Deflation Investments are getting a lot of press this week.  Many experts are now shifting their sites from fears over inflation to a deflationary environment.  While the rampant printing of money and devaluation of currencies had been front and center since the financial crisis, there are now indications that we may be entering a period of sustained deflation both in the US and around the globe.  Naturally, the question is what some good deflation investments would be.  Deflation is generally considered to be an environment of slow economic growth and where there is actually a negative inflation rate, with the end result being an actual increase in the real value of money.  As unfathomable as it seems, it is a real scenario many economists are bracing for.  While the US hasn’t seen a classic case of deflation since the 1800s, other developed markets like Japan and Ireland have in the past few decades.

Some signs pointing toward deflation in the future include today’s Producer Price Report showing a decline and other indications that the economic recovery is slowing like a drop in new building permits.  Lest we not forget that Strategic Defaults are Growing as they’ve become the New Black.  This comes at a time when the Fed is withdrawing from market activities and the dollar is rising against major currencies.

Deflation Investing

Contrary to the concerns over income investments declining in an inflationary environment when inflation erodes the return of income instruments, in a deflationary environment, income investments actually look more attractive.

High Quality Dividend Paying Stocks

With the prospect of sustained or growing dividend payouts from stable blue-chip companies, high quality dividend stocks would continue to fare well, as they have during the month of May.

Some Reasonable ETFs offering High Quality Dividend Payers Include:

SPDR S&P Dividend Fund (SDY) - This ETF seeks to mimic the S&P High Yield Dividend Aristocrats Index and only the 50 highest yielders are included.  The trailing yield on SDY is 3.32%.
Vanguard Dividend Appreciation (VIG) – This ETF seeks to mimic the Mergent Dividend Achievers Select Index which mandates that components have increased dividends annually over the past 10 years.  The trailing yield on VIG is 1.82%.

While these yields may not seem that enticing, the strategy here is “growing” yields, not necessarily current “high” yields.  Many income investors focus on dividend growth over current yield since a very high yield is often a sign of a future dividend decrease or lack of growth, whereas a long trend of sustained increases forces capital appreciation as well as the market continues to adjust for an ever-increasing dividend payout.

High Yield Preferred Stocks

Acting as a sort of hybrid between a stock and a bond, preferreds are primarily offered by Financials, but some other industries participate as well.  To spread risk and enjoy a respectable trailing yield exceeding 7% with a monthly payout, the Preferred ETF is a good choice.  The ticker there is (PFF).

US Currency is King

In the event of extreme deflationary conditions globally, the US Dollar would continue to benefit, as we see whenever investors seek safety and reassurance.  Some options to play an improving US dollar relative to counterparts include the PowerShares DB US Dollar Index Bullish ETF (UUP) which capitalizes on relative US Dollar strength or if you want to continue to play Eurozone contagion, (EUO) is a leveraged short Euro ETF.  Just beware the negative consequences of holding leveraged ETFs over long periods of time if the trend reverses or flattens.  You lose money even with a flat underlying index due to daily volatility decay.

High Yield Investments

While some investments are yielding higher than typical high single digit current payouts, some investors fear these will be the first to experience major capital outflows and price declines when markets panic.  But for those willing to take on some volatility in the pursuit of above-market rates, consider the following high yield ETFs.

Finally, many investors who are positioned correctly and don’t mind some minor tax hassles prefer the asset class many compare to a hidden gem of income investments – MLP Investments.  Master Limited Partnerships are required by law to pay out 90% of their income to investors as with the right tax and investment planning, they could be well-suited to return double digits for prolonged periods with just minor capital appreciation.

Gold is not necessarily considered a universal inflation play, as gold investments are usually touted for their inflationary attractiveness.

Disclosure: Author is long EUO.

