Page 1 Page 3 Page 4 Page 8 Page 9 Page 11 Page 13 Page 14 Market Commentary Style Allocation: DVY, QQQQ, IJJ Sector Allocation: FDN, GDX, IHE International Allocation: EWW, EWJ Commodity Allocation: IAU, DBA Currency Allocation: CYB Fixed Income Allocation: TIP, HYG Real Estate Allocation: ICF Market Commentary This is my last issue of the ETF Action newsletter. Going forward, I will provide investment advice via the recently launched ETF Profits premium service on TheStreet. We intend to continue to provide trading direction regarding our current model portfolio holdings, but I expect to close out many of these positions over the next month in order to focus on a more dynamic trading style. I look forward to being a part of this new product, and I hope that readers will continue to follow my advice on the new Web site. As I review the year-to-date results, the model portfolio has outperformed, thanks to some timely positions and a better mix of securities for current market conditions. Exposure to technology stocks via PowerShares QQQ (QQQQ) and First Trust Dow Jones Internet Index (FDN), as well as exposure to international markets and commodities, has provided a boost to returns. Holding bond and currency ETFs also reduced the volatility in the model portfolio during the market s summer correction. The model portfolio added another 2.34% last week, while the S&P 500 gained 3.66% over the same period. This is the first week in five that we have lost ground to the benchmark. Year to date, the S&P 500 continues to lag the model portfolio, which has gained 13.43% in 2010 vs. the 9.74% S&P 500 return. If the market typically gets it right, then there is a good chance that last Friday s employment report will either be revised upward or prove to be an aberration from the positive trend seen in other reports. Given the steady stream of improving data from other areas of the economy, the Bureau of Labor s report was surprisingly weak. Nevertheless, the market refused to relinquish any of its hard fought gains and is off to a fast start in early December. (Continued on the next page) PLEASE SEE IMPORTANT LEGAL DISCLAIMER ON LAST PAGE
Even though the entire report disappointed, the worst element of this important growth barometer was the payroll number. Nonfarm payrolls gained an anemic 39,000 last month, which was considerably less than both the 150,000 forecast and the revised 171,000 from the prior month s report. The private payroll component, which had been the silver lining for many months while the government laid off its census workers, also disappointed with only a 50,000 increase, which was less than one- third of the projected number. Furthermore, the unemployment rate moved up two ticks to 9.8%, putting it back to the highest level since May. Earlier in the week, initial jobless claims were also higher, but the holiday week is often volatile; the four-week average remains in a downward trend. The true silver lining of the report may be its effect on Washington policy makers. Not only will it help the Federal Reserve fend off its critics and allow it to execute further quantitative easing, the poor results may have spurred politicians to agree on the hotly debated extension of Bush-era tax credits. The theory seems to be that if investors can count on the Fed to follow through with its additional easing of monetary policy, as well as the current tax rates remaining in place -- even for small business owners who will do the bulk of the hiring --then they are likely to respond by bidding up share prices beyond their 2010 highs. Investors answered the call on Tuesday by pushing the S&P 500 and Nasdaq to new heights once a deal was struck on the tax package. Part of the reason the market remained resilient in the face of the somber employment news is that other data have provided evidence that the economy is on solid ground. The third-quarter gross domestic product (GDP) number was revised upward to an annualized 2.5%, with a stronger composition of growth in domestic demand and final sales. Recent manufacturing data have also been solid, helping to put fears of a double-dip recession to rest for the time being. The ISM manufacturing results remain in growth territory at 56.6, which is above the average dating back to 1948 for expansionary periods. Although poor employment results tend to weigh on the consumer s outlook, recent sentiment readings have been rising. Last week, the Conference Board consumer confidence index jumped to 54.1 in November from the prior month s 49.9 reading. The future expectations component improved the most, while respondents perceptions of the labor market had improved slightly. This week will bring us the preliminary reading for the University of Michigan Consumer Sentiment, which should extend October s gains. The November election results and early retail promotions probably boosted confidence. As always, please see below for updates on various components of the model portfolio and Watch Lists. 2
