Source: Thinkstock
One thing that investors should look at when trying to determine the overall direction of the stock market is the performance of “risk on” assets. These are assets that people want when they feel confident that the economy is strong and that people are spending more money. Some examples include:
- Small cap stocks
- Financial stocks
- Growth stocks
- Retail stocks
It is pretty evident why many of these asset classes outperform during “risk on” periods. When times are good, people are borrowing more money and spending it. This, in turn, entices businesses to expand, project more growth, and borrow more money in order to fund this growth. Small cap companies don’t intuitively fit this mold at first glance, but consider that small companies have more substantial growth potential, and this potential is often built into stock prices before it becomes a reality.
Investors who have been watching these sectors have noticed that they are underperforming. This is a sign that the risk on trade is over — at least for now. The bad news is that this could mean that there is trouble ahead for the global economy. This shouldn’t surprise anyone, especially since the economy enters a recession every 4 to 6 years. The good news is that there are clear signs out there, and if you follow them you can prepare yourself by reducing your equity exposure and by buying safe haven assets such as Treasuries, gold, or even inverse ETFs that rise in value if the stock market falls.
A good way to follow these signs is to look at the performance of certain ETFs. ETFs have made it very easy for retail investors to see what is going on with certain asset classes and to make decisions based on these observations without having to compile a seemingly endless amount of data. Here are three ETFs that I follow that suggest to me that we are transitioning from a “risk on” period to a “risk off” period.
1. The iShares S&P Small Cap 600 Growth ETF (NYSEARCA:IJT)
This is an excellent fund to put on your watch list because it satisfies two of the categories I mention above — small cap stocks and growth stocks. The IJT filters through the S&P 600 — S&P’s small cap index — in order to locate growth stocks. These companies are going to be economically sensitive, and they are going to leverage your exposure to the stock market. If the stock market is rising, IJT will outperform, and if the stock market is falling, then IJT will underperform.
While the S&P 500 has been more or less flat on the year, the IJT is down 5 percent. This underperformance suggests to me that investors are becoming risk averse, and that they are less willing to hold these more volatile stocks. By comparison, if we look at a large-cap value ETF such as the iShares Russell 1,000 Value ETF (IWD), we find that this asset class is up 2 percent for the year, which means the difference is 7 percent. This is a big deal, and it indicates that growth is slowing and that investors want to own large companies — which are typically more stable than small companies — that trade at low valuations.
Source: Thinkstock
2. The SPDR S&P Retail ETF (NYSEARCA:XRT)
Retailers, like small caps and growth companies, often outperform on the upside and underperform on the downside. When retailers are underperforming, this means that consumers are spending less money. Furthermore, retail earnings are highly volatile because it costs about the same amount to keep a store open whether customers are shopping there or not. So if just 5 percent fewer shoppers come into a store, that could mean that earnings drop by 25 percent or even 50 percent! While retailers can respond by closing locations they usually take some time to do so.
In a downturn, there are inevitably going to be some retailers that fail, and chances are they are components of the XRT. Already this year we are seeing significant weakness in some of the more discretionary retailers, as well as some of the weaker players. Whole Foods (NASDAQ:WFM), for instance, has had a miserable year, and its stock is substantially underperforming the market. The same can be said about J.C. Penney (NYSE:JCP), Amazon (NASDAQ:AMZN), and Chipotle (NYSE:CMG). As a result, the XRT is down nearly 7 percent for the year. This means that, in all likelihood, consumer spending is weakening despite official statistics. It could also mean that consumer spending may not be down, but that it is being redistributed, and Wal-Mart (NYSE:WMT) and other discount retailers are the beneficiaries. In fact, Wal-Mart is down just 1 percent this year versus 7 percent for its peer group, and McDonald’s (NYSE:MCD) – another low income retailer — is actually up for the year. If this trend continues, I expect this weakness to bleed into the rest of the stock market.
Source: Thinkstock
3. The Financial Select Sector SPDR (NYSEARCA:XLF)
Financials haven’t been underperforming year to date like the other funds, but they have been underperforming more recently. Furthermore, we are seeing some of the larger financials come out with bad news and this is sending their shares lower. Financials are a reflection of economic activity. If financials are doing poorly, this is in part due to a lack of economic activity, or the failure of financial assets such as loans. This doesn’t portend well for the economy and for the stock market more generally.
