3 Important Things to Know When Investing in ETFs

ETFs are cost effective, tax efficient, liquid and can be traded throughout the day (unlike mutual funds). Most investors are familiar with the appealing ETF basics, but here are a few tricks and traps the average Joe investor may not know.

ETFs (Exchange Traded Funds) have been called the best thing since sliced bread.

The ETF universe has ballooned to well over 1,300 ETFs, controlling nearly $2 trillion in assets. The $15 trillion mutual fund industry is less than thrilled about the splash ETFs made in their investment pool.

ETFs are popular for a reason, but this article addresses not only the ETF basics, it also reveals some tricks and traps the average investor may not be aware of.

ETF Basics

Know what’s under the hood: The initial success of broad market ETFs, like the SPDR S&P 500 ETF (NYSEArca: SPY), sparked much innovation and the need for additional ETF structures.

Today there are five different ETF structures, each with its own pros, cons, and tax treatment. In fact, in recognition of this diversity, what used to be called the ETF universe, has become the ETP (Exchange Traded Product) universe.

A detailed look at the different structures along with advantages and disadvantages is available here: Basic ETF Structures Explained

Diversification:  Most ETPs provide exposure to a basket of stocks or bonds. Most often that basket is linked to an index.

Some ETPs screen their holdings based on certain filters, are actively managed or designed to track the performance of commodities, currencies are other assets classes.

Cost & Tax Advantages: There are exceptions, as you would expect in any group numbering over 1,300, but ETPs in general are more cost and tax effective. The cheapest S&P 500 ETFs costs only 0.05% per year.

Liquidity: ETPs sell like stocks and can be instantly (assuming the market is open and you have a brokerage account) bought or sold with the click of a button. Mutual funds are redeemed (time delay is at least a few hours), often at a price that has yet to be determined.

ETF Tricks & Traps

Like every other investment, ETPs don’t come with a built in protection against moronic decisions.

The emergence of short, leveraged and leveraged short ETPs actually makes it easier for investors to lose (and make) money even faster. The epitome of a two-edged sword.

Due to the structure of short and leveraged ETPs, the odds of landing a profitable trade are not always 50/50.

Some leveraged (short) ETPs have a tendency to enhance returns in a down market, others in an up market. Sideways markets may deliver unpredictable returns, even returns unrelated to the underlying benchmark.

For example, the popular but notoriously declining iPath S&P 500 Short-term VIX ETN (NYSEArca: VXX) has been a trap for many investors.

The first chart below plots VXX against its benchmark, the VIX. I’ve inserted a 50-day SMA to show the basic trend. VXX has been down even though VIX has been trading predominantly sideways.

The second chart plots VelocityShares Daily Inverse VIX ETN (NYSEArca: XIV) against its benchmark, which is also the VIX.

You probably get the point. The choice of ETPs can influence the odds of winning beyond the normal odds dealt by the market.

More details about the subtle, but important idiosyncrasies of ETPs is available here: The Must Know Basics of Short & Leveraged ETFs

Know Thy ETF Universe

With over 1,300 ETPs comes the freedom of choice. The following criteria should be considered when on the prowl for the best ETP:

  • Cost
  • Trading volume
  • Performance track record
  • Structure and tax advantages/disadvantages
  • Tracking method (sampling or replication) and accuracy

ETPs also offer exposure to asset classes and currencies that, in the past, used to be off limits for the average investor. So take a stroll through the ETP universe. You may find asset class ‘galaxies’ that may harmonize with your portfolio on planet Earth.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF to get actionable ETF trade ideas delivered for free.

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3 Perils of Chasing Red Hot ETFs

Few things are worse than watching an ETF that was on your mental buying list – but not in your actual portfolio – go up … and up … and up. It’s always tempting to chase performance, but here are three risks and one solution.

The seven most notorious words of the financial industry: “Past performance does not guarantee future results.”

In other words, anyone buying a hero and ending up with a zero has no one to blame but him or herself.

+65%, +55%, +38% are the digits of the three hottest ETFs right now (based on 3-month return). Does it make sense to chase those ETFs?

The trend is your friend until it bends, so chasing ETF hot shots isn’t always a terrible idea, but being aware of three common pitfalls may reduce embarrassment at the water cooler investment chat.

Peril #1: Leverage

Leveraged ETFs usually crowd out any ‘Top 10” performance list. Leveraged ETFs are ETFs on steroids. Currently 9 out of the 10 best performing ETFs are leveraged or leveraged short ETFs.

