Just the Beginning of June Gloom for Stocks: ETF Plays

by: Danny Furman

A week ago I suggested the Dow Jones Industrial Average (NYSEARCA:DIA) was on the verge of a major setback. Mr. Market laughed-- along with a bull or two in comments responding to the article-- at my aggressive and mistimed prognostication. The month of May ended with three days in the green yielding broad market gains of approximately 2%. A beating is to be expected sometimes when one often predicts the imminence of drastic events.

While the DJIA more than held 12,000 the last full week of May, my prediction of "June Gloom" is off to a good start. Indexes are off nearly 2% halfway through the first trading day of the month. With earnings season coming to a close, market participants are forced to focus on recent data showing drastically declining mortgage applications and employment far below expectations. These are mere extensions of recently progressive deceleration in the effectiveness of fiscal policy, the lone growth driver in developed economies for years now. Food and energy costs have risen back to levels only seen briefly in 2008, leaving future policy effectiveness to decline rapidly towards zero.

With QE2 in its final stage, inflation concerns abound, employment dwindling in the private sector and global growth taking a back seat to sociopolitical turmoil, no realistic outlook is favorable for businesses that rely on demand from able consumers. Food stamp dependency in the United States has skyrocketed to almost 20%. Disposable income is becoming a less and less understood term. Even those still employed in the private sector earn less on average than government employees, who make up an all-time high percentage of the total national workforce.

Recent reports have also shown slack in manufacturing activity and industrial demand. Reduced consumer demand will become an accelerating trend as focus shifts to survival from eternal celebration.

Even additional easing measures will not have a lasting effect on the overall business and stock market outlook, other than perhaps an international loss of faith in King Dollar and the end of his purchasing power. With demand coming in such high concentration from the United States, hyperinflation would be the reason businesses from Procter & Gamble (NYSE:PG) to Apple (NASDAQ:AAPL) would find themselves leveraged beyond salvation, and entirely bankrupt. Stocks may be a decent inflation hedge, however those relying on consumer demand are the worst hyperinflation hedge.

Even with a 2% pullback, investors can still do well by taking profits in expensive growth stocks and looking for hedging opportunities or to flip net short. Given the severity and number of factors calling for a significant pullback in U.S. stocks, aggressive plays to the short side are worth considering. Leveraged inverse ETFs appear deserving of attention for investors less interested in options trading or short selling. Holding times should still be limited to avoid premiums, but Proshares Ultrashort Technology (NYSEARCA:QID-OLD), Consumer Goods (NYSEARCA:SZK), Industrials (NYSEARCA:SIJ) and Financials (NYSEARCA:SKF) will outperform indexes of respective sectors during sell offs.

Options are also available for leveraged ETFs, however they garner high premiums due to short-term volatility. Still, with stocks priced optimistically without fundamental support, a small position in a highly leveraged instrument may be the best way to hedge a portfolio. Removal of monetary stimulus could send markets down faster than anytime in 2008, declaring many assets worthless and most others worth less. Even rosier economic scenarios are loaded with thorns and hopes for a sustainable recovery wilt by the day as the eurozone fails, the Middle East ignites, Japan picks up the pieces and the United States revokes capitalism and free markets.

For investors looking to entirely avoid a time premium while gaining exposure to the short side, selling shares of overpriced individual stocks can yield massive returns in a violent sell off. Here are some recommendations.

In order to limit invested capital while seeking aggressive returns, I continue to favor trading short-dated, near the money index put options. Technology (NYSEARCA:XLK) and retail (NYSEARCA:XRT) are sectors I consider most overpriced and attractive for shorting, though financials (NYSEARCA:XLF) may face an equally challenging road ahead.

Disclosure: I am short XRT.