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Cramer: Sector ETFs Overpower Individual Stocks

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

Traditionally, a stock's sector plays a tremendous role in performance. Sec­tor gravity has been considered responsible for close to 50 percent of a stock's move. These days, however, during very big stretches in time, and certainly on any given session, it can be as much as 75 to 80 percent of the move in short-term bursts. So sectors are worth exploring and fleshing out when we talk about what causes your stocks to move intraday on no news. Sector groupings, like broader index funds, are still one more obstacle that mocks the notion that homework and knowledge of individual stocks can play an important role in the money-making process. You must learn to respect the power of sector exchange-traded funds (ETFs), because you must understand how they can impede, mystify and distort what should be a totally rational process. Yet, like stock futures, the ETF-led sector propulsion gets in the way of the fundamentals on a very regular basis.

Why does the sector pull matter so much? Because stocks are hostage to them, even if individual companies don't deserve to be. That's because of the immense popularity that sector indices and the ETFs that mimic them have gained among huge institutional money managers. To put it bluntly, they would rather play with big, liquid ETFs than mess with try­ing to get in and out of individual stocks. These baskets, designed by firms to, once again, give big-portfolio managers large and quick exposure to a group of stocks instead of one stock, fulfill the same role the S&P 500 futures play for the entire market. You like the banks? There's an ETF that mimics the banks. You hate the gold miners? There's an ETF that you can use to short them at the drop of a hat. You can even own or go long on an ETF that represents gold and short the miners that pull the precious metal out of the ground to come up with a perfect hedge, as the miners have performed poorly even when gold is stellar, and when gold cools the min­ers totally tank.

The federal government has blessed these individual ETFs, and in many cases has even allowed particular ETFs to be traded in a leveraged fashion. In other words, you can get two or three times the buying or shorting power over a sector with a leveraged ETF. Once again, the gov­ernment, oblivious to the impact of the tail that can wag the dog, has ap­proved these machine-gun instruments in a field formerly dominated by the individual rifle-toting stocks. In a matter of minutes all members of these ETFs can be blown to bits or elevated to outrageously high prices with small amounts of selling or purchasing power. In the past few years this financial engineering has become gospel, and those who don't take into account the individual stock fallout from these ETFs are doomed to make a lot less money than those who do. They defy prudent investing.

How do they impact stocks on a day-to-day basis? Let's take the oil service group, one of the sectors most keenly dominated-I would go so far as to say it has been wrecked-by ETF trading. Over the past thirty years, we have seen tremendous differentiation and a superiority-inferiority dichotomy emerge among the players in this industry. For example, Schlumberger, the largest oil service company, has been considered vastly better run than the other well-known players, particularly Baker Hughes and Halliburton. Schlumberger is more global in reach and is less levered to the fickle nature of North American drilling. It is more lucrative than most of the other players and is the open envy of the industry. While there are brief periods when Halliburton and Baker Hughes execute well, the consistency of the company the Street calls SLOB for its SLB symbol is a marvel to behold. Even when its longtime CEO, and a personal favorite of mine, Andrew Gould, stepped down in 2011, the performance of the com­pany didn't skip a beat.

Same with the actual drilling concerns. Most of the time Transocean, Ensco and Weatherford trade in lockstep on a day-to-day basis, but their true colors do surface at certain times, typically during earnings reports, when the fundamentals exert themselves in a most definite and material fashion. Ensco is the best of these three because of its technologically su­perior and younger rigs. Transocean is second best, but it became deeply scarred by the Macondo fiasco, as it was contracted to do the actual Gulf drilling for BP. Weatherford is third best, dogged by unfathomable ac­counting issues and a confused and out-of-touch management. Yet for most of the year, none of these seemingly germane characteristics matters at all because of sector domination over individual securities. They might as well be the Transocean-Ensco-Weatherford Company.

It is obvious and logical that when the West Texas and Brent oil fu­tures, the principal pricing structures of crude oil, rally, all of these stocks should and will trade higher, as they all stand to make more money when oil is moving higher than when it is going down. What's mystifying for most of you, though, is that even though the gradations of management and performance are severe, they are not differentiated when the underly­ing oil futures do their tugging.

While there has always been a similar relationship to the group's oil gearing, the nature of the sector pull has gotten increasingly pronounced in the past few years-pronounced, frankly, to the point of absurdity, with the stocks of the worst companies often increasing in price almost exactly as much as the stocks of the best. That's because of the underly­ing pull of the extremely popular OIH, the Market Vectors Oil Services Sector index, which includes all of these stocks. Consider the OIH to be the sun that all of these stocks revolve around, both good and bad, with equal speed. Yes, the gravitational pull is that overwhelming. When big institutions want quick exposure to the stock market, they buy the S&P 500 index. When they want instant exposure to the oil service indus­try, they don't bother with the individual stocks; they just come flying in to purchase the OIH, or call options on the ETF for more leverage. That has become the de facto way for big institutions, particularly the hedge funds, who don't want to bother to differentiate-or are too lazy to differentiate-the individual members of the index, to play the group. It's just much easier to buy the basket of stocks than to select which ones you want in the endless chit of oil-related stock movements. Heaven forbid you decided to play-and it is playing, believe me-the wrong stock, say, a Weatherford, and you miss the oil sector move you are trying to catch when Weatherford is hit with another restatement because of its obviously inferior internal controls. So big institutions are willing to buy the known best with the hideously bad, and somehow they consider this homoge­nized purchase actual investing.

