11 ETFs For The Dow 6,500 Portfolio

• By Simon Maierhofer
• On 11:44 am EST, Tuesday February 3, 2009

Dow 6,500 sounds a bit over the edge, but before you dismiss the idea, did you think it was possible for the Dow (AMEX: DIA - News) to tumble 43% in less than a year? Did you expect the Nasdaq (Nasdaq: QQQQ - News) to drop 80% after its 1999 peak? 

Stock market declines in excess of 30 % are a rare occasion. When they do happen, they usually mark a good buying opportunity. You could say that over the past half century we've been conditioned to believe that any significant drop in the stock market is an opportune time to buy. True to form, even investment stallions like Warren Buffett have splurged on stock shopping sprees recently.

However, this bear market dwarfs previous bears in terms of scope and downside potential. Buying into declining values is truly like catching the proverbial falling knife. Since Warren Buffett decided to take a major stake in Goldman Sachs on September 23rd, 2008, the S&P 500 (AMEX: SPY - News) has dropped an additional 30%. That's bad, but not as bad as the 55% drop seen in the Financial Select Sector SPDRs (NYSEArca: XLF - News).

Even with Warren Buffett's long-term investment horizon, a 50% drop is no peanuts.  

Dow 6,500...Why?

As of today, the November 21st, 2008 lows remain intact. Nonetheless the market's behavior is reminiscent of pre-November 21st moves and indicative of new lows to come. Weeks before the November lows we pointed out via our ETF Profit Strategy Newsletter that the Dow will break below 7,500 (it did) which was to be followed by a rally going into November/December (it did).

On December 12th we wrote: 'Optimistic sentiment, which should be more visible above Dow 9,000, gives way to further declines. These should draw the indexes close to or below their November 21st lows of 7,445 for the Dow and 740 for the S&P.'

On January 6th, we issued a sell signal. Extreme investor sentiment (optimism) was one of the many factors that lead us to call a top on January 6th. Why is this important?

Extreme optimism is followed by equally extreme corrections. Case in point; pervasive optimism also overshadowed the market's October 2007 highs. We know what happened since.

Another parallel between today and the pre-November lows is the financial sector's break to new lows. Financials dropped to new lows on November 12th, at that time we wrote: 'The Financial Select Sector SPDRs actually closed beneath its October 27th low. This should serve as a nice foundation for the next push down. Once the Dow breaks beneath 7,500, it's time to lighten up on the short ETFs.'

Once again, on January 20th, financials took out their previous (November 21st) lows. Based on the extreme optimism seen on January 6th, the indexes should eventually break well below their previous lows.

The Dow 6,500 ETF portfolio

There are different options to grind out the bear. Highly conservative ETFs simply maintain your purchasing power, others will turn the bear market into profits while some will soften the blow of the bear as they fall and rise with the tide, but to a lesser degree.

How to find safety in a bear market  

A 20% drop in corporate bond ETFs has driven investors to government Treasuries. Short term Treasuries such as the iShares Barclays Short Treasury Bond ETF (NYSEArca: SHV - News) maintain a steady price with a low yield.

Long term Treasuries such as the iShares Barclays 20+ Year Treasury Bond ETF (NYSEArca: TLT - News) offer a higher yield in exchange for fluctuations caused by interest rate changes and supply and demand forces.

30 year Treasuries peaked on December 31st, the same day we recommended the ProShares UltraShort 20+ Treasury ETF (NYSEArca: TBT - News). As prices have retreated, we highlighted the future prospects of TLT in the January 28th issue of our newsletter.

TD Ameritrade's TDX In-Target Independence Fund (NYSEArca: TDX - News) was 2008's best performing target date ETF. With a 70% allocation to U.S. Treasuries and despite a 19% allocation to financials, TDX posted a negative return of only 1.99%. 

How to soften the blow of the bear market 

High beta ETFs tend to fall harder and faster than the overall market while low beta ETFs can soften the blow. A beta of 1 indicates volatility equal to the S&P 500. Even though low beta ETFs will rise and fall with the tide, they tend to fall to a lesser degree. 

Such low beta ETFs are often considered defensive sectors. Defensive sectors include consumer staples, health care and utilities. To illustrate; while the S&P ended 2008 down 38.49%, the Consumer Staples Select Sector SPDRs (NYSEArca: XLP - News) did comparatively well with a 14.98% loss. The health case sector shed 23.15% while utilities lost 29.09%.

Recent losses emphasized the cushioning effect of dividend yields. Yield hungry investors however are caught between a rock and a hard place. The best performing sectors pay the lowest yields while the highest yields spring from the worst performing sectors. High yields from the financial and real estate sector were more than offset by steep losses.

The SPDR S&P Dividend ETF (NYSEArca: SDY - News) offers a happy medium. The 23.02% 2008 loss was sweetened by a current dividend yield of 6.45%. Due to its 18.3% allocation to financials, SDY has a beta of 0.65. The iShares Dow Jones Select Dividend's (NYSEArca: DVY - News) 27.55% exposure to financials results in a beta of 0.73.

How to profit in a bear market

Past bear markets left some breathing room for one or two pockets of strength. Thus the phrase 'there is always a bull market somewhere'. This bear market has suffocated all pockets of strength. The only bull market to be found is in short ETFs and Treasuries.

Starting in the middle of 2007 we recommended short ETFs such as the UltraShort Financial ProShares (NYSEarca: SKF - News) and UltraShort Real Estate ProShares (NYSEArca: SRS - News). Above we discussed sectors with the tendency to soften the blow (consumer staples, health care and utilities).

When shorting individual sectors, it is smart to bet on sectors with the propensity to fall harder and faster than the market such as financials, real estate and the UltraShort Consumer Services ProShares (NYSEArca: SCC - News).

If you don't feel comfortable shorting individual sectors, you may use broad market short ETFs such as the UltraShort S&P 500 ProShares (NYSEArca: SDS - News) or UltraShort Dow 30 ProShares (NYSEArca: DXD - News).

Just as taking precautions when working with power tools, it pays to be completely familiar with the make-up of short ETFs. Short ETFs have certain quirks affecting their performance (read related article 'Short ETFs - 3 Flaws You Should Know).

Depending on your investment horizon and philosophy, you may choose to implement any one or all of the above strategies. Just like a hurricane ready to hit the shore, the stock market's path cannot be altered. You however, can stay put and take your chances or prepare for what's coming.

What is coming? The next few months will be marked by extremes. Like scorching heat followed by freezing cold, the stock market will see a decline to new lows and the onset of the biggest rally since the October 2007 high. Is your portfolio prepared for such extreme conditions?

In times like these, an investment in knowledge always pays the best dividends. A detailed road map of the market's short, mid and long term direction along with detailed target levels is available via the ETF Profit Strategy Newsletter.

Buzz up!