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ETFs have given investors a great way to build diversified portfolios easily and cheaply. But many people don't realize that even if you prefer to invest in individual stocks, looking at exchange-traded funds can give you incredibly valuable insights into investor sentiment -- as well as great leads on potentially lucrative stock picks.
Show me the money
ETFs have revolutionized investing partly by making sectorwide investing a whole lot faster and more visible. Before ETFs became readily available, you could invest in sector mutual funds that held the same underlying stocks. But once-a-day pricing and other barriers to frequent trading kept short-term investors from using traditional mutual funds as trading vehicles. That, in turn, made information about mutual fund money flows more indicative of long-term investing trends, and less useful for those looking for short-term catalysts that could create immediate profit opportunities.
Now, though, you can tell a lot about investor interest in a particular market niche by looking at the volume of related ETFs. By looking at the sectors with the highest ETF volume, you can gauge where most investors think the action is right now -- and where you might be best able to take advantage of those short-term traders with your longer-term perspective.
Let's look at three sectors whose ETFs have dominated the action on the trading floors lately:
1. Financial stocks
Ever since the housing bubble burst, financials have been the hot story. The failures of Lehman, Bear Stearns, and Washington Mutual brought riches to short-sellers and allowed Wells Fargo, JPMorgan Chase, and Bank of America to swoop in and take advantage of the resulting industry consolidation.
ETF traders disagree on whether the next step for financials will be higher or lower, but they do think it'll be a big one; they're focusing on leveraged bets. Although more shares of the bearish Direxion Daily Financial Bear 3x ETF (NYSE: FAZ ) have traded on average in recent months, the dollar volume of the bullish counterpart, Direxion Daily Financial Bull 3x ETF (NYSE: FAS ) , is somewhat higher.
In the long run, financials have established a good base to springboard future earnings. Although current favorable rate spreads won't last forever, they'll last long enough to let banks deleverage to acceptable levels. From there, financials will likely restructure themselves to make the most of a higher-regulation environment.
2. Asian stocks
With Europe in turmoil and the U.S. failing to rebound strongly, a lot of the market's attention is turning to Asia. ETFs focusing on China and other emerging markets are well-represented on the top volume lists, while even the Japanese broad-market ETF has sustained investor interest.
With the Bank of Japan finally intervening to try to stop the yen's appreciation against other world currencies, the question remains whether Japan can jump-start exports and get its economy back on track after 20 years of stagnation. If so, Ford (NYSE: F ) and other companies that compete with Japanese exports could face a reversal of fortune.
Meanwhile, China faces the opposite problem: It already has healthy export levels, but it must maintain them, despite pressure to allow its currency to appreciate against the U.S. dollar. One long-term idea here is Baidu (Nasdaq: BIDU ) ; while most see the company's stranglehold on its domestic Chinese market as its main asset, it could one day decide to leverage its worldwide brand toward greater penetration into other markets as well.
3. Energy stocks
There's been plenty of action in the energy markets lately. The BP oil spill has pushed Gulf drilling activity to the forefront, casting a spotlight not just on the majors, but also on smaller companies with proportionately large exposure in the region. ATP Oil & Gas (Nasdaq: ATPG ) , for instance, has major exposure in the Gulf; the oil spill cut its shares by more than half.
Many investors are also angling to play a rebound in natural gas prices -- but if and when one arrives, which investment will work best? Although U.S. Natural Gas Fund (NYSE: UNG ) is a trader favorite, its value has eroded greatly over the long term because of pricing conditions in the futures markets. Direct investments in Chesapeake Energy (NYSE: CHK ) and other major gas producers may be the better way to benefit from a future gas-price surge.
Keep your eyes open
Even if you don't trade ETFs, the activity you'll see there can give you signals about what stocks are likely to move the most. By looking at trends, you'll be able to anticipate catalysts and get better about making smart, timely investments.
Not all sectors are hot. Rick Munarriz says you should stay away from these three sectors.