SET Monthly Issue October 2012

| October 16, 2012

October 2012


After a massive 16% rally over the summer, the S&P 500 has been in consolidation mode the last month.

It’s certainly not the performance we were hoping for in the wake of QE3.  But it’s not entirely unexpected.

First off, it’s normal and even healthy for markets to go through periods of consolidation after big rallies.  And the 16% rally in the S&P certainly qualifies as a big one.

A month of consolidation after a three month rally is nothing to be concerned about. In fact, orderly pullbacks like this typically turn out to be great buying opportunities.

What’s more, keep in mind that traders, not long term investors, are responsible for the direction stock prices move from one day to the next.

They were the ones driving stocks higher when the S&P was in rally mode this summer.  And their lack of buying over the last month is what’s holding the market back right now.

Here’s the thing…

Many traders were long stocks in anticipation of QE3.  It was the future catalyst that they could point to as a reason to be long stocks.

As a result, stocks had a huge rally leading up to the

Fed’s announcement of QE3.  It’s also why the S&P’s high water mark came within a day of QE3 being announced.  As soon as QE3 was announced, traders who were long stocks in anticipation of QE3 locked in their gains.

Now traders are turning their attention to finding the markets next catalyst.  But the problem is they’re having a hard time finding one! And to make matter worse, there’s no shortage of problems.

Over the last month, weak economic data, expectations for weak 3rd quarter earnings, US Presidential elections, slowing growth in China, and the fiscal cliff of higher taxes and government spending cuts set to begin January 1st have kept traders from initiating new bullish bets.

But there’s a silver lining…

These problems are largely overblown.  And they’re all likely to be resolved in a way that’s bullish for stocks.

Put simply, the resolution of these problems will be the bullish catalysts traders have been searching for.  And it should lead to a strong rally into the end of the year.


An interesting thing is happening to hedge funds this year.  They’ve been caught on the wrong side of the market more often than not.

As a result, hedge funds are underperforming the S&P 500 so far this year.

Obviously, that doesn’t sit well with their high net worth clients that pay huge fees to the hedge funds to outperform the market.

Therefore, hedge funds are working feverishly to outperform the market over the last quarter.  So they’re reversing their bearish bets and throwing their lot with bulls.

This tidal wave of hedge fund money is flooding into the hottest areas of the market. And it should continue to push the best performing industries higher throughout the rest of the year.  And nothing has been hotter than biotech…

Macro/Economic Trend:  In The Sweet Spot

Biotech stocks are having a phenomenal year.  The industry’s strong performance has been led by a rush to find specialized niche products.

The companies developing drugs and treatments focused on treating life treating conditions, where the need is high enough to justify the price, is the sweet spot for huge stock gains.

This is a strong departure from the type of blockbuster drugs to treat problems like high cholesterol, high blood pressure, depression, and other widely diagnosed conditions that have driven stock performance in the past.

Today, treatments where the need is high are more likely to be approved by the FDA and the biotech company is allowed to charge more for it.

This shift from blockbuster drugs to specialized treatments has opened the door for many mid-sized biotech companies.  If they can produce one of the many treatments a bigger biotech or pharmaceutical company would love to get their hands on, then their stock is off to the races.

The biotech ETF I believe will benefit the most is the First Trust NYSE Arca Biotechnology Index Fund (FBT).

Fundamentals:  A closer look at FBT

FBT is an equal dollar weighted index.  It puts 5% of its assets into 20 different biotech stocks.  The holdings are rebalanced on a quarterly basis.

The ETF’s an equal dollar weighted index.  This method puts a bigger emphasis on small and medium sized companies than a market cap weighted index does.  And those are the ones who should benefit the most from M&A.

The expense ratio is 0.6%.

Currently, the top five holdings and percentage weight for FBT are –

Company Name Ticker % Weight
Gilead Sciences GILD 6.32%
Regeneron Pharmaceuticals REGN 6.13%
Illumina ILMN 5.91%
Celgene Corporation CELG 5.83%
Nektar Therapeutics NKTR 5.67%

Technicals:  The charts lead the way

This chart of FBT is worth a thousand words…


As you can see, FBT has soared higher over the last few months.  In fact, it’s up about 38% so far this year.  And it’s established a strong uptrend with a series of higher highs and higher lows.

Right now, FBT’s in the process of pulling back from the recent high.  But it should find support, as it has a number of times before, at the uptrend (green line).

As I’m fond of saying, the trend is our friend.  And this bullish uptrend is showing no signs of slowing down.

