5 sector funds you'll need in 2007

By Jim Jubak

The odds are that oil prices are headed higher in the first quarter of 2007. In each of the past five years, crude oil futures have jumped an average of almost 12% in the quarter. Even in 2005, a weak year for oil prices, the gain came to almost 7% in the quarter.

This is the kind of investing situation that ETFs (exchange-traded funds) were made for. With an ETF, an investor can buy an entire sector with one trade and one commission in order to quickly take advantage of a short-term situation like this. And then, with just one trade and commission, an investor can just as easily sell when the market dynamics change.

The coming year is shaping up as one that will be dominated by strong trends with limited life spans such as this one. I can see similar patterns developing during the year in home builders, gold, airlines and Japanese equities. Investors who know their way around ETFs should be able to use them to make solid short-term trading profits. You don't need to master the ins and outs of every ETF (plus near relations such as HLDRS, which track a basket of stocks rather than an underlying index) to use them profitably in 2007.

In fact, I think you can do well with just five ETFs. You might call them "All the ETFs you'll need for 2007."

The first ETF that I can find was offered on the Toronto Stock Exchange in 1990, but the concept didn't really start to get rolling until the first SPDR was launched on the American Stock Exchange in 1993. SPDRS, or Standard and Poor's Depositary Receipts, are ETFs that track the S&P 500, other indexes or particular industries. By last August, assets at U.S. ETFs had climbed to $335 billion.

What's the attraction? For the first time, ETFs give the individual investors the ability to execute at a reasonable cost the kind of basket-trading strategies that professional investors, with their computers and huge trading volumes, have used for years. Want to go long precious-metals stocks? There's an ETF or two or three that let you do just that for a commission of $10 or so.

ETFs are an unfamiliar tool to many investors, but one worth adding to your toolbox. Especially because I think they'll come in handy in 2007. Here are five ETFs that I'd keep right at hand as 2007 unfolds. In each case, I've also briefly sketched in my reasons for thinking why this tool could be employed at a profit in 2007.

Oil

Why: In 2007, with OPEC set to cut production again in February and U.S. inventories projected to show an 82-million-barrel decline -- more than five times the average fourth-quarter decline over the last five years -- the odds are good that we'll see a strong move up in oil prices again in the first quarter of 2007.

When: Buy now. Hold until the March seasonal slump in oil prices kicks in.

What: Oil Service Holdrs (OIH, news, msgs). I know these are oil-service stocks rather than the shares of oil producers, and that technically a HOLDR is different from an ETF. But I still think this is the best basket-bet for profiting from this quarterly trend. By buying this HOLDR, a small group of stocks picked by Merrill Lynch and not an index, you get much more exposure to international oil (the driver for the oil-drilling earnings) than in U.S.-dominated ETFs like Energy Select Sector SPDR (XLE, news, msgs), iShares Dow Jones U.S. Energy (IYE, news, msgs) or Vanguard Energy ETF (VDE, news, msgs). And you also get more volatility, which is good when the market is going up. You'll own a basket with stocks such as Diamond Offshore Drilling (DO, news, msgs), with a beta of 1.23, instead of ExxonMobil (XOM, news, msgs) with a beta of 0.76. (Stocks with a beta above 1 move up faster than the market as a whole in a rally.)

Home builders

Why: The stock market is starting to look past the downturn in home sales and to anticipate a recovery in the second half of 2007. The sector is by no means out of the woods. Building permits, an indicator of future home starts, fell 3% in November. But inventories are starting to edge downward in some regions, and housing starts climbed 6.7% in November to an annualized rate of 1.59 million, up from 1.49 million in October and above the 1.55 million expected by economists for November.

When: Technically, it looks like this ETF bottomed in August and is headed to a buy signal (when the 50-day moving average crosses above the 200-day average) in January. Sell when 10-year Treasury yields start to rise.

What: SPDR Homebuilders ETF (XHB, news, msgs). Good diversification across the sector with no one stock dominating the index. The top 10 holdings make up just 50% of the holdings, and the ETF holds about 5% in each.

Gold

Why: Gold is the best hedge against a falling dollar. The U.S. dollar is headed lower in 2007 on a combination of factors:

• a slower rate of economic growth in the United States than in 2006 (especially relative to the rest of the world);
• interest rate increases in Europe and (still likely but delayed) in Japan while the U.S. is on pause;
• and the continuing huge U.S. trade deficit.

When: The dollar looks like it will have a decent year-end rally as traders close out short positions betting on the dollar's fall. There's nothing going on here but a desire to be out of the market over the holidays. Buying in early January could catch a good low price for gold off the dollar rally before the move against the dollar resumes. To know when to sell: $1.36 to the euro might be a short-term top for the euro and bottom for the dollar.

What: You'll get more bang for your dollar (i.e. more volatility, since the earnings of gold mining companies are leveraged and go up and down more rapidly than the price of gold) by buying gold-mining stocks than by buying the yellow stuff itself. The new Market Vectors Gold Miners ETF (GDX, news, msgs) tracks the American Stock Exchange index of gold-mining stocks. Top five holdings include Barrick Gold (ABX, news, msgs), Newmont Mining (NEM, news, msgs), AngloGold Ashanti (AU, news, msgs), Freeport-McMoRan Copper & Gold (FCX, news, msgs) and Goldcorp (GG, news, msgs). In contrast, the more established Streettracks Gold Shares (GLD, news, msgs) owns only gold bullion.

Airlines

Why: Think of this as the anti-oil ETF. When oil prices go up, airline stocks get crushed. Stands to reason, because fuel costs are the biggest variable cost that airlines face. If oil prices go up in the first quarter, airline stocks will plunge, especially since the winter months are low-traffic months for most airlines. (Yeah, they sell those $350 round trips to Paris in February because everyone wants to go.) That sets up the possibility of a strong rally for beaten-up airline stocks as we head into the heavy summer flying season -- if oil prices begin one of those typical retreats from the heights near $70 a barrel in March.

When: Wait until oil prices climb to $70. And don't fall in love with this ETF. There is no more cyclical or volatile industry than the airline industry. Sell on the companies' reports of strong summer quarter profits.

What: There is no airline ETF, although there is an airline index on the American Stock Exchange ($XAL.X, news, msgs). But the iShares Dow Jones Transportation Average Index (IYT, news, msgs) offers you a basket of transportation stocks (and a relatively small exposure to airline shares themselves) such as FedEx (FDX, news, msgs) that themselves have big exposure to fuel costs.

Japan

Why: Something strange is happening in the currency markets. While the U.S. dollar has been sinking against the euro, so has the Japanese yen. Last week, it actually hit a record low against the euro and is now down 10% against that currency for the year. The yen has even been so weak lately that it has dropped against the dollar: The yen is down about 8% against the U.S. dollar since May. I think this is the result of a market strike against the Bank of Japan. The bank has so far refused to raise interest rates after its quarter-point increase in July. Its announcement after taking no action at its Dec. 19 meeting suggested that it won't raise rates in January, either. The Bank of Japan is afraid of tipping the economy into a recession. But the financial markets want higher rates now, or investors will take put their money into euros and even dollars. I think a recent string of weak economic data has spooked the Bank of Japan, but the Japanese economy is stronger than it looks. I'm anticipating that the bank will raise rates later in the year, which will lead to a yen rally against the dollar that will spill over into the stock market.

 1 | 2 | next >