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Today, the Sprott Physical Gold Trust (PHYS) completed a follow-on offering of trust units at $11.25 per unit.  This was performed in order to acquire physical gold bullion in accordance with the Trust’s objective and subject to the Trust’s investment and operating restrictions.  In other words, the big selling point of this closed-end fund is that investors can actually request delivery of their gold.  Many true gold bugs believe other gold ETFs like (GLD) could never deliver (or own) the assets should there be a financial panic and a run on physical gold.  While Europe’s in shambles, the US has its share of crises in the year ahead, with strategic defaults becoming the “new black” and the government’s insatiable appetite for debt over spending cuts.  These fears had resulted in a substantial premium to net asset value (NAV) in PHYS but this follow-on offering priced shares more in accordance with true NAV, dragging the share price down with it today.

Massive Premium Came Crashing to Earth

Given the fears over paper gold versus the real thing, along with a legitimate benefit to gold tax treatment for other gold investments like GLD (treated as a “collectible”) which should warrant some premium, the premium to NAV on PHYS approached absurd levels earlier in March to the tune of 30% at one point.

In a recent post on an optimal Gold ETF Pairs Trade I highlighted the opportunity to engage in a long/short trade (which I undertook myself) whereby you could short PHYS while buying an equal dollar amount of GLD Long. The thinking was that while there would likely always be some premium on PHYS over NAV, the premium was fluctuating so much on a daily basis, that even a return to the mean at a premium level would result in a virtual risk-free return in no time.  And it did.

My initial post was on May 10 and I opened the suggested pairs trade at that time.  Since then (intra day May 26 closed out position), the spread between GLD and PHYS grew to 6% (GLD was up slightly while PHYS lost 5.5%).  Today alone, the spread was 7% so I was actually in the hole 1% prior to today’s move.  Therefore, this pairs trade paid off at 6% with no net cash outflow (only needed a margin account, but since I went long/short equally, there was no cash outflow) in 2 weeks.  I won’t beguile you with an annualized return on this, but in my mind, it was some of the easiest money I’ve ever made – I made several hundred bucks on zero dollars down.  I just wish there were more shares to short when I undertook the position.

Looking Forward

Inevitably, the premium on PHYS will continue to fluctuate and when similar opportunities present themselves in the future, I may very well back up the truck this time.  To reiterate, I don’t take issue with PHYS commanding a premium to NAV.  I don’t even take issue with a double digit premium per se.  What I don’t see as sustainable is when the long-term premium is say, 15% and it spikes to 25% on a single day.  To me, this says “Pairs-Trade!”.

Disclosure: Author has closed out short PHYS position and still retains some GLD for a net long gold position as well as other precious metals ETF (more on those) hedged positions.

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After one of the most tumultuous months in stocks investors have seen since the financial collapse, it’s instructive to take a look back and see which ETFs fared well through the flash crash, an imploding EU, an environmental disaster in the gulf unfolding before our eyes and a possible war brewing in the Koreas.  For perspective, during the month of May, the broad-market S&P500 (SPY) lost 8%.  I’ve included both some leveraged and non-leveraged ETFs to cover the gamut of sectors and types of ETFs in each bucket:

May’s Hottest ETFs:

SCO – UltraShort Oil – Up 36% - Oil started to crash hard during the month, perhaps not so much due to the (BP) disaster in the gulf, but more so due to concerns about a global economic contraction stemming from the troubles in Europe.  As such, this ETF benefits from a declining crude trend, which while welcome to consumers, is often an indicator of the prospects for future global economic growth.

ERY - Direxion Daily Energy Bear 3X - Up 35% - While also tied to energy prices, ERY is actually negatively leveraged to the Russell 1000 Energy index, so it is more indicative of the operational risk associated with energy companies.  There may be an angle in this approach over playing the price of oil itself with the prospect of higher regulation and costs to the industry which could theoretically have opposing results: Higher oil costs and lower share prices of energy companies.  This may make for an interesting pairs trade but time will tell.