Trade Alert

Buy:  First Trust NYSE Arca Biotechnology Index Fund (FBT) up to $47.00
Recent Price:  $45.37
Price Target:  $53.00
Stop Loss:  $42.00

Remember:  Some of you probably recognize FBT from trades we’ve done before. This ETF is my preferred way to play the biotech industry.  Last time I recommended FBT we captured a 33% gain in a matter of just a few weeks.  And while I don’t see quite as much upside this time (closer to 15%), I think it could happen just as quickly. Grab your shares of FBT now.


Real Estate Investment Trusts, or REITs, have delivered solid gains over the past few years.

In fact, we recently captured a 33% profit on iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) in July.

Our timing couldn’t have been better.  REZ has fallen from $50.24 when we sold it to around $47.00 today.

But the selloff seems a bit overdone.  And the same strong fundamentals should send residential REITs on another surge higher to finish the year.

Macro/Economic Trend:  Rents are still moving higher.

As you know, in the wake of the 2008 financial crisis, lending for new multi-family commercial real estate projects dried up.  And without new construction to replace older building, we quickly saw a demand for rental units outpace supply.

As a result, vacancy rates plunged and average monthly rents for an apartment have soared.

A recent report from real-estate research firm Reis said, vacancy rates declined to 4.6% during the third quarter and rents increased 0.8% in the third quarter to $1,090.

Some investors were quick to notice the rate of rent increases slowed from 1.1% in the second quarter.  And they simply pulled the plug on their investment in residential REITs.

But here’s the thing… I think rents suffered from the same slowdown as we saw in the overall economy last quarter.  And we should see rents begin to increase again more rapidly this quarter.

Don’t forget, there’s a huge demographic of former homeowners that are now renters. And they have little hope of saving enough money or qualifying for a mortgage loan. So, they’re going to be renters for a long time.

And there’s still a large chunk of 18-24 year olds living at home with mom and dad.  If the economy improves enough to spur an increase in employment, we’ll likely see these kids finally leave home and fuel more demand for rentals.

The bottom line is we’re still a long way from the end of the road for multi-family REITs.  And the recent pullback in iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) should be a great buying opportunity.

Fundamentals:  A closer look at REZ

REZ holds 34 residential REITs.  The REITs specialize primarily in multi-family housing, long-term care facilities, and self-storage complexes.

The expense ratio is 0.48%.  And the dividend yield is 3.28%.

The top five holdings and percentage weight for REZ are –

Company Name Ticker % Weight
HCP HCP 10.15%
Ventas VTR 9.83%
Public Storage PSA 9.10%
Equity Residential EQR 8.77%
Avalonbay Communities AVB 6.70%

Technicals:  The charts lead the way

REZ has been in an uptrend for most of its life.

The ETF came into existence October of 2008.  And after reaching a low of around $15 in March of 2009, it has gone nearly straight up ever since.

And we captured a sizeable 33% profit by holding it from January of 2011 through July.

As you can see in the chart below, REZ has recently pulled back from the highs where we took our profits.  In fact, REZ has fallen 6.5% from its 52-week high.

But it’s fallen back to a dual layer of support from a prior resistance level around $47 and the 200-day moving average.  (I didn’t include the 200-day on the chart because’s chart of REZ has it in the wrong place.)


This looks like a great opportunity to get back into REZ before it resumes its uptrend.

Trade Alert

Buy:  iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) up to $48.25
Recent Price:  $47.41
Price Target:  $55.00
Stop Loss:  $45.00

Remember:  A strong macroeconomic trend has fueled a large gain in REZ. And that trend isn’t coming to an end anytime soon. The recent pullback looks like a good low risk, high reward entry point. Grab you shares of REZ.


Consumer Discretionary (-1.7%)

Consumer discretionary stocks are on the upswing as 3rd quarter earnings season gets under way.  The report on US retail sales earlier this week highlighted a strong consumer base.  People are spending more money on everything gasoline to furniture.

Our SPDR S&P Retail Fund (XRT) is holding well as we move into earnings season.  I’m expecting a strong quarter for retailers.  Emerging market growth for consumer items has remained strong and companies have been buying back stock that should improve EPS performance.  Continue holding XRT for bigger gains.

The SPDR S&P Homebuilder ETF (XHB) also held up extremely well over the last month.  And for good reason… the long awaited housing recovery is finally here.  We’re up nearly 18% from when we recommended XHB.  And there’s still plenty of upside as homebuilders ramp up to full speed.  Continue holding for bigger gains.

