There Are Some Bright Spots. Really.

09/16/2008 12:00 am EST

Focus: ETFS

Jim Farrish

Founder and CIO, Jim's Notes

The latest phase of the financial crisis was the catalyst to break the July 15th lows and producing a spike in the VIX (a widely watched measure of fear in the market) to 31. The bankruptcy filing of Lehman Brothers, the growing threat to AIG, and Bank of America's surprise purchase of Merrill Lynch led to one of the worst market days since the first trading day following 9/11.

My first reaction is to jump in and say the sky is falling with everyone else. Over the last 30 days the top six performing ETFs are all ProShares UltraShort funds (QID, SMN, MZZ, TWM, SDS, DUG). When the underlying indexes fall, these funds move up twice as much.

To go one better, four of the six are broad market indexes (Nasdaq 100, Standard & Poor's Midcap 400, Russell 2000, S&P 500). This would lead me to believe the worst looking forward. In fact, scanning through the ten sectors of the S&P 500 index we have six rated as a sell, two as a hold, and two (consumer services and consumer staples) as a buy. Not a pretty picture and one that is reflected in the 30-day data above.

But the optimist in me has a second reaction: if it's this bad, it has to get better. Let me first state that the economic data isn't stellar by any stretch, but it is getting better. In fact, without this credit issue hanging over the markets, most analysts would be talking about that versus who will fail next. The improving data is leading to early cycle rotation. This means money is moving towards the next potential leaders. Institutional money is on the move as well; another positive sign. Energy's leadership is over for now and my outlook is towards the future.

My research found four sectors that look favorable. Consumer Staples Select SPDR (Amex: XLP) remains in an up trend off the July lows. Consumer Discretionary SPDR (Amex: XLY) is in the same situation, with a move higher off the July lows that is holding short term. S&P Homebuilders SPDR (Amex: XHB) has established a short-term up trend as well off the lows. Last is iShares Dow Jones Transportation Average (NYSEArca: IYT), which is not in an up trend, but is in a trading range. The 200-day moving average around $87 is support, and $94 is resistance. I would look for a break out of this range as we move forward.

The short and sweet of why I like these sectors is economically driven. Oil has declined to $92 per barrel from the high of $147. This results in more discretionary income for consumers. While in and of itself it doesn't cure what ails the economy, it helps. In fact, at 50 cents a gallon less for gas, it creates annually more than $110 billion to the US economy.

That explains why XLP is on the list. Because the economy will take time to heal, XLY is on the list. These are the toilet paper stocks, things we have to buy. IYT, the Transports, is an obvious beneficiary of lower oil prices. Look at the airline sector to see the immediate impact.

Homebuilders? Really? XHB is in an up trend off the lows because housing is getting better: The data have actually improved over the last five months. I understand they are still negative, but they have been less negative each month. That is the process of forming a bottom. Throw in lower 30-year fixed-rate mortgages in the wake of the Fannie and Freddie bailout, down from 6.5% to 5.8%, and you have what could be the beginning of an inventory reduction sale in housing.

There is plenty to be positive about if we get away from the panicky headlines and look for the value that does exist in the markets. However, you have to look longer term than Friday.

Jim Farrish, founder and editor of Melbourne, Florida-based SectorExchange.com, writes regularly about sectors and speaks widely about investing and money management.

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