Sectors to Short (from Morningstar)

Stock Strategist


Four Sectors to Avoid, Sell, or Short with ETFs
By Paul Justice, CFA | 11-21-08 | 12:00 PM

Unless you've been on the sidelines or have been shorting the market since the summer, chances are that you have more than a few double-digit losers in your portfolio. You are not alone. I have my fair share of losers, and so do most of yesteryear's "top" money managers. Now, we could all get together and have a big kumbaya party, but that would simply treat the symptoms while ignoring the disease. We would be better served by taking our feelings out of the equation, reviewing our investment strategy, reassessing our tactical investment decisions, and learning from any mistakes that we've made. Once the errors have been identified, rectify them by either determining whether they merit staying in your portfolio or by selling them regardless of how much they have lost.


An interesting bit from the annals of behavioral finance theory is Kahneman and Tversky's prospect theory, which suggests that individuals are more upset by losses than they are pleased by equivalent gains. The pain is so great that investors in stocks avoid selling losers and often take even greater risks in the hope of simply breaking even. The same research also suggests that investors avoid making short sales (bets that an investment will go down) simply because they are afraid of having to cover their short positions at a loss sometime down the road.

Admittedly, short-selling is not for everyone. Don't do it without a sound thesis, considerable research, and a tough stomach. Over the long haul, stocks tend to go up (at least the past says so--let's hope that is still true). But no investor should avoid selling an investment that is down 50% simply in the hope that it will rebound. Here's a fact: An investment that fell 50% from where you purchased it can still go down 100% from where it is today. Reallocating those funds to a better prospect is a good idea, especially if you can use those realized losses to offset taxable gains.

With selling in mind, we've outlined five ETFs that investors should consider selling today. Where appropriate, we've tried to give investors a viable alternative to either purchase outright or with which to establish a pair trade.

High-Yield Corporate Bonds

In September and October, the credit spreads on high-yield bonds shot to never-before-seen levels. As of this writing, the high-water mark was roughly somewhere around 1,550 basis points over Treasury bonds, which translates to yields of nearly 20%. Still, we recommend that investors avoid high-yield ETFs such as iShares iBoxx $ High Yield Corporate Bond (HYG) and SPDR Lehman High Yield Bond (JNK) for the simple reason that we think things are going to get worse for high-yield issuers before they get better. Loose lending was not limited to residential mortgages during the past five years. Buyout firms and companies drank their fill from the cheap and easy debt trough. Now we have a host of companies that were overleveraged during the best of economic times staring a prolonged recession in the face. When a company has a weak balance sheet, its borrowing costs are rising, and its profits are dropping, the likelihood of bankruptcy increases exponentially. Many forecasters are projecting the default rates on these bonds will rise to anywhere between 8% and 12%. We fear that number could go much higher as the shutdown in the capital markets will preclude these firms from selling assets, raising equity, or even rolling over existing debt, thus exacerbating the impact of an economic recession.

Investors looking to capitalize on the high credit spreads that exist throughout the market would be much better served considering an investment in investment grade corporate bonds like those represented by iShares iBoxx $ Investment Grade Corporate Bond (LQD). Even this is not without risk, given that both Lehman and Washington Mutual were still rated investment grade when they went under. Still, the diversification of risk offered by the index structure will minimize the impact of one-off collapses keeping investors from suffering the permanent capital impairment that would have come from holding just a single bond issue.


Emerging Market Large-Caps
Large-cap emerging-markets equities are facing a Category 5 storm of bad market conditions. The global recession continues to drive down commodity prices, which will decimate the earnings of companies like Petrobras (PZE), Gazprom, and Posco (PKX)). National champion banks such as HDFC (HDB), China Construction Bank, and Banco Santander-Chile lent the billions of dollars of credit that funded the recent boom, and their future now holds higher default rates, few profitable loan opportunities, and even the possibility of governments forcing new credit to be supplied at artificially low rates. The advanced technology conglomerates like Samsung and Taiwan Semiconductor (TSM) face the worst global environment for consumer discretionary spending in decades. Finally, emerging-markets currencies are plummeting against the dollar, which further exacerbates the losses for U.S. shareholders. The most positive thing we can say about emerging-markets large caps is that they have already been beaten up, having dropped nearly 60% for the year to date, but that hardly precludes further losses given the potential for currency crises and the still-forthcoming bad earnings news from banks and commodities producers. Investors with stakes in iShares MSCI Emerging Markets Index (EEM) or BLDRs Emerging Markets 50 ADR Index (ADRE) should consider selling out or even shorting.