While specific names are bolstering this fund such as the “best of breed” Wells Fargo (NYSE:WFC), we are seeing underperformance from names that touch the entire nation from Bank of America (NYSE:BAC) to JP Morgan (NYSE:JPM). If this underperformance continues, I expect that we will see broader weakness in the equity markets, and probably in the high yield debt markets as well.
Interested in ETFs? ETFs have altered the investment landscape for retail investors, but how do you choose which one to buy? From an earlier article we wrote, here’s a recap of the best tips to follow in order to pick the best ETFs:
1. Look at expense ratios
ETFs are funds. You are paying a company to compile several assets for you, and this costs money. Depending on the kind of fund, the cost can vary. For instance, if you are buying a managed ETF such as those offered by AdvisorShares, you aren’t just paying for transaction fees but for research as well — and this increases costs. On the other hand, if you just want a simple index fund you should expect costs to be very low.
For many asset classes you have several ETF options. If you come across two funds that offer essentially the same kind of exposure, one way to choose the best fund for you is to pick the one with the lowest expense ratio. The expense ratio is the fee that you pay the fund manager every year to maintain the portfolio. Every ETF’s website should list the expense ratio.
The only time that you should be willing to buy a fund with a higher expense ratio is if there are mitigating circumstances, which I discuss in the next two tips.
2. Volume and assets under management matter
You typically want to own ETFs with larger amounts of trading volume, and with larger amounts of assets under management. In the latter case, larger funds are typically less expensive to manage on a dollar by dollar basis. Regarding the former point, you want to make sure you own ETFs that have a lot of trading volume because you want to be able to sell out of your ETF if you need to for whatever reason. For instance, if you are looking to buy gold through an ETF, I would stay away from the ETFs Gold Trust (SGOL), which trades just a few thousand shares every day. I would rather own the SPDR Gold Trust (GLD), which trades a few million shares every day. If you need to sell the latter fund, you should have no trouble doing so in a timely fashion, and you will be able to do so at a price that is very close to the funds’ net asset value.
3. Maximize your diversification
One of the great things about ETFs is your ability to diversify your holdings through the purchase of a single trading vehicle. But you need to make sure that you are actually diversifying. For instance, consider the Powershares DB Agriculture Fund (DBA) versus the Rogers Agricultural Commodity ETF (RJA). Both funds are designed to give investors exposure to a variety of agricultural commodities. However, the former fund holds just a few commodities while the latter holds more than a dozen. It holds commodities such as oats and greasy wool that DBA doesn’t. If your goal is to get broad exposure to agricultural commodities, RJA is probably a better option.
Conclusion: Making sacrifices
Ultimately, you are going to be in a situation where you need to decide: Do I want more diversification or more liquidity? Or, do I want a lower expense ratio or more diversification?
Ultimately, there is no right or wrong answer to these questions. You need to decide what is important to you as an investor. Maybe it is worthwhile to pay an extra 0.2 percent per year in order to get exposure to 500 stocks instead of 50 stocks. Maybe it isn’t worthwhile. There isn’t an “apples to apples” comparison for every set of ETFs. However, a good rule of thumb is as follows: use the above three rules to eliminate extreme cases, and otherwise go with your personal preference. So for instance, don’t buy a fund with a 3 percent expense ratio even if it is liquid and highly diversified. But if you are choosing between paying 0.5 percent and 0.3 percent, but the 0.5 percent fund is much more diversified and liquid, it may be the better option. As another example, don’t buy an ETF with just $10 million under management and with just 5,000 shares traded in an average day, even if it is highly diversified and even if it has a low expense ratio. It may end up being too difficult to sell.
If you eliminate extreme cases, you will end up with a list of candidates for which making the “wrong” choice will have a negligible impact on your performance. Under these circumstances, you will be prepared to take advantage of the many benefits of ETFs.
Disclosure: Ben Kramer-Miller has no positions in the stocks and funds mentioned in this article.
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