VXX - S&P500 VIX ETN -Up 35% – VXX provides the rare ability to capitalize on fear, regardless of sector.  As investors perceive more risk in the market and put buying starts to dramatically overtake call buying, the VIX shoots up.  Since there’s no way to play the VIX index directly without a futures account, the VXX ETN (exchange-traded note) is the next best thing.  We last saw VXX spiking to over $100 per share during the financial collapse with a steady decline since then.  In May, the move was dramatically upward.  While owning VXX is not usually a great “long-term investment” if you believe the general trend of the market will be upward with volatility declining, during moments of panic, VXX is an excellent way to net 20% in a single day like during the flash-crash for anyone following my twitter.

EUO – ProShares UltraShort Euro – Up 17% – EUO is a play on a continuously weakening Euro vs. the US Dollar.  While the dollar has had its fair share of naysayers in the face of our economic crisis, deficit spending, a new healthcare bill that will be nowhere near deficit neutral and 2 simultaneous wars, the USD still becomes the safe haven for investors globally when fear sets in.  In the case of the Euro, there are now serious doubts as to whether the Euro can even survive with the $1 Billion backstop announced in May.  Greece is in shambles with Italy, Portugal and other debt-constrained economies being called into question.  The austerity measures (see country by country list) announced during the month did little to quell the shorts.  If you foresee a continued decline, expect EUO to continue to move upward as long as the trend isn’t reversed.

GLD – SPDR Gold Trust – Up 3% – Gold is getting non-stop attention these days and not just from the late-night infomercials.  What was particularly interesting is that gold has been the perennial weak dollar and inflation play and yet in May we still saw gold rise in a strengthening dollar environment where there is no serious consideration being given to Deflation (see Deflation Investments if you believe that’s where we’re headed).  The overriding theme for May’s gold rise was neither inflation or a weak dollar, but just a general fear of fiat currency worldwide.  As crazy as it may sound now, many investors pile into the camp that there may be a complete devaluation of paper currencies around the globe, with the only true item of value being gold – hard assets.

In a down 8% month, it’s tough to tout too many non-leveraged long funds, but anything above 0% in that context is a winner for sure, so even GLD made the list.  This list somewhat sums up what some of the hottest trends were for the month.  If the adage “Sell in May and go away” is prophetic in 2010, some of these ETFs may well outperform cash or your standard long broad market ETFs.  While buying put protection become more expensive this month with volatility spiking, investors must also be mindful that holding leveraged ETFs over long periods of time is often a loser as well given the leveraged ETF decay that can occur rather rapidly and unexpectedly.

Disclosure: Author is long EUO and still holds a small position in VXX.  Long GLD after closing successful gold pairs trade with PHYS.

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With the S&P500 losing over 3% on the week on a poor jobs report, further implosion of the Euro zone (check out country by country EU Austerity Measures) and the realization that the disaster in the Gulf is likely going to start to have long term implications outside the scope of whatever legal bills BP is served with, most of last week’s winning ETFs were short sector ETFs, leverage or tied to volatility.  For the prior week, here are some top winners amongst the wreckage:

Non-Leveraged ETFs

UNG - US Natural Gas Fund – Up 12% - In a somewhat bizarre twist (to sideline bystanders), even though energy was down last week on global slowdown concerns, natural gas was up – big!  This is what an endorsement from Obama does during a speech.  As oil spews in the gulf, finally, the administration makes mention of the enormous natural gas deposits domestically that may help shift us away from importation of foreign oil (since there isn’t a heck of lot of promise in new offshore oil leases in the near future).

VXX -Volatility Index ETN – Up 10% – I’ve written about VXX somewhat routinely, especially in the context of investments that benefit from market volatility.  In short, VXX rallies when market volatility (fear) is high.  While holding VXX is not the best long-term investment because the long-term trend of volatility isn’t higher, but it makes for a nice hedge when it’s evident all hell is breaking loose.  With the news out of Europe, the gulf, and now the middle east, it may not be a bad idea to hold at least some of the volatility ETFs out there to liquidate for bargain hunting later.