Style Allocation This category consists of broad funds that typically conform to the Morningstar Style Box (a tool that represents the characteristics of a security in a graphical format) definitions -- e.g., large-cap value, small-cap growth, etc. Portfolio Positions ishares Dow Jones Select Dividend Index (DVY) Target Allocation: 27% PowerShares QQQ (QQQQ) Target Allocation: 16% ishares S&P MidCap 400 Value Index (IJJ) Target Allocation: 12.5% IJJ: The outperformance of mid-cap stocks relative to the broader market that we saw in the first quarter is attempting to reassert itself once again. The bullish trend is supporting smalland mid-cap shares that can benefit from faster growth or corporate finance activities such as mergers and acquisitions. I will look for this trend to continue in 2011. Watch List WisdomTree Emerging Markets Small Cap Dividend (DGS) PowerShares FTSE RAFI US 1000 (PRF) ProShares UltraShort Russell2000 (TWM) WisdomTree DEFA Equity Income (DTH) 3
Sector Allocation This category consists of sector funds that provide targeted exposure to one or more industries. Portfolio Positions First Trust Dow Jones Internet Index Fund (FDN) Target Allocation: 5% Market Vectors Gold Miners ETF (GDX) Target Allocation: 5% ishares Dow Jones U.S. Pharmaceuticals Index Fund (IHE) Target Allocation: 2% GDX: Along with the precious metals (discussed below), mining shares have been performing very well of late. Over the past three months, Global X Silver Miners (SIL) has outperformed ishares Silver Trust (SLV) by about 10%, as shown by the chart of their relative prices below. Gold miners have also outperformed, but at a smaller rate. The recent pickup in GDX, however, is just a small bounce compared to the relative price level over the past few years. Gold is still trading about 40% higher per ounce than it was in March 2008, while GDX is trading about 14% higher. Since company earnings can increase faster than the price of gold, mining stocks will eventually gain much more than the metal if the current trend of low inflation and higher gold prices continues. In hockey, one skates to where the puck will be, not to where it is now. Similarly, many stock investors are looking at the miners as if gold is overpriced, when, in fact, it is the mining stocks that are underpriced; therefore, those stocks will likely trade higher in 2011. The one exception so far is the junior miner shares, which are tracked by the Market Vectors Junior Gold Miners (GDXJ). This ETF has outperformed ishares Gold Trust (IAU) by about 15%. Due to the small market capitalizations of many of these companies, in addition to the possibility of takeovers by larger producers, there is still much greater potential upside in the junior miner stocks. Whereas GDX should eventually see this level of outperformance over gold, GDXJ will continue to outpace GDX. Still, GDXJ can have violent reversals and will underperform whenever mining shares drop, giving investors an opportunity to add to their positions. (Continued on the next page) 4
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Watch List ishares Dow Jones U.S. Oil Equipment Index Fund (IEZ) ishares Dow Jones U.S. Healthcare Provider Index Fund (IHF) SPDR KBW Regional Banking (KRE) ishares Dow Jones U.S. Utilities Sector Index Fund (IDU) IEZ: Last week, I showed the outperformance of IEZ relative to the S&P 500. Here is a shorterterm view, which shows that IEZ outperformed SPDR S&P 500 (SPY) every single day during the past week. (Continued on the next page) 6
KRE: The regional bank ETF KRE, has recently exhibited its own outperformance. However, if we look at a chart going back to the financial crisis in 2008 and 2009, we can see that KRE is near its lows relative to the S&P 500. Financial stocks have had only slightly positive returns year to date, and this explains why the S&P 500 looks set to finish 2010 with a gain in the single digits. Financials make up 15.5% of the S&P 500, which is second only to technology names. 7
International Allocation This category consists of individual country or regional funds. Portfolio Positions ishares MSCI Mexico Investable Market Index (EWW) Target Allocation: 3% ishares MSCI Japan Index (EWJ) Target Allocation: 2.5% EWJ: The recent weakening of the yen has supported Japanese equities and EWJ s momentum has increased relative to other foreign ETFs. The Bank of Japan s monetary easing has also provided a boost. More important, however, has been the spurt in domestic demand thanks to government subsidies and the prospects for continuing export growth through a reacceleration of machine orders. Although the preliminary leading index for October fell more than a point to 97.2 this week (which is the fourth consecutive decline), I believe equities are on solid ground due to global growth and monetary easing. However, I will continue to watch for new developments that may cause a reversal in momentum. Watch List Claymore/AlphaShares China Small Cap Index ETF (HAO) Market Vectors Indonesia ETF (IDX) ishares MSCI Taiwan Index (EWT) ishares MSCI Chile Investable Market Index (ECH) SPDR S&P Emerging Europe (GUR) ProShares Short MSCI EAFE (EFZ) 8
