Best ETF Strategies For The Fourth Quarter

With a recovering economy, still accommodative monetary policy and better-than expected corporate earnings, US stocks have continued their slow upward march this year. The Fed’s latest FOMC statement and the Chairwoman’s press conference somewhat allayed investor concerns over an earlier-than-expected rate hike. Now, barring any unexpected major geopolitical flare-up, stocks seem well positioned to continue their positive momentum in the last quarter of this year.

The Fed is still your friend

The Fed will end its asset purchase program in October this year as the economy has been picking up but they will not be in a hurry to raise rates. Nevertheless, they made it clear that the course of the monetary policy will be determined by their assessment of the economy.
Janet Yellen emphasized during her press conference that “the Fed will move sooner if its progress is achieved sooner than expected”.

Can the Bull market continue its run?

Per WSJ, Dow Jones has now run without a correction (more than 10% drop) since November 2011— the fourth longest of such runs since 1929.  The longest one—that started in January 1991 lasted through October 1997—1,705 trading days. In the current favorable environment, stocks may still continue to add to their gains but the further we go, the higher the risks of a pull-back.

The S&P 500 index has returned 9.7% this year, after a whopping 32.3% return in 2013. Since stocks still look attractive compared to most other asset classes, they may remain in favor.
 
Further increase in interest rates—in particular the initial phase of rise from very low levels—is actually good for stocks. Rising rates are bad for stocks only when the central bank raises them to combat inflation, which is not going to be the case anytime in the near future.
 
Will we finally see the “great rotation”?

The beginning of the year 2013 saw a lot of talk about the “great rotation” from bonds to stocks. And while there was a lot of money coming into equities last year, that money did not come out of bonds. After a brief period of stress in 2013 due to “taper-tantrum”, bonds have remained in favor for the last one year or so, as interest rates plunged lower while the Fed remained on course to wind down asset purchases.

Even though the Fed decide to retain the phrase “for a considerable time” in the latest FOMC statement, the market saw a slightly hawkish tone in their interest rate projections, sending the two year treasury yield to a level not seen in three years. On the other hand, longer-term treasury yields did not change much, thanks mainly to low inflationary concerns.

While short term bonds look particularly vulnerable to any signals of increase in rates, the broader bonds space may also see elevated stress as interest rates have to go up eventually. Junk bonds look especially risky as of now, as their spread over treasuries is still quite low.

iShares iBoxx $ High Yield Corporate Bond (ARCA:HYG) has been one of the top asset losers year-to-date. During the week ended September 17, high yield bond ETF saw a cumulative outflow of $3.2 billion, their largest outflow in six weeks, which reflected nervousness in the junk bond market after FOMC.

Euro and yen to weaken further, lifting stocks in those regions

Euro-zone economic data has been underwhelming, which led the ECB to announce new measures to stimulate the economy. After the surprise move, European stocks surged to their six-year highs while the currency sank. With the Fed winding down its QE and the ECB continuing on its easing path and possibly starting a full-fledged QE (purchase of government bonds) sometime in the coming months, money is likely to flow into European equities. 

Recent signs of further weakness in the Japanese economy greatly increase the odds for additional monetary and fiscal stimulus. As a result, yen has weakened to a six-year low against the dollar.

Thanks mainly to a weaker yen, which is good for export focused Japanese companies, the Nikkei stock index rose to its highest level since November 2007.  Further proposed reforms of the Japanese pension fund—the world’s largest—should result in more inflows into Japanese equities.

WisdomTree Japan Hedged Equity Fund (NYSE:DXJ) and Europe Hedged Equity Fund (NYSE:HEDJ)--that provide exposure to stocks while hedging the currency risk—are excellent ways of playing this trend.

Top Sectors/Styles for the fourth quarter

For the last quarter of this year, I like Technology, Healthcare and Energy sectors. A pick-up in the global macroeconomic environment and business spending will benefit the Technology sector.  

Rising geopolitical stress had pushed energy prices up this year, resulting in energy stocks’ outperformance earlier this year and while the prices have softened of late, the sector still looks attractive.

For the second year in a row, healthcare stocks have been beating the broader market by a wide margin. Rapidly aging global population and rising healthcare expenditure in emerging markets should bode well for this sector. Some of the top ranked ETFs from these sectors, NASDAQ-100-Technology Sector Index Fund (NASDAQ:QTEC),  iShares U.S. Oil & Gas Exploration & Production ETF (NYSE:IEO) and SPDR Pharmaceuticals ETF (NYSE:XPH) are worth a look.

Avoid Consumer Discretionary and Retail sectors, which continue to face headwinds due to weak consumer environment. Per Zacks earnings estimates, earnings for these sectors are expected to decline by 9.5% and 2.3% respectively for Q3 2014.

I still favor large, high quality stocks over smaller, higher-beta stocks. Further, while markets have remained rather calm so far this year, we have seen volatility rising of late, particularly in fixed income and currency markets. Mid-term elections may add further add to uncertainty in the market. In such an environment, consider investing in Market Vectors Wide Moat ETF (NYSE:MOAT) or iShares MSCI US Quality Factor ETF .

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