Commentary: ETFs to help prepare for a short-term, cyclical bull market
HOUSTON (MarketWatch) -- Given the somber assessment of the global economy so prevalent in the news today, it is reasonable to assume equity markets will struggle for some time.
But while stocks remain in a bear market that began March 2000, investors shouldn't ignore the potential for a substantial rally in a short-term, cyclical bull market.
Ned Davis Research looked at 18 previous bear markets and found that the average cyclical bull market within the bear has seen the Dow Jones Industrial Average rise 64% over 508 days. The conclusion is that massive rallies have occurred during severe bear markets, including some of the worst contractions in history in the 1930s and 1970s.
In recent weeks, we've noted several positive developments that make us more optimistic on equity performance during the first half of 2009. First, investors put $23 billion into equity mutual funds in December after taking out a record $320 billion from all funds in 2008. That suggests forced selling is beginning to abate.
Some of the record cash that's now on the sidelines, earning less than 1%, eventually gets allocated to equities. Second, the CBOE Volatility Index
has dropped 50% from its November high. That indicates investor psychology, while still fearful, has greatly improved.
Third, early signs have emerged that the tremendous stimulus provided by the Federal Reserve and U.S. government are helping to stabilize credit markets. Finally, many of the classic signs of market bottoms occurred last fall, suggesting that the lows of October and November could hold for near term.
Assuming November equity market lows hold, stocks could be set for a rally over the next several months as investors begin to feel confident that the massive economic stimulus package to be enacted by Congress will result in a second-half recovery.
How should investors position portfolios to take advantage of an equity market rally? We think there are three exchange-traded funds that, when included within a diversified portfolio of asset classes, should allow investors to participate in a market recovery.
Exchange-traded funds offer an efficient, low-cost method of easily investing in specific investment opportunities. SPDR Trust Series 1 seeks to replicate the performance of the large capitalization sector of the U.S. equity market represented by the S&P 500 Index.
This ETF has a very low expense ratio of 0.095 percent. Studies have shown that the majority of actively managed mutual funds in the large capitalization sector fail to outperform the S&P 500 after fees and expenses.
The reason is that this sector of the market is highly efficient, which makes it very difficult for stock pickers to consistently have an edge. As a result, we recommend that investors index much of the large capitalization allocation in their stock portfolio via an investment in SPY.
Small capitalization stocks also should be part of a portfolio positioned for a market recovery. The iShares Russell 2000 Index Fund seeks investment results that correspond to the performance of the Russell 2000 index of U.S. small capitalization stocks.
Small-cap stocks no longer sell at a valuation premium to large cap stocks and a transition to small cap leadership could develop in the coming months. In addition, increasing investor confidence in an economic recovery would likely favor the shares of small cap companies.
One last recommendation is that investors maintain a modest investment in emerging markets. The iShares MSCI Emerging Markets Index seeks to replicate the performance of a diversified index of emerging market equities. Emerging markets were hit particularly hard in 2008 as commodity prices plunged, exports to developed markets slowed and the U.S. dollar strengthened.
However, the long-term trend of emerging market-led growth likely remains intact. Looking at past emerging market corrections, much of the losses were retraced quickly during a recovery.
In addition, the massive stimulus in the U.S. and other countries, particularly in China, is likely to spark inflation in the years ahead, benefiting emerging markets. Finally, an international equity allocation still makes sense as a currency hedge against the potential devaluation of the U.S. dollar.
James Shelton is chief investment officer at Kanaly Trust in Houston. 
*Courtesy of MarketWatch
*Courtesy of MarketWatch
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