Commodity Allocation This category consists of funds that seek to replicate movements in the commodities markets. Portfolio Positions ishares COMEX Gold Trust (IAU) Target Allocation: 7% PowerShares DB Agriculture Fund (DBA) Target Allocation: 2% IAU: Gold and silver remain in strong bull markets as the year approaches its end, and the potential head-and-shoulders pattern visible last week was negated by the rally over the past week. Currency markets are as fragile as ever, with fear on all sides. Europe is concerned about sovereign debt, the U.S. is conducting what many fear will be a highly inflationary, or at the least very destabilizing, monetary policy, and China looks poised to take strong action to slow its economy. What we are seeing in the precious metals market is more of a simmer than a boil, however, as many investors remain on the sidelines of these markets. If concerns prove to be overblown, there is considerable short-term downside risk in gold and silver, but neither will turn negative for the year. Since late August, IAU is sitting on a gain of more than 20%, while SLV is up more than 60%. On the other hand, crisis has been a friend to the metals. Whether there is inflation or deflation, if it is accompanied by crisis, then the metals have had much higher prices in store. (Continued on the next page) 9
Watch List PowerShares DB Base Metals Fund (DBB) ishares Silver Trust (SLV) ipath Dow Jones-UBS AIG Grains Subindex Total Return ETN (JJG) ipath Dow Jones-UBS AIG Agriculture Subindex Total Return ETN (JJA) SLV: Please see the paragraph above headed by IAU 10
Currency Allocation This category consists of funds that seek to provide exposure to specific foreign currencies or baskets of currencies. Portfolio Positions WisdomTree Dreyfus Chinese Yuan (CYB) Target Allocation: 2.0% CYB: Although the bout of U.S. dollar strength this fall has also weighed on the yuan, the longerterm case for appreciation remains intact. Data such as China s exports and purchasing managers index (PMI) sentiment have been resilient, leading to a tightening of monetary policy in November. This should allow government officials to support additional currency appreciation, which in turn can help to control inflation. Right now its 200-day moving average may offer solid support, but we cannot rule out further dollar strengthening as we approach year-end. Watch List PowerShares DB U.S. Dollar Index Bullish Fund (UUP) WisdomTree Dreyfus New Zealand Dollar Fund (BNZ) CurrencyShares Euro Trust (FXE) (Continued on the next page) 11
UUP: Last week, I wrote that the U.S. dollar could experience a short-term pullback from overbought conditions, and we got the pullback from the end of last week to the start of this week. Judging from the action in the past year, the odds are that if the dollar has entered into a bullish period against the euro, then the recent dollar selloff has ended or will end in the next couple of days, and the dollar is about to resume its upward march. Since the strength in the U.S. dollar is mainly coming from the euro, the aggressive play is still with ProShares Ultra Short Euro (EUO). 12
Fixed-Income Allocation This category consists of funds that provide current income or high-yield opportunities. Portfolio Positions ishares Barclays TIPS Bond (TIP) Target Allocation: 11% ishares iboxx $ High Yield Corporate Bond Fund (HYG) Target Allocation: 3% HYG: Although high-yield bonds benefited from another strong corporate earnings season and the broad equity rally, they also suffered in the November selloff. Nevertheless, the return of risk appetites in early December and the continued low default rates may be putting another floor under these securities in the near term. Watch List ishares Barclays 20+ Year Treasury Bond Fund (TLT) ishares Barclays 3-7 Year Treasury Bond Fund (IEI) ishares Barclays Intermediate Credit Bond Fund (CIU) 13
Real Estate Allocation This category consists of funds exposed to the domestic and global real-estate sectors. Portfolio Positions ishares Cohen & Steers Realty Majors Index Fund (ICF) Target Allocation: 2% ICF: Although the domestic real estate investment trust (REIT) industry remains solidly bullish, it remains to be seen whether it can return to outperforming the domestic stock market or global real estate. This is a traditionally weak season for residential real estate -- in particular, due to the difficulty in raising rents -- but I expect the low-growth economic environment and low interest rates to remain supportive of development. The low cost of funding will also support sporadic property acquisitions and merger activity. In the meantime, the global real estate picture may become mixed due to inflation and development controls in Hong Kong and China. Watch List ishares S&P Developed excluding-u.s. Property Index Fund (WPS) ishares FTSE NAREIT Residential Plus Capped Index Fund (REZ) 14
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