Leveraged ETFs:

DRV – Direxion Real Estate Bear 3x – Up 23% – Real estate has really become the most volatile sector both during and coming out of the recent financial meltdown.  In prior market crashes, it was internet companies, tech, regional banks, and other sectors, but here, it’s been real estate.  With the various government subsidies coming to an end like the homebuyer tax credit and still not much to show for it, investors are tiring of real estate prospects and seeking safety.  This leveraged short ETF cleaned up last week even though real estate shares have been very strong out of the crisis.

FAZ - Direxion Financials Bear 3x – Up 17% - The Financials are next on the list of volatile components.  While the solvency of the large institutions is no longer of great concern, the recent Financial Regulatory Reform hasn’t done much to help ensure an increase in margins for the banks.  If looking to participate in a resurgence in investment companies but want to shy away from the large investment banks, consider MLP Investments.  Master Limited Partnerships have some nuances worth watching related to tax treatment, but given the combination of tax efficiency, high yield and modest leverage, MLPs are one of the hidden gems oft-overlooked by retail investors.

ERY – Direxion Energy Bear 3x – Up 11% – Contrary to the rise we saw in natural gas for the week, energy shares as a whole have been dropping.  Not only does the overall economic malaise not bode well for energy consumption, but now, the prospect of higher regulation (and costs) to extract oil is really driving many of these shares down.  There are some ideas on pairs trades and value plays since entire sectors have been taken down in the wake of the BP disaster, but until it’s clear that the issue is resolved and the Euro situation is under control, there don’t appear to be any near-term catalysts for a rise in energy company shares.

Disclosure: Long VXX, Long DRV [both near term trades] and long/short positions in FAZ and ERY pairs trades.

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I couldn’t help but notice the press release today on the reverse splits announced for 4 more leveraged ETFs:

• Direxion Daily Energy Bear 3x Shares (ERY)
• Direxion Daily Real Estate Bear 3x Shares (DRV)
• Direxion Daily Small Cap Bear 3x Shares (TZA)
• Direxion Daily Technology Bear 3x Shares (TYP)

Some Details on the Reverse Splits:

• These splits will occur for all shareholders of record after the market closes on July 7.
• They will undergo 5:1 reverse splits, thus increasing the share price by 5X and decreasing the number of shares held by 5.
• No transaction fees are assessed when such a transaction occurs.
• If there are fractional shares, you’ll have the cash proceeds delivered via cash to your trading account.

This has become somewhat of a routine occurrence.  I got an email from one reader a while back rejoicing over how much his ETF had risen in value since he last checked recently only to be informed that this was due to a reverse split and he now owned fewer shares.  Whoops!  But this is all too common; sometimes, charting results on financial websites can’t even keep up with all these reverse splits on leveraged ETFs.

For the uninitiated, leveraged ETFs offer 2X or even 3X the DAILY return of a particular sector or index.  I emphasize “daily” because over time, it is a mathematical certainty that unless there is a pure sustained trend in one direction for an infinite period of time (what comes up must come down), the value of your holdings will decrease over time due to leveraged ETF daily rebalancing (see article for much more detailed explanation and numerical example).

Admittedly, in some circumstances, I’ve employed leveraged ETFs to jump on a trend as a TRADE, not an investment, like when the Euro was imploding, utilizing EUO to short the Euro on a 2x basis (position closed for a small gain).  However, I never, ever recommend blindly holding any leverged ETF given the eventual demise in share price.

All you have to do is look at the evidence:

• Past history – just view a long/short combo in Google Finance over a multi-month period and in many cases, they’ve actually BOTH lost money!
• Continued Reverse Split Announcements
• Warnings on the prospectus themselves

Despite the warnings and even new margin requirements (which really only made it more costly for traders, but likely won’t deter retail investors from using them), new investors that don’t fully understand this phenomena continue to pile into these instruments.  There is so much demand chasing supercharged returns that 16 New Leveraged ETFs just launched earlier this year.

