9 ETFs You Don't Want to Own Now

by: Hedgephone

For the past few months, the strategy of "buying dips and selling rips" has been incredibly profitable. Almost every rally has been reversed, while QE and the rash of bullish analysts on CNBC has helped to support the market. They have created strong "snap-back" rallies which have violently hurt short sellers who are trying to trade a down trend. In other words, thanks to policies that "arrest" market declines, every sell-off is met with a violent clearing rally which crushes the shorts. This "chop suey" environment has been very hard on value investors and trend followers alike.

Here are nine index funds which look to be overvalued and therefore should be good short candidates if markets begin to crater. With margin debt higher than at any time since 2007 and with mutual fund redemption's adding up to $108 Billion since the start of 2010, I would be looking for the favorite investments of margined speculators to go short on, and as a result this likely means shorting the popular leading funds, which everyone loves, at nosebleed PE ratios.

DRN -- One of the greatest oddities of the recent rally in stocks, which in itself is a bit bizarre as we have rallied 84% from the bottom, is that REIT investments and companies paying dividends have outperformed the major averages. They have done so even though real estate prices themselves are down some 40% from their peaks and many companies paying dividends are highly leveraged or overvalued from a fundamental analysis point of view. In the past we have urged investors to study the cash flows of their dividend picks as many times companies fund dividend payments with borrowed money. We view the DRN (the Direxion triple leveraged REIT index) as the most speculative investment in the most speculative area of the stock market. Investors should consider taking profits in this or could consider shorting this via selling call spreads or naked call options on this fund.

VNQ -- The Vanguard REIT index fund is a cheap way to buy an overvalued basket of real estate trusts. The REIT market is notoriously governed by booms and busts. And what is so striking is that this fund, like DRN, is in a boom while real estate is still in a bust. While trends could change and the real estate market could pick up, we feel the best case scenario for commercial real estate is already priced in to the market. It is hard to argue that commercial real estate should be more valuable today than it was in 2007, but looking at VNQ you would have to think that commercial property is in a secular bull market that will last for decades. We couldn't disagree more.

TYH -- This triple leveraged tech index starts out with an initial layer of overvalued technology names that make up the Russell 1000 Technology index fund and then adds three layers of leverage to produce a speculative masterpiece of overvalued opulence that only the most aggressive investor could love. While the fund is clearly a rocket ship both up and down, we feel the risk to the downside is much too great at current levels to make sense for most investors. A good alternative would be to buy shares of Google (NASDAQ:GOOG), Oracle (NYSE:ORCL), Apple (NASDAQ:AAPL), Intel (NASDAQ:INTC), Cisco (NASDAQ:CSCO), etc... instead of betting on the Hail Mary pass that this fund represents to me in its speculative and inherently risky nature.

QLD -- The levered QQQ fund is a risky, but less aggressive choice for those who are convinced that the QQQ, with a 23 PE ratio, simply will never go down and only has one direction to move in -- namely, up! Personally, I find that these speculative index funds make little to zero sense for most investors because over time the leverage usually hurts investors due to slippage, interest costs, counter-party risks, etc... One has to look no further than the USO to see index fund investments that simply fail to meet their investment objectives, and that fund is un-leveraged. QLD will likely perform to its objectives better than the USO and will meet its goals in the shorter run. But longer term I feel the QQQ is overvalued, which might make QLD a better short than a long.

QQQ -- Speaking of overvalued, the QQQ is trading at 23X earnings and likely for an even higher multiple if one includes companies with negative earnings or if profit margins revert to historical averages. With corporate profit margins at all time highs and with stocks at levels not seen since 2007, investors should be very carefull speculating on higher prices for equities given that rallies have not been sustainable once stimulus measures are withdrawn. The QQQ contains many undervalued or fairly valued stocks to be sure, but on average the index is riding high on a wave of Quantitative Easing and not on a wave of sustainable fundamentals. While I am not recommending shorting this fund outright, I do think that buying put options that are slightly in the money against an investor's long book could provide them with a good risk reward opportunity to make money in both up and down markets.

IWM -- Overvalued, overbought, and over-hyped are the three adjectives I would use to describe the never ending rally in the Russell 2000 and the stocks which make up this widely diversified index fund. To be sure, this fund contains many undervalued stocks and several good long term investments. However, the average stock in this fund is trading for 30X earnings and 3X book value, which are multiples historically associated with bubbles and market tops and not market bottoms. I would be very surprised to see this fund higher than $80 in two years, but I could always be wrong. Investors buying puts here have to be ready for turbulence and volatility, as "making it go up" is now a political and monetary policy agenda item that is made clear by the statements of Ben Bernanke. I hate to fight the Fed, but with stimulus leaving the market, I think betting on higher prices is quite risky and akin to casino gambling more than it is to a sound investment decision.

TNA -- The triple leveraged Russell 2000 Index Fund is a lot like the DRN in that it starts off with a speculative, already highly leveraged investment which investors have bought on margin, and adds on two extra layers of debt. This fund is highly speculative and to me is far too risky to own for most investors looking to buy and hold stocks for the longer term. One strategy which makes sense to me is to short equal amounts of TNA and TZA. Although because I am so bearish on the TNA here, I think shorting the TNA via selling call options makes quite a bit of sense at present.

MDY -- The Midcap Spider is another fund that most diversified investors likely own in their portfolios as Wall Street analysts are very bullish on the sector and space, however I feel that this fund is likely in a mini-bubble, with prices for the fund above their highs in 2007. I have not met too many small business owners who say that business is better than it was in 2007, so I am pretty skeptical of the rally in MDY. Given the fund's 20 plus PE ratio when including companies with negative earnings, I would be hesitant to recommend or own this fund.

USO -- Obama is releasing oil from the Strategic Petroleum Reserve. The USO, which suffers from slippage and Contango, looks to be a good sell or short idea here. The fund has not been able to keep up with oil prices at all and has underperformed the spot price of the commodity bby some 50% or more over the past few years. While I am not condemning the fund for missing its objectives, I would not be a buyer of this fund at any price. I would much rather own shares of ConocoPhilips (NYSE:COP), Chevron (NYSE:CVX), Statoil (STO), etc... when compared to buying the USO index fund. With that said, I am not resolutely bullish on oil here, as it seems that "making oil go down" has become a political hot button for the election season. That being said, I don't think oil will go down very much over the longer term and if more QE is announced, expect all commodities to jump as they did last year.

Disclosure: I am short DRN, TNA, IWM, QQQ.