Use ETFs to ride out market volatility

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846- Edited from an article written by Brian Hoffman


In the months leading up to the October ’87 crash, stocks marched higher before getting hammered by higher interest rates and commodity prices.

Now, fast-forward 27 years. In the U.S., stocks have continued to march steadily upward despite some weakness at certain points during the year.

Despite  fears  over  when  the U.S. Federal Reserve will start “tapering” its bond-buying program, higher interest rates alone aren’t bad for stocks, although higher inflation certainly is.

As a result of extensive stimulus measures over the past three decades, investors have seen interest rates decline along with the rate of inflation. But it now seems the bond market senses that higher inflation is working its way into the economy, despite the fact that governments continue to post low inflation rates.

As any household can attest, the reality of inflation is different from the officially-reported rates. Sure, some expense categories remain in check, but there are several expenses that seem to rise at high rates year after year. Think of property and car insurance premiums, day care and recreation fees for children and, of course, home prices.

Inflation’s  impact  generally makes itself felt after commodity prices rally — something that’s occurred this year to some degree, albeit after prices for both gold and silver took a big tumble.

To confirm a breakout, as well as a reversal of the downtrend, gold needs to hit the US$1,600-an-ounce level. But if gold falls below US$1,200 an ounce, the technical outlook for precious metals could become tarnished — at least for a while.

Meanwhile, in the energy sector, U.S. oil prices are trying to break through a resistance point of US$110 a barrel. A breakout will be confirmed if oil manages to reach US$125 a barrel, whereas a breach of US$95 would, of course, weaken the technical outlook.

If commodity prices do continue to rally while interest rates climb higher, we could very well reprise the crash of ’87.

After all, major  bottoms in commodities generally occur when stocks near bull-market highs — something very much like the situation we now face.

Back in April 1987, commodities started to rally sharply, causing interest rates to increase and bond prices to tumble. Stocks then peaked in August, only to crash in October. Still, commodity prices continued their rally into mid-1988.

Signs point to trouble

Combined with U.S. military action in Syria, which could easily stir up a Mideast hornet’s nest, these potentially ominous signs bode ill for stock markets facing technical resistance. After all, wars involving the U.S. generally start after stock markets weaken, although often in the late stages of a bear market.

Commodity bull markets usually start before such wars with price spikes occurring when the associated fears hit a climax.

In the meantime, investors need to remain on high alert for breaches of key support levels on the broader stock market indexes, as well as in the prices of their individual holdings.

Here at home, the S&P / TSX Composite Index continues to face overhead resistance around the 12,800 level with any breach of the 11,200 support level considered quite bearish.

Despite the S&P 500  having managed an all-time high above 1,700, a breach at the 1,500 level would now be significant. Remember what happened when gold fell through the US$1,500 level?

To ride out market  volatility during what’s often the most treacherous time of the year for stocks — September and October you might buy one of the equity inverse exchange-traded funds we have profiled earlier this year.

For U.S. stocks, the ProShare Short S&P 500 (SH-NYSE, $28.22) provides the inverse performance of the S&P 500 Index, while the Ranger Equity Bear ETF (HDGE- NYSE, $14.76) shorts lower quality stocks from an earnings and / or accounting perspective.

Meanwhile, in Canada, the Horizons Beta Pro S&P/TSX 60 Inverse ETF (HIX-TSX, $9.74) provides the inverse of the iShares Canadian S&P/TSX 60 Index (XIU- TSX, $18.66).

Should commodities rally, you would, of course, have less need to hedge your holdings through a Canadian equity inverse ETF.

In any event, stay away from any double or triple equity inverse ETFs; they’re much too dangerous to hold. Indeed, a commodity rally would juice the performance of Canadian stocks.

Should gold and oil prices remain strong, you could then consider exchange-traded funds for both these commodities.

Elsewhere, the iShares S&P/TSX Global Gold Index Fund (XGD-TSX, $12.07) offers diversified exposure to senior gold plays, while the iShares S&P/TSX Capped Energy Index Fund (XEG-TSX, $16.62) provides diversified exposure to senior oil and gas producers.

The technical outlook for both these funds would weaken considerably if their unit prices were to fall below $11 and $15, respectively.

If you’re interested in taking positions in specific companies, then consider some of the gold and oil producers that we’ve profiled over the past couple of years.

For example, Argonaut Gold Inc. (AR-TSX, $6.74) is a gold miner with properties in Mexico. During gold’s collapse, Argonaut fell fairly severely. It appears to have support around $5 a share — the 52-week low it reached a few months ago when prices for gold bullion imploded.

But because a drop below this point would be bearish, you’d be smart to wait for Argonaut to bounce off that support level.

Elsewhere in the gold column, you might consider Lake Shore Gold Corp. (LSG-TSX, $0.47). Headquartered in Toronto, Lake Shore is morphing into a mid-tier producer, thanks to its exploration and development of several properties — mainly in Timmins, Ont.

The technical outlook for Lake Shore would weaken if its stock were to fall back below $0.30.

Round up Renegade

In the oil and gas sector, you might consider Renegade Petroleum  Ltd.  (RPL-TSX/VEN, $1.06)  or Anderson Energy Ltd.(AXL-TSX, $0.14). Both names offer tremendous potential given the deep discounts on their share prices relative to the value of their production. More over, both companies are reviewing strategic alternatives in light of their steep share price declines and high debt levels.

Renegade, a light oil producer operating mainly in Saskatchewan, recently cut its dividend by about 60 per cent. Its stock, whose dividend yield is about nine percent, recently tested its April low of about $1 a share.

Although Renegade ’s share price offers a decent entry point, a breach of the $1 mark could send its shares into free fall.

On the other hand, Anderson is an Alberta-based energy play that’s focused on increasing its production of oil and natural gas liquids given low prices for dry natural gas. Although an investment in Anderson isn’t for squeamish, its price could turn into an amazing gift for
more adventurous investors.

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846