as long as housing/real estate numbers prove dismal, there are better exchange-traded stock fund assets to pursue in the Q4 2007 market surge.

What are those better ETFs? The ETFs that stand to gain the most from the Fed activity are those with ties to the banks; that is, as long as the Fed is intent on cutting through year-end, you can expect to profit from:

  1. iShares Dow Jones Financial Services Index (NYSEARCA:IYF)... for broad financial exposure.
  2. ProShares Ultra Financials (NYSEARCA:UYG)... for leveraged financial exposure on the broad spectrum of banks, brokers, insurers, lenders and so forth.
  3. KRW Bank Index (NYSEARCA:KBE)... pure play on the biggest U.S. banks.

Of course, near-term success in financials depends largely on continued rate-cutting activity. And while forecasting the Fed isn't necessarily an easy task, the Fed's next move doesn't appear as difficult as in months past. Here's why:

A. The Fed's Most Recent Statement. "The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally." Nobody believes that lenders are opening their wallets to offer no-income/no-asset/teasers/stated-income loans. Even as credit may be loosening up from a complete clampdown, there is a general tightening of standards. What's more, the Fed is genuinely concerned about growth. Ergo, the Fed will keep easing.

B. Prices and Sales of Housing Slipping/Inflation Tolerable. The basic data that continues rolling in is that the overall inflation picture is within the Fed's comfort zone. Meanwhile, housing data only gets worse and worse. It follows that this gives the Fed room to keep cutting.

Granted, strong employment numbers and strong ISM numbers might have the potential to make the Fed think twice. But it hasn't happened. An employment picture and a consumer picture that is at best "holding up" and at worst "faltering" means lower rates to come.

So expect a strong Q4 for Wall Street... overall. And pursue the biggest beneficiaries of those rate cuts, whether it's the banks in the KRW Bank Index (KBE), the Euro through the Rydex CurrencyShares Euro Trust (NYSEARCA:FXE) or even the AIG Commodity Index (NYSEARCA:DJP). Note: The Euro and the Commodity Index are at or near 52-week highs.

If you are intrigued by banks as a rate-cut beneficiary, you may be more intrigued by banks as a long-term value investment. See "What Warren Buffett and Joseph Lewis Think of Financial Stocks."