Disclosure: Currently engaged in various short pairs trades with leveraged ETFs but no net long position in any leveraged ETF.  My current portfolio can be viewed for reference which is updated monthly.

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There are two main schools of thought in dividend investing and for whatever reason, investors tend to be polarized into one camp or the other.  On one hand, investors tend to be drawn to juicy dividend yields of 8% or more given that this matches the long-term return on equities over long periods of time but provides for current yield matching that, plus the prospect of capital appreciation.  Typical holdings offering yields this high include MLPs (one of my personal favorites), Real Estate Investment Trusts (tons of them listed) and various types of energy trusts, financials and other entities with high cash flows or net payouts due to company structure, etc.  Conversely, there’s an entirely different universe of stocks that have modest current dividend payouts, often in-line with the yield of the S&P500 as a whole or even lower, at say, 1.5% to 2.5%, yet they are rapid dividend growers in that they tend to increase their dividend payouts year after year at a rate even greater than inflation.  It’s worth considering the pros and cons to each approach and whether perhaps it makes sense to accumulate both types of holdings simultaneously.  Fortunately for retail investors, now there are ETFs to capitalize on each strategy:

High Yield ETFs

Many investors find the prospect of an 8-10% dividend yield in a near zero interest rate environment to be incredibly appealing.  As long as those yields remain steady, until interest rates increase, this is indeed a good proposition.  Investors should be cautioned though, that once interest rates start to increase (which they will inevitably, but many experts now expect no action on the part of the Fed until late 2011 or even 2012), that makes income investments appear to be less attractive and they may very well sell off.  For individual issues, one must consider just why the yield is so high and how likely it is to last.  However, there is a diverse mix of high yield ETFs from which to pick for diversification.

For the ultimate in current yield, there are the junk bond ETFs (full review) with tickers (JNK) and (HYG) showing trailing yields of 12% and 9.6% respectively.  Note that these have the benefit of monthly payouts but also, these yields may not be this high in the future, as JNK’s latest payout was lower than in previous months.  Then there’s always the hybrid stock-bond approach with Preferred Stocks.  The Preferred ETF (PFF) yields over 7% and has already accounted for the recent demise of the Financial sector and what financial reform has to offer.

Dividend Growth ETFs

Many of the highest quality blue chips (including the only remaining 4 AAA Companies in the S&P500) have seemingly low dividend payouts but those payouts are viewed as sacrosanct and growing.  Many dividend investors place more emphasis on the GROWTH RATE of dividend payouts over CURRENT YIELD.  The reasoning here is that if a stock is yielding 10%, it’s for a reason – the market is pricing in a dividend cut, or it will be unlikely to pay out at that rate indefinitely.  However, a company that routinely increases dividends may not show a high yield because the underlying share price keeps increasing over time in lockstep with those increased dividend announcements.

For some opportunities in this space, consider Vanguard’s Dividend Appreciation ETF (VIG) at 2.1% or the S&P High Yield Dividend Aristocrats index ETF (SDY) at 3.84%.

Which approach you focus on is dependent on many factors and perhaps a dual-approach works.  Bear in mind that in trying to match up recent performance, it’s difficult to put this into context given the complete meltdown in Financials which had historically comprised a mix of both high yielders and dividend increasers.

Disclosure: Author holds HYG in self-directed IRA account. No other holdings mentioned in this article.

©2010 ETF Base. All Rights Reserved.

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Financial ETFs have been among the most volatile sectors over the past few years, with the sector swinging from near complete collapse to euphoria over year over year comps for earnings (any positive earnings announcement compared to a year ago multi-billion dollar loss looks great).  With the the investment banks especially, able to borrow from the Fed (taxpayers) at near 0% and lend it at 6% or invest it at an even higher rate [Goldman Sachs (GS) went an entire quarter without a single losing day on trading operations], it’s no wonder that investors were piling into Financials.