Leverage can be a blessing and a curse. It’s important to know that leveraged ETFs -like carnival mirrors – always skew the real condition of the underlying sector. For more details on the dangers and delights of leveraged ETFs click here: The Must Know Basics of Short and Leveraged ETFs

Weeding out all leveraged (short) ETFs and zooming in on ‘pure ETFs’ will offer a more accurate picture of the best performing sectors and their ETFs.

Peril #2: FOMO

FOMO (fear of missing out) is a powerful motivator, but it’s a terrible reason to buy. If the sole reason for buying a hot ETF is fear of missing out on more gains, it’s probably a bad idea. FOMO is not an investment strategy.

Strong momentum, persuasive fundamentals, or yet unreached up side targets are better reasons to buy an ETF that’s already trading well above its low.

Peril #3: Performance Chasing & Trend Reversals

Here’s a real life example of the perils of performance chasing.

Gold was one of the hottest assets in Q1 2014, but one of the worst performers in Q3.

The SPDR Gold Shares ETF (NYSEArca: GLD) was up as much as 15.13% in March. It’s fallen as much as 17.96% since. The VelocityShares 3x Long Gold ETN (NYSEArca: UGLD) was up as much as 50.69%, followed by a 46.95% drop.

Burnt trend chasers still hear the ringing of those chewed out Wall Street phrases in their ears:

“Past performance is no guarantee of future results”

“The trend is your friend until it bends”

The key question is how you can tell how long a trend is to last.

The gold chart features an observation made by the Profit Radar Report on March 12, three trading days before gold rolled over: “Gold has now reached our initial up side target at 1,365. RSI is lagging price and traders are quite bullish on gold. We are looking to short around 1,400.”

Bullish sentiment and chart resistance capped gold’s up side in March (blue circle).

It appears that bearish sentiment and chart support ended gold’s slide on November 7.

Having a pulse on investor sentiment and technical support/resistance levels does not guarantee winning trades, but it generally prevents against joining the performance chase at the worst of times.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Simon Says: This May Be The Only Bearish Looking Broad Market Index Chart

Aside from the autumn colors, everything is green on Wall Street. Stocks are up almost everywhere you look. There is only one broad market index that could reasonably be interpreted as being bearish.

The Dow Jones, S&P 500 and Nasdaq are at new (all-time) highs, and it takes a permabear or nit-picky glass half empty kind of a person to find anything alarming in those charts.

Perhaps the most bearish looking chart is that of the NYSE Composite Index (NYA). The NYA measures the performance of all common stocks listed on the New York Stock Exchange (NYSE). There are currently 1867. The iShares NYC Composite ETF (NYSEArca: NYC) replicates the performance of the NYA.

Unlike the Dow Jones and S&P 500, the NYA also includes small cap stocks, which explains why the NYA is lagging.

In fact, the NYA chart gives hope to all those who missed the latest rally. Why?

The NYA is bumping up against a serious resistance cluster made up of:

  1. 78.6% Fibonacci resistance
  2. Trend line resistance
  3. Prior support shelf

In addition, (bearish) Elliott Wave aficionados may be quick to point out that the NYA’s decline from the September high to the October low could be counted as five waves.  Such a 5-wave move would suggest at least one more leg lower.

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The overall strength of the “October blast” rally suggests that NYA will eventually surpass this resistance cluster. But if NYA is going to pull back and fill some of the open chart gaps, right about now (or at 10,850 – 10,900) seems like an appropriate time to do so.

The Dow Jones is also about to run into the same resistance level that caused the September correction.

Solid resistance levels, like the ones shown above, increase the risk of a pullback, but obviously don’t guarantee said pullback. Higher targets are unlocked if the NYA and Dow Jones sustain trade above resistance.

A detailed forecast for the remainder of the year – based on an analysis of seasonality, sentiment, technical indicators and historical patterns – is available in the November 2 Profit Radar Report.

Simon Maierhofer is the publisher of the Profit Radar ReportThe Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

NYSE Composite Chart is Sending Strong Message

Although not nearly as popular as the S&P 500 or Dow Jones, the NYSE Composite sports one of the most transparent technical pictures we’ve seen in quite a while. Here’s a closer look at the strong message of the NYSE Composite.

The NYSE Composite Index is not often discussed, but as one of the broadest U.S. indexes (1,868 components) it offers a unique big picture perspective, especially right now.

First off is a weekly log scale bar chart of the NYSE Composite since its March 2009 low along with some basic support/resistance levels and trend lines.

The second chart zooms in on the more recent price action.

