The market's 3 most vulnerable ETFs

Two of these could drop big on a market downturn.

By InvestorPlace Feb 15, 2012 10:40AM

By James Brumley

While the market is still technically in an uptrend, things are getting uncomfortably frothy, and a pullback might be closer than you think. A dip would whack ETFs, too -- some of them more than others.

Here's a closer look at the market's most overbought exchange-traded funds, and exactly why they're so vulnerable now.

Select Sector Technology SPDR

Since the Dec. 19 market bottom, the technology sector -- represented by the Select Sector Technology SPDR (XLK) -- is the market's third-best performer, with a 16.4% gain. Since the middle of January it's the top performer, with a 10% advance. Yes, it's a fun ride while it lasts, but those big moves don't come without a price. That price is more than the fund's fair share of potential profit-taking.

Bear in mind such a pullback would be an intermediate-term phenomenon at best and probably closer to a short-term correction.

Why? Despite plenty of pessimism, technology stocks just posted their most profitable quarter ever. And it's one of the few groups expected to hit record earnings levels by the end of the year. Better still, the sector as a whole remains near a record-low valuation of 14.85 times its trailing 12-month earnings.

iShares Barclays 20 Year Treasury Bond Fund

In August and September, when investors thought the world was going to end (when interest rates plunged and traders fled to the safety of U.S. Treasury bonds), the run-up from the iShares Barclays 20 Year Treasury Bond Fund (TLT) came as no surprise. TLT advanced 27% in a little over two months -- a huge move for a bond fund.

There's a problem with seeing that kind of move right here and right now, however. Interest rates already were rock-bottom based on some serious economic and currency worries before the rally. For traders to think things could be even more alarming come August may have been a little unrealistic in retrospect. Nevertheless, the TLT popped and is very vulnerable to a dip now.

In fact, that dip might already have started now that the economy -- and Europe in particular -- seems to be on firmer footing. The 20-day moving average has fallen below the 50- and 100-day moving average lines, and all three are pointed lower now.

iShares S&P MidCap 400 Value Index

Since the market bottom from early 2009, mid-caps have been leading the bullish charge. And since the major bottom hit in early October, value stocks have been blazing the trail for the rest of the market. The overlap of those two groups, however, has carried one group of stocks too far, too fast.

Yes, it's the S&P 400's value names -- via the iShares S&P MidCap 400 Value Fund (IJJ) -- that are alarmingly overbought right now.

That's not to say the rest of the market isn't overbought. However, this segment as a whole is overbaked in the near term. As was the case with technology, though, investors might not want to steer clear for too long. With a forward-looking (2012) price-to-earnings ratio of 13.7 and an anticipated earnings growth rate of 28.5% for this year (following 2011's income growth of 21.3%), the mid-cap value names still pack a potent long-term punch.

Last word

Being overbought is one thing, but doing something about it is another. While these three ETFs come with a little more than their fair share of downside risk now, at least in the case of the iShares MidCap Fund and the Technology SPDR, it will take marketwide weakness to trip them up. Once we get that weakness, though, look out below.

As for the Treasury Bond Fund, its pullback can materialize independently of stock market pressures.

And speaking of being overbought/overvalued, I know of at least 3 stocks that are overvalued and are due for a pullback.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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