ETFs: A Way to Play the Rally

Probably one of the best ways to have played the market’s recent rally would have been through ETFs.  The leading stocks I focus on simply haven’t gotten it done quite yet (more on that tomorrow), but the market has been a bargain hunter’s paradise, and one way to play that was through ETFs.

If the blast-off indicators are right, then the indexes have some more gas left in the tank.  So I want to give a few helpful hints about this still-evolving world of ETFs.

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First, the so-called leveraged ETFs (Ultra S&P 500 ProShares (SSO), which moves twice the S&P 500 and Ultra QQQ ProShares (QLD), which moves twice the Nasdaq 100) are a solid way to play the market … but only if the market’s going to make a consistent move.  As it turns out, these leveraged ETFs see their value decay somewhat over time–so if the market fluctuated for a few weeks, but on balance went nowhere, you’d actually see SSO or QLD down a bit.  Thus, these leveraged ETFs are better for shorter-term trading than long-term holds.

Second, when buying ETFs, you’re usually better off sticking with very liquid securities.  If you’re buying an ETF that only trades 10,000 or 20,000 shares per day, as many do, then you’re more likely to get bad prices if you try to buy or sell in a fast-moving market.

Third, if you’re going to play a sector-specific ETF, you probably want to trail some sort of stop behind it.  Sector-related ETFs can move quickly, but when the group comes under pressure, they can take away lots of your gains.  So don’t be afraid to take some chips off on the way up.

Finally, I know some of you are going to ask, “What ETFs do you like, Mike?”  One I’m watching is iShares China 25 (FXI), which tracks the performance of 25 mostly large Chinese stocks traded here in the U.S.  I am big on China, as that country’s stocks are performing very well.  The ETF just completed a nice two-week pullback, spiked to new recovery highs and has consolidated this week.  The 32-33 area would be a solid buy point, with a stop under 30.

In the same (but broader) theme, I also like the iShares MSCI Emerging Markets Fund (EEM).  It’s actually a bit stronger than FXI, but has generally the same pattern.  You could buy a little here, but to me, a shake down toward 29 would be much better, with a stop at 26.

Another ETF that’s been acting better is the DB Commodities Tracking Index (DBC), and the main reason for this is energy–heating and crude oil make up about 60% of the fund.  I like that it trades more than 1.5 million shares per day, and that it’s been trying to emerge from a bottoming formation for some time.

While oil ETFs are nice, the stock picker in me went hunting for the strongest, most fundamentally sound energy firm I could find.  The result:  Southwestern Energy (SWN), a major leader from the commodity boom earlier this decade.  Not only did the stock hold up better than most energy plays (SWN is actually all about natural gas), it consolidated for many months and recently moved to within 20% of its peak following a great earnings report.

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Fundamentally, I’m very impressed that the company churned out 16% earnings growth last quarter, and is projecting a hike in earnings for all of 2009.  Remember, this growth is happening despite natural gas prices that are down more than 50% from a year ago!  That means production is going nuts–in the first quarter, Southwestern Energy cranked out 64% more product than a year ago, and expects production for the full year to grow 49%.

Obviously, if natural gas prices continue to sink, SWN isn’t going anywhere.  But with oil and most commodities showing signs of life, I think there’s a good chance natural gas will follow suit.  Considering Southwestern Energy has the best growth prospects in the group, I think nibbling in the high 30s could work out well over time.