There are a number of noteworthy developments:

There is a possible head-and shoulders top. The red line is the neckline. The projected target is 10,655, which was already reached last week.

The measured HS target at 10,655 also coincides with green trend line support.

Despite the measured HS target having been fulfilled, the August 3 Profit Radar Report predicted another leg down.

The NYSE Composite (NYSEArca: NYC) already exceeded last weeks low and the measured HS down side target. Today it broke below last week’s low and first green trend line support.

What does this mean for the NYSE Composite?

It doesn’t take a ‘chart Sherlock’ to perceive that the next leg down is underway.

While the trend is still down, the outlook is not as bleak as many expect. There is support at 10, 447 (200-day SMA) and 10,250.

From this support I expect a reaction that will surprise Wall Street and investors alike.

More details along with an actual projection for the S&P 500 are available via the Profit Radar Report.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

The S&P 500 is Overvalued Based on P/E Ratio

Do valuations matter in today’s market? Just as you look at a Blue Book before buying a car, you should look at valuations before buying a stock. Even though it doesn’t mean stocks are ready to decline right now, P/E ratios suggest stocks are priced for long-term pain.

Are stocks overvalued? That’s a good question, but a better question is whether stocks are priced for long-term gains?

An individual stock – or the entire stock market – can be overvalued and still increase in value. A drunk driver may still be able to operate a vehicle, but the odds of a drunk driver or overvalued market to crash is much higher.

Buying an undervalued stock (or staying out of an overvalued market) on the other hand, places the odds in favor of the investor.

When dealing with probabilities – which is what investing is all about – having the odds in your favor is the best you can do.

Having that in mind, we ask again: Are stocks set to delivery long-term gain or pain?

Before we get to the valuation analysis, keep in mind that valuations are a long-term guide. We don’t use long-term indicators for short-term trades. A number of shorter-term indicators point to still higher prices ahead.

Pain or Gain?

Today we’ll look at valuations based on P/E ratios.

The current P/E ratio (based on Robert Shiller’s cyclically adjusted P/E ratio) is 21. The average P/E ratio going back to the year 1900 is 16.9. In other words, the P/E ratio is 26.9% above its historic average.

A reversion to the mean would imply a 26.9% drop in stock prices or a dramatic increase in earnings.

Is there a correlation between P/E ratios and the S&P 500? The chart below plots P/E ratios against the S&P 500. The vertical red and green lines highlight the correlation between P/E ratios and market tops/bottoms for the S&P 500.

Current P/E ratios are not at extremes that have historically marked major tops or bottoms, but P/E ratios do at best suggest sluggish growth going forward.

The visually illustrated study below shows the correlation between P/E ratios and their respective forward return.  The study covered the period from 1871 – 2010 and is based on the S&P 500 (S&P predecessors prior to 1957). P/E ratios are based on rolling average ten-year earnings/yields.

P/E ratios and the corresponding ten-year forward returns, were grouped into five quintiles in 20% intervals. As the chart shows, the cheapest quintile had the highest ten-year forward return while the most expensive quintile had the lowest return.

The projected 10-year forward real return for the S&P 500 (and SPY ETF) with a P/E ratio of 21 stocks is around 4.5%.

Keep in mind that the 1871 – 2010 span hosted multi-decade bull markets where P/E ratios remained in overvalued territory for extended periods of time. During a bear market, the forward return is likely to be much lower than the study suggests.

There are other factors that influence earnings, P/E ratios, and ultimately stocks’ performance. Those factors will be the subject of an upcoming article.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

Insider Selling of Stocks is at Highest Level for the Year

Insiders are fearful of an impending sell off. When this happened earlier this year the S&P 500 quickly declined 10%. Other sentiment measures are reaching extremes too, but there’s a silver lining.

All major U.S. stock indexes continue to trade near multi-year highs, but insiders are selling stocks of the companies they own or manage at a pace not seen at any other time in 2012.

Investors Intelligence reports eight sales for each purchase and considers the current rush for the exits “panic selling.” The question we should ask is, “what do insiders know that we don’t?”

Another sentiment extreme can be seen in the high yield bond market, more appropriately called junk bonds. Companies just issued the third-highest amount of junk bonds.

The prior records were set in October 2010 and May 2011. Those two dates are marked in the chart below. I’ll explain in a moment the significance of those two dates.

Mutual fund managers tracked by the National Association of Active Investment Managers report that managers have a median exposure of 95% to equities. This is close to a six-year high and sets an 18-month record.

The Dow Jones just went an entire quarter without losing more than 1%. Jason Goepfert with SentimenTrader took a look at what happens historically when the Dow goes an entire quarter without a 1% decline, while trading close to a 52-week high.

