How to use ETFs to think like a Contrarian

The market's broad sell-off in May and June has drawn comparisons with "Black Monday" the crash in October 1987 because of its highly coordinated selling. When world markets are all spiraling lower at the same time, profit (and even survival) may depend on thinking differently from other market participants. For ETF watchers, thinking differently may mean thinking beyond ETFs-- examining the stable of ETFs available for investment as such. While there are now hundreds of ETFs, representing virtually every major market internationally and every sector, there are at least four important sectors not currently represented by any ETF:

1. Auto Manufacturers

2. Chemicals

3. Airlines

4. Tobacco

Fund companies are not rushing to develop ETFs for these sectors for simple reasons: labor costs have pushed the airline and automotive sectors to the brink of bankruptcy, high oil has hurt the chemical sector, and tobacco is a small sector without the need for stock selection, certainly in comparison with some of the other specialty ETFs in areas like semiconductors or nanotech. Some of these sectors also lack a widely accepted tracking index upon which to base an ETF.

How have these sectors been doing while markets fell? The charts below compares the 3-month performance of the airline sector with the benchmark SPY.

As the chart above shows, while on a three-month basis the airline sector is just slightly higher than the benchmark, its rebound from lows in early June has been much stronger than the SPY. Coming off a multi-year declines and with much of the bankruptcy industry-- lawyers, bankers, restructuring specialists-- now turning its focus to the automobile sector, airlines look like an emerging investment opportunity.

The chart below compares the chemical sector and the SPY on a three-month basis:

As the chart above shows, the chemical sector is moving closely with the SPY. While it might be nice to have a chemical ETF, there does not seem to be the same opportunity here for a contrarian trader.

There is no single dominant tobacco index, so shown in the chart below are some of the key names in tobacco: Altria (NYSEArca:MO), Reynolds American (NYSEArca:RAI), U.S. Tobacco (NYSEArca:UST), Loews Corp. (NYSEArca:LTR).

As the chart above shows, over the last three months the tobacco sector has improved, easily outperforming the benchmark SPY. Equally important, during the period of the broad market sell-off mid-May through mid-June, these stocks held up and in fact posted gains.

The chart below shows the performance of key companies in the automotive sector compared to the benchmark SPY. The generals are General Motors (NYSEArca:GM), Ford (NYSEArca:F) and Daimlerchrysler (NYSEArca:DCX). Also shown here is parts maker Lear (NYSEArca:LEA) and engines maker Cummings (NYSEArca:CMI)

As the chart above shows, the automotive sector as represented by these companies has generally weathered the broad market sell-off reasonably well.

The importance of ETFs to the overall market grows every day. The number of ETFs trading has increased from 117 in the beginning of 2004 to about 250 today. During this time the value of assets held in ETFs also has more than doubled, with about $150 billion held in ETFs in early 2004 growing to over $300 billion today. Among the specialized ETFs newly available are Powershares Water Resources (AMEX:PHO), Powershares Lux Nanotech (AMEX:PXN), iShares Dow Jones Medical devices (AMEX:IHI). Popular and trending sectors such as oil-related sector now have over twenty offerings for investors to consider. And each new ETF draws fresh dollars into its area of specialization.

But some sectors-- even critical sectors-- remain unrepresented in the ETF family. These, especially in times of stress and market collapse such as we have seen lately, deserve a second look.