Consumer Staples (+0.6%)

Consumer staples joined the other defensive sectors as the only three sectors to post gains last month.  It was a solid month but I’m expecting much bigger things from cyclical stocks in the weeks and months ahead.

Energy (-4.8%)

Energy stocks are expected to have some of the weakest earnings in the 3rd quarter. The current estimate pegs them at a year-over-year decline of 18.6%!  That’s an ugly number any way you slice it!

However, with expectations already so low, even a less bad number could send energy stocks soaring.

Our SPDR S&P Oil & Gas Equipment & Services ETF (XES) has had a bumpy ride so far.  After being up as much as 8%, we’ve seen those gains evaporate as the markets consolidated over the last few weeks.  But as I mentioned earlier, expectations have already fallen so low we could see a modest improvement in earnings spur a big rally in XES.  Buy these shares up to $36.00.

The rally in our First Trust ISE Revere Natural Gas Index Fund (FCG) has taken a breather.  But the future for this ETF is bright!  Natural gas prices have nearly doubled from the April lows.  And those higher prices will translate into positive earnings momentum in 2013.

The ALPS Alerian MLP ETF (AMLP) hit a new high of $16.87 this month.  That’s good enough for a gain of more than 10%.  But don’t forget, the energy infrastructure boom has only just begun.  Continue holding AMLP for further gains.

Financials (-1.8%)

Low mortgage rates and a modest recovery in the housing market are fueling a resurgence of mortgage loan profits at the largest banks.  The improving lending should also help REITs.  In fact, we’re jumping back into the iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) that we recently sold for a 33% gain… see Trade Alert 2 for more details.

Healthcare (+3.1%)

Healthcare was the best performing sector over the last month with a 3.1% gain.  And it should continue to do well as 3rd quarter earnings hit the wire.

Our PowerShares S&P SmallCap HealthCare Portfolio (PSCH) is in a solid uptrend. But as a small cap focused ETF, it has been more volatile than the larger healthcare stocks.  But that shouldn’t prevent it from posting solid gains in the weeks and months ahead.  Continue holding PSCH for bigger gains ahead.

The iShare Dow Jones U.S. Pharmaceuticals Index Fund (IHE) is back on the right track after a slow start.  I’m expecting massive market share gains by generic drug makers to fuel big gains in this ETF.  Continue holding for bigger gains.

Industrials (-2.8%)

Industrial stocks limped lower last month.  But the pullback was in line with the broad market pullback. So it’s nothing to be concerned about.

Earnings growth for the sector is expected to slow to around 4.5%.  But stronger than expected sales of building materials could drive earnings beyond this conservative estimate.

The Market Vectors Agribusiness ETF (MOO) has fallen back a bit from its recent high.  But the uptrend is still in place and fundamentals are still strong.  That’s good enough for me… continue holding for bigger gains.

Technology (-4.8%)

Tech stocks have taken a step back ahead of several key earnings reports over the next few weeks.  Investors are once again pondering how much of an impact the slowdown in Europe and China will have on business tech spending.  We’re also in a bit of a dead period for PC sales ahead the Windows 8 operating system release.

This has investors concerned that the boost the sector gets from the release of the new iPhone 5 won’t be enough to fuel even modest earnings growth.

Our iShares S&P NA Technology-Software Index Fund (IGV) have pulled back to support around $25 to $26.  If tech earnings come in even modestly better than expected, we could see IGV explode to the upside.  Continue holding IGV…

Our First Trust Internet Index Fund (FDN) hasn’t done much since we recommended it last month.  But I’m expecting big things as internet companies begin to monetize mobile internet.  Buy your shares up to $39.50.

Materials (-4.4%)

Materials stocks are expected to have an awful quarter.  In fact, the 18% year-over-year decline in EPS is the worst performance of any sector.

But here’s the thing.  These expectations were already baked into the cake when we recommended iShares Dow Jones US Basic Materials Sector Index Fund (IYM) a few months ago.  In fact, at a recent price of $67.57, the ETF is up modestly from where we recommended it.  If materials stocks have a quarter that’s a little less bad than the 18% decline that’s expected, we could get a nice rally in the sector.  Grab your shares up to $70.00.

Utilities (+0.3%)

Utilities had a good month.  The defensive sector posted a modest gain while the majority of the market was taking a step backward.  But at this point, I see more upside in cyclical sectors.  They should benefit more from an uptick in economic growth.

Portfolio Changes

  • This month we’re buying FBT and REZ.


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