There were 16 such instances since 1900. Over the next six months, the Dow was positive every time with a median return of +6%.

Getting back to the two dates highlighted in the chart above, we are currently in a situation where sentiment is becoming extreme. But just as Advil covers up pain, QE3 tends to neutralize extreme optimism.

Back in October 2010 it took several months before sentiment extremes caught up with stock prices. In May 2011 however, it resulted in a nasty sell off.

From a seasonal perspective October is an interesting month. It has hosted a number of crashes but also a number of important lows.

Looking at stocks, we see that the S&P 500 (S&P 500 SPDR – SPY) has been trading in a well-defined parallel trend channel. The strategy – as long as the S&P remains within this channel – is to sell when it reaches the top of the channel and buy at the bottom.

Once the bottom (of the channel) falls out, it’s probably time to become more bearish.

The Profit Radar Report monitors literally dozens of sentiment gauges, seasonal patterns, and technical developments to identify high probability investment opportunities for the best investment strategy.

Is QE3 a Big Fat Buy Signal for Stocks?

It’s official, QE3 is here. Unlike QE1 and QE2, which had a predetermined ceiling and expiration date, QE3 is open ended. The Federal Reserve pledges to buy $40 billion worth of mortgage backed securities (MBS) per month for as long as it takes.

Investors got what they wanted, so is this a big fat buy signal for the S&P 500, Dow Jones, gold, silver and all other assets under the sun?

To answer this questions we will analyse the effect of previous rounds of QE on stocks (some of the details may surprise you) and compare the size of QE3 to its predecessors.

QE Like Snowflakes

Just like snowflakes, no day in the stock market and no version of QE are alike. Nevertheless, a better understanding of QE1 and QE2 may offer truly unique iinsight about QE3.

The chart below provides a detailed history of QE and Operation Twist (detailed dates are provided below).

QE1 Review

The S&P 500 (SPY) dropped 46% before the first installment of QE1 was announced (the Financial Select Sector SPDR ETF – XLF – was down 67% at the same time). By the time QE1 was expanded the S&P was trading 51% below its 2007 high.

Even without QE1 stocks were oversold and due to rally anyway (I sent out a strong buy alert on March 3 to subscribers on record). One could say that the Fed’s timing for QE1 was just perfect. The S&P rallied 37% from the first installment of QE1 (Nov. 25, 2008) and 51% from the expanded QE1 (March 18, 2009) to the end of QE1 (March 31, 2010).

QE2 Review

The S&P lost 13% from its April 2010 high to August 28, the day Bernanke dropped hints about QE2 from Jackson Hole. The S&P rallied 18% (from the July low to November 3) even before QE2 was announced.

The market was already extended when QE2 went live, but was able to tag on another 11% until QE2 ended on June 30, 2011.

QE3 Projection

Even before QE3 goes live, the S&P has already rallied 33%. Although the S&P saw a technical break out when it surpassed 1,405, the current rally is in overbought territory.

The timing for QE1 was great and the S&P rallied 37 – 51%.

The timing for QE2 was all right and the S&P rallied 11%

QE3 doesn’t have an expiration date, but is limited to $40 billion a month. During QE2 the Fed spent an average of $75 billion a month on bond purchases in addition to the $22 billion of reinvested matured bonds. Operation Twist is still active, where the Fed is selling about $40 billion of short-term Treasury bonds in exchange for long-term Treasuries (related ETF: iShares Barclays 20+ year Treasury ETFTLT).

In summary, the timing for QE3 is less than ideal, the committed amount is less than during QE1 and QE2, and QE2 has shown that stocks can decline even while the Fed keeps its fingers on the scale. QE3 may not be as great for stocks as many expect and rising oil prices may soon neutralize the “benefits” of QE3.

Detailed timeline:

November 25, 2008: QE1 announced.
Purchase of up to $100 billion in government-sponsored enterprises (GSE), up to $500 billion in mortgage-backed securities (MBS).
January 28, 2009: Ben Bernanke signals willingness to expand quantity of asset purchases.
March 18, 2009: Fed expands MBS asset purchase program to $1.25 trillion, buy up to $300 billion of longer-term Treasuries.
March 31, 2010: QE1 purchases were completed

August 26 – 28, 2010: Ben Bernanke hints at QE2
November 2 – 3, 2010: Ben Bernanke announces $600 billion QE2
June 30, 2011: QE2 ends September 21, 2011: Operation Twist
June 20, 2012: Operation Twist extended