More recently however, there’s still constant tinkering and probably a Part Deux to FinReg, the housing market’s a mess, unemployment is going nowhere fast and the Euro has only taken a breather from its likely implosion, so Financials are still very likely to move in a rapidly volatile fashion; the question is which way.  While mortgage rates are amazing low (current rates are at an all-time low in fact), it’s evident that buyers are questioning whether it’s even worth buying at any rate. Rates could go even lower rendering a rush into the market now futile, and people are starting to learn about restraint and frugality in the New Normal.  Also, as is usual, both sides of the political spectrum are at the extreme on the Financial Regulation Reform Bill.  Some say it’s going to destroy competitiveness in the US financial sector while others say it’s toothless and will be business as usual.

With that in mind, it’s first worth evaluating what some of the major Financial ETFs are to consider and then how to play them.

Key Financial ETFs and Strategies

1.  Financial Select Sector SPDR (XLF) - For a straight bullish play on the Financial sector without any leverage, XLF is a prominent ETF.  The top holdings are the usual big names you see in the headlines (usually negative press these days) like Goldman Sachs (GS), JP Morgan (JPM) and Citigroup (C).

Strategy – Long large banks/investment banks with no particular play on smaller/regional banks.  The thinking here is that FinReg is in fact toothless and the large will continue to get larger while pushing out smaller banks.

2. SPDR KBW Regional Banking (KRE) – Conversely, this ETF is devoid of the large insurers and investment banks and top holdings include unkowns like Fulton Financial Corporation (FULT), Bank of Hawaii Corporation Comm (BOH), Old National Bancorp Capital (ONB).

Strategy - Long small banks thinking that Financial Regulation is going to put constraints on the large players that don’t exist on the small ones and they were unfairly beaten down due to “guilt by association” but Fin Reg wasn’t really targeting these smaller regionals that didn’t dabble so much in CDOs, derivatives and taxpayer bailouts.
Strategy #2 – For investors unsure of which direction the sectors may go, but feel regionals will outperform, a pairs trade is always an option.  Long KRE/Short XLF.  This would mute a massive downtrend or uptrend and deliver some moderate gains as long as KRE did in fact outperform on either the upside or downside.

3. Direxion Daily Financial Bull 3X Shares (FAS) – For the extreme risk-seekers, there’s always leverage.  That’s what got us into this mess in the first place right?  Without bothering to even consider a 2X daily return fund, FAS is the 3X Daily Long Financials ETF.  The top holdings are very similar to XLF, but the returns are triple what the daily returns are, so on a daily basis they track hand in hand.  But let’s face it, retail investors aren’t using them the way they should.  They’re scratching their heads at the end of a week when XLF is flat at FAS is down 4%.  To understand this phenomena fully, read up on leveraged ETF decay.  For this reason, I’m not a huge fan of retail investors using leveraged ETFs but they’re worth mentioning for day traders.

Strategy - Short term (on the order of a few days) long FAS to exploit burst in the underlying Financial sector.  The sector tends to trade up on any positive news on both the political front or also, jobs, housing, earnings, further Fed delays in interest rate hikes or any excuse to move upward for that matter.

4. Vanguard REIT Index ETF (VNQ) – Real Estate Investment Trusts have rocketed back from the brink and they carry hefty yields to boot given the 90% payout provision.  This ETF spreads the risk around and carries a nice yield of ~4.5% as well.  For higher yields approaching 9%, consider individual issues (full REIT List of dozens of publicly listed companies in the segment).

Strategy - Long VNQ banking on either continued stability or improving conditions.  Regardless of broad market direction, the high yield and diversification is likely to deliver above market returns.  Note however that solvency concerns will arise if credit conditions deteriorate again and VNQ could be more volatile than the market at large.

Personally, I’m relatively agnostic on financials and don’t condone one strategy over the other necessarily.  But I wouldn’t be surprised to see the base XLF and other higher beta options more so, very far removed from current levels by Fall.

Disclosure: No long positions in any ETFs covered.  Author does have a hedged short position involving FAS.

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