ETF Periscope: Is VIX a Fix for What Ails You?

"We cannot solve our problems with the same thinking we used when we created them." ~Albert Einstein

A whole lot of commotion, but not so much motion. It all depends on your perspective.

If you look at the past week's market action, there was certainly something for everybody. The Dow Jones Industrial Average had its second down week in a row, ending at 10,213. That's a 500-point smack down in the course of two weeks. The benchmark S&P 500 index, as per usual, did its correlation dance, ending at 1,071, down a hefty 50 points over the same period, taking out the psychologically important 1100 mark along the way. Crude-oil futures declined to a six-week low on Friday, with September delivery down 2.6% on the week. Following a 7% loss just one week earlier, it was quite the rude correction. Even Treasuries entered the fray, with short-term yields hitting a record low on Friday, indicating a high degree of doubt as to the sustainability of the current recovery.

That sort of takes care of the Bears. How about the Bulls?

Well, gold did its part, with the lustrous metal gaining 1% on the week, on top of its 1.6% gain the week previous. The U.S. dollar didn't do badly either, rising against most major currencies in response to all the not-so-hot economic data. And a few stocks spiked sharply in reaction to proposed mergers, notably Potash Corp. (POT) and McAfee (MFE).

But if you take a step back from the last week or two, a broader look at the overall summer market action might surprise you. In spite of all the angst over negative economic reports, the giddiness over good earnings in general, and the negative numbers of the employment figures, we find ourselves pretty much where we started. The S&P 500 is down about 50 points since school let out, with the Dow off a notch below 200 points. These are not big numbers in terms of overall percentage.

If you were a fairly diversified investor who went away for summer holiday and didn't read the papers during your vacation, you'd probably be OK with coming back to no major gains, and maybe no real losses. So you could say you didn't miss much, and everything was essentially as it was before.

You could say it. But you'd be wrong. Here's why: Sentiment.

In July, consumer sentiment crashed and burned, hitting the lowest levels in about a year, according to the highly regarded Reuters/University of Michigan "UMich" index. Although the levels edged up slightly for August, they are seen as remaining deep in depressed territory. One of the key reasons is certainly reflected in the past week's initial jobless claims report from the Labor Dept. Claims rose 12,000 to 500,000, the highest level since November 14, 2009. This is a scary stat, and it's been trumpeted long and loud, as it probably should be.

Sentiment is a function of perception. The saying "No news is good news" can take on a different meaning, as in "Whatever the news is, it's no good." Big difference. And right now, the skew on the noise that comes out of the financial and popular press seems to be leaning to the negative side, if you go by short-term market reactions.

So with summer winding downwards towards its annual conclusion, there seems to be a certain level of apprehension among the pundit class, in regard to September's predicted market action. Fear may be in line to trump greed, but of course, that remains to be seen.

In the meantime, it may be worth considering adjusting your portfolio by adding a little insurance to the mix.

One idea of possible interest may be to utilize an ETN (exchange-traded note) that attempts to track the VIX, a popular measure of the implied volatility of the S&P 500 Index options. The VIX is often referred to as "the fear index," and if proof was needed that it earns its name, just look at the fact that it shot up a total of over 60% on the day of, and the day after, the infamous "flashcrash" of May 6th.

Why trade the VIX? Well, if the market takes a fast hit, you're potentially positioned for both a big bang for the buck and a way to turn even the sharpest market dive into a profitable moment.

If you trade futures, you can trade the VIX directly. However, for those who may seek an easier way to use this tool, you are in luck. Two ETNs that attempt to track the VIX are the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and Mid-Term Futures ETN (VXZ). Just don't expect them to track the VIX exactly. They don't, for a number of reasons that I'll get into in a future column. However, they do strongly correlate to the VIX, and therefore can serve effectively as a downside counter-weight to a long-leaning portfolio. Buying some out-of-the-money puts, a few months out, can be a cost-effective way to hedge your bets.

So is the VIX fix a fit for you? There may be a certain "fear" involved in what might be entailed to get up to speed on the subject. But fear not. If the markets take a swan dive in September, you'll be feeling pretty fearless, if you take the time now to bone up on a tool to handle the downside.

