ETF Plays to Watch This Week

03/30/2009 12:54 pm EST

Focus: ETFS

Deron Wagner

Founder and Head Portfolio Manager, Morpheus Trading Group

When a stock market rally is primarily led by extremely weak sectors bouncing off their lows, rather than leading sectors breaking out to new highs, the rally is usually short-lived. As such, it's important to point out one key difference between Thursday's rally and most other "up" days this month: Those gains were not driven by dead sectors, such as banking and insurance, that are merely bouncing off their lows. Rather, a broad range of industry indexes such as semiconductors, software, retail, and transportation all logged percentage gains greater than the main stock market indexes.

The banking index ($BKX), on the other hand, gained just 0.5% Thursday. Overall, we view this as a possible sign that investors may slowly be becoming more comfortable with market risk by deploying funds outside of perceived "value" plays. Such a change of sentiment is necessary in order for the stock market's rally to be sustainable. Nevertheless, the Nasdaq Composite is now approaching a major level of price resistance that could trigger a pullback or short-term price consolidation. This is shown on the daily chart below:

The dashed horizontal line on the chart above marks resistance of the Nasdaq's prior significant high from last month, which also acted as resistance throughout December and January. Because the Nasdaq has shown relative strength over the past several weeks, it is the only one of the major indices that has already reached resistance of its February highs. Since the Nasdaq has shown leadership on the way up, a pullback triggered by bumping into its February highs could similarly cause the S&P and Dow to retrace a greater percentage of their recent gains than the Nasdaq.

Though the broad market remains in both short- and intermediate-term uptrends, resistance of the Nasdaq's February highs means it may be a good idea to consider just one or two short positions (or inverse ETFs) near current levels, especially if you're now heavily positioned on the long side of the market. Trailing tight stops on winning long positions isn't a bad idea either. One bearish setup we're monitoring for potential entry is the inversely correlated UltraShort Financials ProShares (SKF). The hourly chart appears below:

As explained on the chart above, we're planning to buy SKF if, and only if, it breaks out above resistance of its multi-week downtrend line, which neatly converges with resistance of the 20-period exponential moving average on the hourly chart (regular subscribers should note our specific trigger, stop, and target prices below). Ideally, such a breakout would occur as the Nasdaq retraces at resistance of its February high, causing the S&P and Dow to lead the way lower to the downside. Since financials showed relative weakness by failing to participate in yesterday's rally, the sector could be one of the first to fall if the broad market shows any weakness, or even mere consolidation, over the next week.

If you plan to trade this setup, there are a few things to be aware of... |pagebreak|

First is the importance of not "jumping the gun" with a premature entry before SKF breaks out. Since SKF is consolidating at its lows, there's nothing to prevent it from making another leg lower right now. However, if SKF breaks out above its downtrend line, short-term momentum should reverse. The second point is to remember the UltraShort sector ETFs are only effective for very quick, momentum-based trading, which is all we're planning to do with the SKF.

Finally, be aware that SKF is an extremely volatile ETF. As such, be sure to decrease share size accordingly in order to account for the wider-than-usual stop that is necessary when trading SKF.

If you're concerned about initiating new long positions at current levels, you may want to check out some of the fixed-income (bond) ETFs. Not only do treasury bonds offer a relatively safe place to park cash, but technical analysis can also be used to time a buy entry in which, in addition to monthly dividend distributions, capital gains are most likely to be realized as well. Check out the daily chart of the iShares 1-3 year (short-term) Treasury Bond (SHY):

Circled in pink, notice how SHY has been consolidating right at resistance of its 50-day moving average. In the coming days, we anticipate a breakout above the high of its recent range ($84.21), which will enable SHY to move back above its 50-day MA as well. That would be a logical place to initiate a new buy entry for an intermediate- to long-term hold in the Treasury bond markets.

Because SHY has a very low volatility (it has traded in a range of just one point all year), it is not advisable to treat this as a short-term trade. There simply isn't enough beta to turn a decent profit. However, when viewed as a long-term trade, perhaps in an IRA account, one additionally benefits from the major advantage of bond ETFs-regular dividend distributions. Over the past year, for example, SHY has paid monthly to bi-monthly dividends, averaging approximately 25 cents per share, which adds up in the long term. But if you're looking to profit from short-term trading of the bond ETFs, consider the iShares 20+ year (long-term) Treasury Bonds (TLT) instead, as it has a much wider trading range. For a list of all the other bond ETFs (with an average daily volume greater than 50,000 shares), download our free Morpheus ETF Roundup.

In our March 27 commentary, we said, "Though the broad market remains in both short and intermediate-term uptrends, resistance of the Nasdaq's February highs means it may be a good idea to consider just one or two short positions (or inverse ETFs) near current levels, especially if you're now heavily positioned on the long side of the market. Trailing tight stops on winning long positions isn't a bad idea either." Given last Friday's losses, as well as the S&P and Nasdaq cash futures indication of a sharply lower open to Monday's session, the market seems to be confirming our suggestion. Yet, since the Nasdaq actually reversed before actually touching its February high, there still may be one more upward thrust to sucker in a few more bulls before the market pulls back much further. But if last Friday's weakness continues straight into today's session, keep a close eye on whether or not the main stock market indexes manage to hold new support of their 50-day moving averages (792 for S&P 500, 1,463 for Nasdaq Composite, and 7,597 for the Dow).

Last Friday's setup to buy UltraShort Financial ProShares (SKF) did not yet trade through our trigger price, but will likely do so today. Depending on how high it gaps on the open, we may buy the inversely correlated SKF on a breakout above last Friday's high (and the 20-EMA/60 minute). But because it was intended to be a quick, momentum-driven bounce play, we need to be sure the risk-reward ratio of the setup is not too negatively skewed if SKF opens too much higher than Friday's close.

By Deron Wagner of Morpheus Trading Group


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