A naked bet on further falls may seem too risky. After all, the MSCI Emerging Markets Index trades around a P/E ratio of 8.5 and a price/cash flow ratio of 5.5. Clearly these stock prices already anticipate a deep recession and poor future earnings, so how much further could they fall? To offset the potential risk that emerging markets have hit bottom, we suggest a long position in emerging-markets small caps using WisdomTree Emerging Markets SmallCap Dividend (DGS). Relative to emerging-markets large caps, this fund has far less exposure to commodities producers or telecoms while concentrating instead in local consumer and business services, which should hold up relatively well as growth in emerging economies merely slows rather than halting. WisdomTree Emerging Markets SmallCap also has far smaller investments in the vulnerable Chinese, Mexican, Indian, and Russian markets than its rival large-cap funds, which should help its relative performance. Finally, emerging-markets small caps are likely to outperform because they will start from an even cheaper basis. Although these stocks did not fully participate in the gigantic emerging-markets rally of 2003-07, they have suffered alongside large caps in the fall. For that reason and the general value tilt from WisdomTree's dividend-weighting methodology, the stocks in WisdomTree Emerging Markets SmallCap Dividend are currently trading at a P/E ratio of 7 and a stunningly low price/cash flow ratio of 4.7 despite their brighter future! Shorting emerging-markets large caps and investing in their smaller cousins provides a tempting relative-value trade for intrepid investors.


Coal Producers
Few sectors were impacted as greatly as the energy sector by the proliferation of new ETFs over the past two years. Nuclear, natural gas, oil, and alternative energy all have several different funds from which to choose, and most of those include inverse and leveraged bets for both long investments and shorting. Included in that lineup was Market Vectors Coal ETF (KOL), an ETF frequently purchased by individual investors in the face of rising coal prices. What many investors failed to consider when spot coal prices were soaring is the fact that over 90% of the trading of this commodity is conducted via direct contracts. Thus, the spot market is only a proxy for a small fraction of the actual sales. Not all coal producers were realizing triple-digit prices for their goods, and those that were have seen the spot market evaporate with the recent pullback in global economic activity. While our equity analysts see only a modest contraction in the volume of coal consumed for electricity production over the next few years, the same cannot be said for coal used by industrial consumers. Thus, the good times for coal producers will not likely reach the levels seen in 2007 and 2008 until robust world economic growth returns. Throw in the sweeping victory by Democrats, and the appointment of Henry Waxman as chairman of the Energy and Commerce Committee replacing John Dingell, and it appears the federal government's attitude toward curbing greenhouse gas emissions is becoming more determined. Given coal's distinct disadvantage in this space, times indeed look more pessimistic for America's most abundant fuel.


REITs
The residential real estate market sits at the epicenter of the current crisis. Chances are that if you've picked up a newspaper or turned on the television over the past few months then you've already been briefed on just how ugly it's getting out there. However, we'd also like to highlight some cracks we see in the commercial real estate market. We want to caution investors about a potential parade of dividend cuts that seem to be on the horizon for the REIT industry. Avoiding the sector altogether is probably a wise choice, but the most daring and risk-seeking investors might even consider selling the sector short.

The REIT market has benefited over the past several years from loose credit terms, low interest rates, and rising property values. Strong and consistent historical performances over this period led many investors to believe that REITs could be considered a safe haven with healthy dividend income streams. Surprise! The party is now over. The tail winds that benefited the industry over the past several years are turning into strong head winds. Many firms in the industry took on unsustainable levels of debt to expand their asset bases. Now, those same assets are falling precipitously in value. We should also expect to see rental rates come down as vacancy rates increase. This should in turn depress cash flows and possibly impair some firms' ability to meet the debt obligations they assumed when the economic outlook was rosy. The long lead times that are typical for commercial real estate projects brings up another issue. Many projects that were undertaken a few years ago may have been economically attractive at the time. However, things have changed drastically and many projects may turn out to be value destroyers. But, because many projects are already so close to completion, there's no turning back.

So, how can investors apply this sector thesis? UltraShort Real Estate ProShares (SRS
SRS) is the easiest way to gain leveraged short exposure to the industry. Barclays' iShares family of ETFs has also sliced the REIT market every which way, so we'd take a look at getting short the retail and hotel subsectors of the REIT industry there (iShares FTSE NAREIT Retail (RTL) and iShares FTSE NAREIT Industrial/Office (FIO)). The most popular REIT ETFs, in terms of assets under management, that investors may wish to keep an eye on include Vanguard REIT Index ETF (VNQ), iShares Dow Jones US Real Estate (IYR), and SPDR DJ Wilshire REIT (RWR).
John Gabriel









Paul Justice is a senior stock analyst with Morningstar.