What the Periscope Sees

Each week, ETF Periscope scans Sabrient's current SectorCast-ETF Rankings in search of a few good plays on both the upside and the downside. This week, circling the Bull Ring, a pair of ETFs shows promise.

First off, we find QTEC (First Trust NASDAQ-100 Technology Sector Index Fund) within the top 10% of the Rankings. It is an equity fund which invests in stocks of companies operating in the Technology Sector and seeks to replicate the NASDAQ-100 Technology Sector Index by investing in stocks of companies listed in this Index in proportion to their weighting in the Index.

Looking at QTEC's chart, we see this ETF rests just below its 50-day and 200-day moving averages. A pattern of consolidation has emerged over the past week, and a small nudge upward could change both moving averages from resistance into support.

Another Bullish choice, this one within the top 5% of the rankings, is KBE (SPDR KBW Bank ETF). This exchange-traded fund invests in stocks of companies operating in the Banking Industry, including national money center banks and regional banking institutions. The fund replicates the KBW Bank Index (Ticker: BKX) by investing in the companies of that Index in approximately the same proportion and, before expenses, seeks to closely match the returns and characteristics of that Index.

A glance at KBE's chart reveals that it ended the week with a bounce off the same low point that it has touched on three times since February. It is well below both its 50-day and 200-day MA, which is converging at $24, but if the triple bottom turns out to be support yet again, it could serve as a springboard back towards the MA convergence point.

Choosing from the lower rungs of SectorCast-ETF Rankings, about two-thirds of the way down is IWP (iShares Russell Midcap Growth Index Fund), an exchange-traded equity index fund launched and managed by Barclays Global Fund Advisors. The fund invests in stocks of companies listed on the Russell Midcap Growth Index in proportion to their weightings in the index. The Russell Midcap Growth Index measures the performance of the mid-cap growth segment of the U.S. equity universe. The fund seeks to replicate the performance of Russell Midcap Growth Index.

I have found that IWP serves as a reasonable proxy for the overall markets, and it remains as a valid choice for the purpose of insurance against a downturn. You can buy slightly out-of-the-money put options a few months out, or short the ETF itself. Exactly how much downside "insurance" you choose to secure is a question for you to decide, reflecting your overall market bias as well as your risk-management strategies.

ETF Periscope

Full disclosure: The author does not personally hold any of the ETFs mentioned in this week's "What the Periscope Sees."

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.

The Process

For myself, as always, I look to Sabrient's SectorCast-ETF Rankings for some effective insight. The Rankings consist of over 340 ETFs (exchange-traded funds) that are ranked and scored via sixteen of Sabrient's proprietary analytics, that, when taken as a whole, offer a forward-looking take on the markets.

My process in selecting from among the SectorCast-ETF Rankings includes scanning the top 10-15% of the current list, which is updated three times weekly. I'll limit my choices to one ETF per sector, in an effort to achieve a healthy level of diversification.

Among the analytics that I pay particular attention to is what Sabrient terms "Bull Score" and "Bear Score." The Bull Score offers a "technical" measure of how underlying stocks performed on "up days" in the broader market during the last two month's action. The higher an ETF's Bull Score, the better it has performed on recent up days in the market. The flipside analytical, Bear Score, indicates the reverse. The higher an ETF's Bear Score, the better it has performed on recent "down days" in the market. A high Bear Score implies a "defensive" ETF.

For me, the Bull Score and Bear Score are among the tools that I incorporate into the overall hedging equation. My ultimate goal is to craft a hedged, lower-risk portfolio that protects against the markets inevitable gyrations while continuing to allow for upside potential.

Next, I'll look at the ETF's chart, seeking divine inspiration, or, failing that, at least a high level of technical confirmation via support and resistance levels, simple moving averages, etc. Finally, I'll check to see if the ETF offers options, which I frequently use in place of buying shares in the ETF itself.

In selecting ETFs to cover the short side of my portfolio, I'll flip the process, scanning the bottom 10-15% of the Rankings and adapting the Bull Score/Bear Score analytic as appropriate.