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5 ETFs Flashing Danger Signs

Sumit Roy

The U.S. stock market has come a long way since August. Since bottoming out at 1,867 on Aug. 24, the S&P 500 roared back to as high as 2,116 in November. Since then, it's been trending modestly lower, as traders weigh solid U.S. economic growth against a host of concerns related to overseas economies and the coming Fed rate hike. Still, stocks remain well above the year's lows.

As of Friday morning, the S&P 500 was trading at 2,030, a loss of 1.5% for the year. With only three weeks left in December, it's anyone's guess if 2015 will turn out to be an up or a down year.

S&P 500

The Fed rate decision and guidance next Wednesday will surely play a big part in deciding the fate of the market into year-end and beyond, but that's not the only thing to keep an eye on. A number of ETFs have recently been flashing warning signs that could be signaling troubles for the market ahead. Here are five ETFs to watch closely as we head into 2016:

iShares iBoxx $ High Yield Corporate Bond ETF (HYG)
A proxy for the high-yield bond market, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68) has been dropping steadily all year long. The latest leg lower in oil prices to under $36/barrel only adds to concerns that the energy-heavy junk bond market could face significant stress in the coming months.


HYG is down 11% for the year. The fund seems to hit new lows every day, and is now trading at its cheapest price since 2011, with no signs of a bottom in sight.

HYG

Bond guru Jeffrey Gundlach has warned that the plunge in high-yield bonds signals danger for financial markets and the economy, and that the Fed should heed the message by refraining from hiking interest rates.


For now, the Fed seems undeterred, with a rate hike next week extremely likely. That certainly won't help junk bonds. The only questions now are whether the slide continues and if the damage spills over into other areas of the financial markets.

Vanguard FTSE Emerging Markets ETF (VWO)
As one of the key contributors to the market volatility in August and early September, emerging markets are a big concern for investors. The Vanguard FTSE Emerging Markets ETF (VWO | C-88) hit a six-year low on Aug. 24 before rebounding along with the S&P 500.

But now VWO is quietly rolling over again and was last trading just above the August lows, down 20.7% year-to-date.

VWO

A notable slump in South African stocks, which represent 7.6% of VWO's portfolio, has been the biggest drag on emerging markets performance recently. If VWO takes another leg lower, that could reignite the same worries that sent the S&P 500 plunging in August.

iShares Russell 2000 (IWM) & SPDR S&P 400 (MDY)

While the large-cap S&P 500 rebounded significantly from its lows of August, the same can't be said for the small-cap iShares Russell 2000 (IWM | A-92) or the midcap SPDR S&P 400 (MDY | A-83).

IWM and MDY only recovered about half way to their highs on the recent rebound and are now quickly reversing course. The underperformance in these ETFs underscores how most of the equity market is doing much more poorly than the big indexes like the S&P 500 suggest.

IWM, MDY, SPY

In fact, according to a CNBC article published on Wednesday, were it not for the top 10 most valuable companies in the U.S., even the S&P 500 would be down much more this year. Those largest companies, which include mega-caps such as Google, Facebook and Amazon, are up 21.4% for the year as of Wednesday, compared with a loss of 2.6% for the other 490 stocks in the index.

Smaller companies, which are much more vulnerable to rising interest rates and are riskier in general, may be indicating underlying weakness in the stock market. If the mega-caps falter, the SPDR S&P 500 (SPY | A-98) could quickly join IWM and MDY at lower levels.

Energy Select SPDR (XLE)

The worst-performing sector by far this year, energy is down 22.9% in 2015. The Energy Select SPDR (XLE | A-91) fell 10% just in the first 11 days of December and looks poised to revisit its late-summer lows.

XLE

Like junk bonds, the driver of the latest downturn in XLE is the dip in oil to new six-year lows. If oil prices continue lower to $30―or even $20 as some analysts believe―XLE may fall off a cliff, dragging the broader market with it.


Fortunately (or unfortunately, depending how you look at it), the energy sector now only represents 6.5% of the S&P 500 based on market capitalization, down from 10.3% two years ago. That limits the damage to the rest of the market from declines in energy stocks.

However, if there's any contagion―in the junk bond market, for example―from energy's woes, the sector could have a disproportionate impact on broader indexes.

WisdomTree Chinese Yuan ETF (CYB)

One of the big events that set off volatility in markets late this summer was China's devaluation of its currency, the yuan. The nearly 4% devaluation over the course of a few days raised fears about currency wars, the health of China's economy and capital flight.

After the surprise move, China had to spend hundreds of billions of dollars (by selling Treasurys) to stabilize the currency as capital fled the country, anticipating further devaluations. That initially pushed the value of the yuan modestly higher, but it's quickly sinking again to last trade near 6.45 to the dollar.

Dollar-Yuan Exchange Rate (in the chart below, the dollar is rising against the yuan)

The WisdomTree Chinese Yuan ETF (CYB | C-56), which tracks the yuan, is likewise sinking. Any Fed rate hikes will only add pressure to the managed yuan exchange-rate, leading to potentially more capital flight and perhaps another devaluation.

The Chinese government has insisted that's not in the cards; nevertheless, the risk remains out there.

Contact Sumit Roy at sroy@etf.com.

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