After a bear market, money tends to lay dormant in money market funds far too long. During the recovery after a bear market (that is, in the early stages of the new bull market), individual stocks churn. They often break down while the market rises. Market watchers will announce that the market is up 5% year-to-date, but you may not see that in your own account. Though some individual stocks may be whipsawing up and down while others collapse after aborted attempts to rise, the general movement of hundreds of stocks is an upward climb. For those who do not know how to navigate in a treacherous market environment like this, ETFs (Exchange Traded Funds) provide ways to participate in the advance even though individual stocks are in a state of high turbulence.
Most of the time (in normal times), investing in individual stocks can generate much better returns than investing in a market index fund. Even when the S&P500 is rising, it will usually have many declining stocks that offset many of the rising ones. Your individual stock selections, on the other hand, can be from among the better bargains or stronger stocks in the S&P500. You may hear advisors project 7% to 10% returns for the general market (which usually means the S&P500) in coming years. That return is the net after balancing all the losers against all the winners. Selected individual stocks within the S&P500 may appreciate 30% or more during the coming year (they may even cycle more than once from trough to peak by 30% or more during the year).
Now let’s narrow the focus a little. Individual sectors within the market are also made up of many stocks. Even when a sector is rising, some of the stocks within that sector may not be rising. Some will be much stronger than the average, and some may be declining. Some of the stocks within the sector may be rising quickly over a short time and then plunging to give up most of the previous gain. Even if many stocks within the sector break down to lose most of a recent gain, the cumulative effect of all the stocks in the sector going through this process at slightly different times will be a generally rising sector.
Therefore, when good individual stock selections cannot be found, or when individual stock behavior is treacherous, investing in index or sector ETFs makes good sense. Expert traders have learned the importance of tracking and ranking a wide range of ETFs daily. Why? Even when individual stocks can sustain their trends, it is helpful to know where the pockets of strength are in the market. When stocks cannot sustain their trends, the scanning process reveals alternatives to individual stocks. How can one know when to use ETFs instead of individual stocks? The issue hinges on whether the new market trend has sufficient internal momentum to support individual stock trends long enough for them to be profitable. If you buy several stocks a little above the price where there is significant support and the setup suggests the stock wants to go higher, but in each case the stock sells off enough to lose all or nearly all of the gain, then it is probably too early to invest in individual stocks.
For example, a simple way to monitor the development of a new up-trend in the market is to watch the 50-day moving average of the Dow. If the 50-day moving average is rising and the closing price is above the 50-day average, then the Index can be considered to be in an up-trend. The angle of ascent of this moving average together with its consistency can give you some information about the strength of the new trend. In a strongly rising market, the index will remain above the moving average, sometimes rising well above it and sometimes going sideways or declining until it encounters the average again. When it meets the average, it should rebound again in a new thrust upward. If the 50-day moving average is rising strongly, then a good time of entry would usually be when the stock first begins an upward thrust after encountering the average. Experienced traders consider this to be a relatively low risk point of entry. Why? It is considered to be low risk because the support offered by a strong 50-day moving average is nearby, and because the stop loss can be placed close to your purchase price (just below the 50-day moving average). The Index would have to plunge through the support offered by the average in order to trigger your stop loss. Such a penetration would indicate something is wrong and that the position is one that you do not want to keep. To invest in the Dow, a person could buy shares of DIA, an ETF that invests in the 30 stocks that make up the Dow.
Now, expand on the concept. When the market is falling, you might consider investing in the no-load Rydex Ursa fund (Ursa is a “negative S&P500 fund” that goes up when the S&P500 goes down). Then, when the market is rising, you could buy shares of DIA (the Dow) or SPY (the S&P500) until individual stocks meet your “buy” requirements or until they begin having trends that don’t break down right away. Either method of employing a cash balance should give better returns than a money-market fund. There are a variety of ETFs that can be used when individual stocks are still too volatile even though the market or certain sectors of the market are in an up-trend. If you are a utility investor, you could use a utility SPDR based on the S&P Utilities (symbol = XLU) just as you could use SPY for a multi-sector account. When the 50-day average (or other indicators you monitor) convinces you that the market is in a decline that may persist for awhile, you could invest in the Ursa fund or an ETF that goes up when the market goes down. You could short the Dow with DOG, short the NASDAQ with PSQ, short the S&P500 with SH, short the S&P Midcap 400 with MYY, and so on. There are also ultra ETFs that seek daily investment results that are double the results from a targeted index. For example, Ultra QQQ ProShares seeks daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the NASDAQ-100.
The point and purpose here is not to change individual stock investors into ETF investors. It is to offer suggestions for investing in a rising market even when timely individual stocks cannot be found, or to profit in a declining market when shorting individual stocks is too risky.
Copyright 2012, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com