This is where you can find the fun and the profit, because, remember, I am at all times trying to meld the market's overall mechanical imperfec­tions with opportunities for you to profit from individual stocks. We hear endlessly from academicians and proselytizers of index funds, and myriad proponents of ETFs in particular, that you can't possibly stock-pick and make money. They think it is too hard for us, that we are kidding our­selves and should just throw in the towel on managing our own portfolio. But these "sages" are either out of touch because they are not boots-on­the-ground students of this market, or they are self-serving because they are conflicted. They will profit only if they convince you of your own in­ability to take care of your money and your utter inadequacy when it comes to spotting the differences between companies. Remember, ETF proponents incorrectly regard stocks as pretty much the same, regardless of the fundamentals, something that has been proven to be false, empiri­cally, time and time again, and anecdotally by the thousands of viewers of Mad Money who regularly tell me otherwise. Nevertheless, once the S&P futures commoditized stocks, it was an easy leap for individual sector ETFs, like the OIH, to commandeer and commoditize whole sectors on a short-term basis.

Of course, this index-to-ETF nexus isn't an accurate picture of the long-term fortunes of the individual companies. I know dozens of people who work in the oil patch and interview them frequently on Mad Money, and the in-the-know execs scoff at this commodity-based view of the stocks. They know it is patently incorrect. We know that these service companies are competitive, and they win business from each other based on the merits. I deal with the index participants themselves, and they, not the short-term performance of the ETF, influence my opinions. Their input plus my homework gives me the ability to make informed judg­ments about which companies will be most successful longer term at prof­iting in different environments.

Now, here's the real irony: the academics and the ETF purveyors have been able to brainwash enough participants, and the hedge and mutual funds have fallen so in love with the ETFs, that they have created their own reality-distortion fields, to appropriate a terrific term normally asso­ciated with the late Steve Jobs. In other words, the academic-ETF-money management complex has successfully been able to homogenize short term what can't be homogenized long term: the differences between the best-of-breed, the so-so, and the worst-of-breed participants. But you can differentiate. So when the linkage with oil sends the ETFs and their com­ponents in the attendant direction, you can sell the bad ones, often at considerably higher prices than you deserve, when oil goes higher, and you can buy the best of breed at lower prices than you should normally be able to obtain when the oil futures plummet. In fact, you can do this trade until the cows come home, or get a better basis for your investment if you choose to go longer term. The same scenario goes for any of the powerful ETFs and their leveraged brethren, especially in housing, banking, retail, real estate investment trusts, semiconductors and restaurants. Yep, the movements of these stocks are now largely dictated by the ETFs that lord over them. But the short-term frustrations of stocks divorced from their fundamentals can lead to healthy long-term opportunistic marriages be­tween you and the best ones in each industry.

This against-the-grain stock picking has never been as bountiful as it is now, and the lack of short-term correlation between the companies' per­formances and their stocks is something you must not only accept but profit from if you are going to get the best basis, and ultimately the best performance, from an individual stock in the ETF basket.

So let's be granular and more practical. Let's say you are stuck in Baker Hughes because you mistakenly thought it was inexpensive enough relative to its peers, or perhaps because you incorrectly disagreed with some downgrade, or you didn't see an earnings shortfall coming. Believe me, Baker Hughes will give you a shortfall quite regularly. You shouldn't just blow it out. You should use ETF-engendered artificial, ephemeral strength to sell it. The opposite side holds true too. If you think oil can rally after a downturn, then I can almost guarantee that Schlumberger is mispriced in your favor because the ETF has been mercifully whipping it down along with the second- and third-tier players.

What an amazing opportunity to take advantage of fabulous imper­fections created daily by the overpowering ETFs!

This same strategy works in virtually every major sector these days. You can buy the best-of-breed bank stocks at ridiculous discounts to the worst of breed because of the XLF, the banking ETF. That's how I was able to snare the top-notch U.S. Bancorp at about the same valuation as the worst of the worst players at the moment for my ActionAlertsPlus.com portfolio. It is also how I was able to get an excellent exit price for the underperforming SunTrust for the charitable trust.

Retailers, technology stocks, you name it, are all subject to the ETF sector shackles. If you think, for example, that the holiday shopping sea­son will be a good one, you just need to wait until the ETFs have their per­nicious lockstep impacts on the better-managed companies like Costco and Home Depot and the inferior Kohl's and J. C. Penney.

Use this incredible instant distortion of the reality of the stocks of in­dividual companies to your advantage when managing your own money and get the best entry and exit points imaginable for individual stocks. Oh, and yes, thank you, academicians, theorists and ETF creators. You have sufficiently impacted stocks in such ludicrously effective ways that we can all profit from exaggerated sector distortions to give us bountiful outperformance that we could never obtain otherwise.

You will need to keep in mind this new trick of the trade when I show you how to compare the fundamentals of individual stocks in individual industries so you know what can be sold and what needs to be bought at the artificially inflated and deflated prices that now predominate because ETFs have become, along with S&P Index funds, the chief determinant of stock price action.

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

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