How To Profit In A Range Bound Market

• By Simon Maierhofer
• On 12:06 pm EDT, Thursday April 30, 2009

Let's face it; range bound markets are a pain. Much like watching a slow movie, non-directional markets grind and test the patience of investors. But not all is bad. With a half glass full attitude, investors can draw valuable benefits and even make money from what otherwise would be lost time.

Once you are use to the thrill of Magic Mountain's roller coasters experience, it is tough to settle for Disney's Tea Cup ride.

The events over the past few years have turned many of us into financial news junkies - we have to know what's going on. It has gotten harder, though lately to find our daily fix of sensational news. De facto, for over a month now, stocks have essentially been range bound.

Since March23rd (with the exception of March 30th), the Dow Jones (NYSEArca: DIA - News) has been stuck between 7,800 and 8,100. The S&P 500 (NYSEArca: SPY - News) has been confined to the 820 to 870 range.

The tech-heavy Nasdaq (Nasdaq: QQQQ - News) and Technology Select Sector SPDRs (NYSEArca: XLK - News) have fared better as they've been able to actually generate and hold on to some of their gains.

Just like having to watch a slow movie, being stuck in range bound trading can be frustrating. It may not be obvious, but even a seemingly unmotivated stock market serves a purpose. During a similar range bound period (11-28-2008 to 1-6-2009), the ETF Profit Strategy Newsletter observed the following:

'Range-bound trading, as we've seen over the past several weeks, grinds and tests the patience of investors. More importantly, it gives the stock market a chance to calm extreme levels of investors' pessimism. Conversely, optimistic sentiment, which should be more visible above Dow 9,000, gives way to further declines. This should draw the Dow below 6,700.'

This time around, the non-directional market is not needed to digest the extreme pessimistic sentiment as seen at the March lows. The 30% rally from the lows erased a fair portion of investor pessimism. The market has simply been digesting the biggest jump since the end of the Great Depression.

To many, this powerful rally was no surprise. In a special Trend Change Alert (sent on March 2nd) the ETF Profit Strategy Newsletter recommended to sell short ETFs and buy long ETFs due to, 'a multi-months rally, the biggest since the October 2007 all-time highs, will lift the indexes by some 30%.'

Ready to compete

One thing is for certain, this 'lull asleep' type market won't last forever (more about that later). But while it lasts, it gives investors a chance to get their ducks in a row and prepare for the next major move.

Just as athletes train and prepare for an upcoming competition, investors need to be ready to compete when stocks awaken from their dormant state.

Review your current investment strategy. What is working and what is not. If you've been fully invested in a diversified portfolio over the past months and years, chances are that your portfolio mirrored the performance of the broad stock market. This has obviously not been working. Is it too late to change strategies?

Resisting the urge to chase performance

The first inclination for many is to dump what hasn't been working and replace it with what has been working. This however leaves the door open for performance chasing which backfires most of the time.

Gold and certain bonds stand out as asset classes that kept losses to a minimum. The iShares Barclays Aggregate Bond ETF (NYSEArca: AGG - News) gained 7.90% in 2008 and lost 1.47% year-to-date.

ETFs tracking the price of gold, such as the SPDR Gold Shares (NYSEArca: GLD - News) and iShares COMEX Gold Trust (NYSEArca: IAU - News) gained some 5% in 2008 but have been flat in 2009. News in favor of propelling gold to all-time highs couldn't be better; nevertheless, the precious metal has been stagnant. Gold's lackluster performance must truly be a source of frustration for gold bugs. A related article, discusses whether a 30% drop is next for gold ETFs.

The allure of high yields

Dividend yields have been on the rise ever since stocks began to fall. Double digit corporate bond yields seem like a no-brainer. The iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG - News) yields a whopping 11.56%. Only 47% of HYG's holdings have a financial rating of B+ or better. If you think B+ is good, remember that AIG was rated A++by Moody's and S&P less than two years ago.

The PowerShares Financial Preferred Portfolio (NYSEArca: PGF - News), iShares S&P U.S. Preferred Stock ETF (NYSEArca: PFF - News) and iShares FTSE NAREIT Mortgage REIT (NYSEArca: REM - News) come with a yield ranging between 12% and 20%. Eventually, what all moms and dads tell their children will come true, if it sounds too good to be true, it is too good to be true.

A compelling value?

Back in December, Morningstar claimed that the Dow Jones is undervalued by at least 30%. This leads to the conclusion that the Dow would be fairly valued around 12,000. In December, the Dow traded around 9,000. Today, the Dow is hovering around 8,000. According to Morningstar's train of thought the Dow has nowhere to go but up.

How do you determine fair value? There are different approaches, some of which obviously miss the mark of accuracy.

The U.S. stock market as a whole currently pays a dividend of about 3.5% with a P/E ratio of 10. Both measures have reached extreme levels compared to data over the past two decades. Compared to the expansion seen in the 1940s, 1950s, and 1960s though, today's levels are nothing special.

Interestingly, the fundamental which fueled the 1987 to 2008 bull market were much weaker compared to the 1940 - 1960 period. The United States, once a manufacturing powerhouse, morphed into a finance powerhouse. Profits were extracted and manipulated by easy money and easy credit. The outcome of any analysis will be flawed if recent data is analyzed out of context with true historic data.

A study of P/E ratios and dividend yields going back to the early 20th century shows that the stock market will not bottom until rock-bottom yields and ratios are reached. Just as water does not thaw until the temperature goes above 32 degrees Fahrenheit, the stock market won't bottom until dividend yields and P/E ratios reach levels of prior major historic market bottoms.

But, back to profiting in a range bound market. After a digestive period (validated by the 30% bounce) this rally should continue to lift the market higher.

Usually a market correction is needed to digest an overbought condition. The market however seems to be telling us that the teeter-totter action over the past few weeks has accomplished the same thing. Today's break above the upper range of the recent channel indicates that the next leg up is underway. High beta ETFs are one way to take advantage of this rally.

High beta ETFs are ETFs that rise and fall faster than the overall market. They include niche markets such as the PowerShares WilderHill Clean Energy ETF (NYSEArca: PBW - News), or financial sector ETFs such as the Financial Select Sector SPDRs (NYSEArca: XLF - News).

Even more leverage can be attained via leveraged ETFs. ProShares and Direxion offer a suite of double and triple leveraged ETFs. The Direxion Daily Financial Bull 3x Shares (NYSEArca: FAS - News) combines the volatility of the financial sector with triple leverage for a truly potent mixture.

FAS should only be used by seasoned investors, and like all other ETFs, we recommend not to get to cozy with them as this rally will eventually exhaust itself and give room to the next leg down. Against popular belief, our trusted indicators show that the worst is still to come. The March issue of the ETF Profit Strategy Newsletter contains a detailed analysis of dividend yields, P/E ratios and other indicators, along with target levels for the ultimate market bottom.

Regardless of your investment style, the market's current 'ceasefire' can be used to formulate a strategy for the next 'battle.' Even though you may have lost the last battle, you can still 'win the war.'

Buzz up!