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Our ratings model takes a cautious view of domestic stocks. While the market is still up over the 12 months ended Feb. 28, the momentum is slowing. February's losses erased all the gains made in January.

You can blame it on falling home prices. You can blame it on a former

Federal Reserve

chairman's media-magnified comments. Or you can blame it on speculation in either Chinese stocks or the Japanese yen. The results are the same. The U.S. stock market seems to be pausing but still retains some positive aspects.

Our theoretical $10,000 portfolio of 10 exchange-traded funds illustrates this. In the period from Feb. 6 through Feb. 28, the portfolio lost 2.65%, in line with the major large-cap benchmarks. During the same period, the

Dow Jones Industrial Diamonds

(DIA) - Get Free Report

dropped 2.98%, while the

S&P 500 SPDR

(SPY) - Get Free Report

(SPY) fell 2.73%.

Domestic utilities, European value and Pacific Ex-Japan held up the best amid February's selloff, while capital markets, REITs and emerging markets were hit the hardest.

The positive highlight of the month was the

ML Utilities HLDR


. This ETF benefited from the news that private-equity investors were lining up for a $45 billion buyout of a core holding,

Texas Utilities


. On Feb. 26, the day the deal was announced, the fund gained 3%. It finished the period up 2.85%.

Before we discuss our portfolio changes, a note on the chart above: We have relabeled the columns to make it clearer that our monthly performance numbers are based on total return, which includes both price appreciation and dividends. As we have said in the past, the monthly aggregate total return is based on the amount allocated to each investment. For this purpose we use 10 funds to cover a broad universe of investment options and markets allocating approximately $1,000 to each based on the actual market price and without using fractional share positions.

Because we rebalance the theoretical portfolio back to $10,000 each month, multi-period returns may be understated. In effect, we cap the gains on our winning picks, although, to be fair, we also cap losses on our losing positions. But the point is that a successful investment strategy takes advantage of compounding returns -- this is key to building wealth over longer time horizons.

So how are we readjusting? We're moving money out of financials and into materials, large-caps and dividend plays.

Here's a recap of our ongoing ETF investment themes:

Look abroad for real growth:

  • Europe is a beneficiary of the flight to quality. With the dollar on the decline again, European large-caps promise to deliver gains that beat the DJIA. Our selection in this area remains the iShares MSCI EAFE Value (EFV) - Get Free Report ETF. It sells at 15.8 times earnings vs. 19.3 times for the more popular iShares MSCI EAFE (EFA) - Get Free Report. The iShares MSCI EAFE Value provides global exposure with a geographic portfolio distribution that is 50% Europe, 25% Japan and 25% other.
  • Emerging markets are still core holdings. Investing in Brazil, Russia, India and China means you will see occasional overreactions to news and corrections. Our choice among these is still Vanguard Emerging Markets ETF (VWO) - Get Free Report, which lost 4.4% during our February holding period and 8.58% last week. Investing in emerging markets is risky, but the current downturn looks to be more of a correction than a new bear market.
  • Invest in China indirectly. Our portfolio pick, the iShares MSCI Ex-Japan (EPP) - Get Free Report has two-thirds of assets in Australia, 20% in Hong Kong and the rest in Singapore and other Pacific countries. The main sector exposure is primarily banking and real estate, which together account for almost 40% of the portfolio. This ETF also provides a 4.25% yield, for long-term investors looking to add income to their overall portfolios. But note that this distribution comes at year-end, not on a quarterly basis, as is more common with ETFs based on U.S. stock indexes. The iShares MSCI Ex-Japan held up relatively well in February, losing only 1.1%.

The U.S. economy is still growing:

Let's not forget that we still have positive economic growth in the U.S. The chart below illustrates the trends in 12-month moving returns for some of the leading sector funds. Two ETF groups that ranked well in our model were sectors that tend to do well late in the economic cycle, such as materials and utilities. These sectors were up 18.17% and 21.15% over the 12 months ended March 2, respectively, on the basis of U.S. SPDR benchmarks for those two sectors. The chart also points to the weakness in technology stocks, which were up just 3.10% over the same period a year ago.

Materials Sector Holding Up Well

Click here for larger image.

  • A growing economy needs power. Among the nearly 400 ETFs we monitor, the ML Utilities HLDR posted the second-best total return performance in February, second only to the PowerShares DB Oil Fund (DBO) - Get Free Report. The potential for more buyouts, as well as frequent dividend payouts, should provide good downside protection to this group.
  • A growing economy needs materials. We are switching into SPDR Materials (XLB) - Get Free Report and out of KBW Capital Markets ETF (KCE) - Get Free Report. In addition to a list of brand-name defensive holdings such as DuPont (DD) - Get Free Report, Dow Chemical (DOW) - Get Free Report and Alcoa (AA) - Get Free Report, the materials ETF sports a dividend yield of 4.2% which should translates into lower market volatility. The beta for XLB is 1.23 vs. a beta of 1.39 for the high-flying KCE.

The KBW Capital Markets ETF was the worst performer of the selections last month, down 7.3%. More-patient investors with higher risk tolerances should consider keeping the capital markets and brokerage ETF as a growth candidate, since the exchanges collect trading commissions whether stocks are rising or falling. But the risk here is that volumes may slow if indices drift downward.

Get income:

  • Keep your real estate income. Despite the strong run in these REITs, we are holding on to the Vanguard REIT ETF (VNQ) - Get Free Report, whose largest holding, Simon Property Group (SPG) - Get Free Report, was featured in Ratings: Top Property Stocks. If you have this ETF, keep it. It pays dividends on a quarterly schedule and the March dividend is worth the wait.
  • Going more defensive with long-term dividend plays. We are swapping the iShares Morningstar Large Value (JKF) - Get Free Report for the PowerShares Dividend Achievers Portfolio (PFM) - Get Free Report in an attempt to limit the potential for future losses. This ETF invests in those companies that have increased their annual dividend for more than 10 consecutive fiscal years. The benefit of this is these are usually the last holdings to be sold by long-term investors. Top holdings include Exxon Mobil (XOM) - Get Free Report, General Electric (GE) - Get Free Report and Citigroup (C) - Get Free Report.

Watch sectors closely:

  • Keeping the iShares S&P Global Telecom (IXP) - Get Free Report worked well during the recent market selloff, and the fund provides good exposure to global telecommunications growth. About two-thirds of holdings are non-U.S. companies, including Vodafone (VOD) - Get Free Report and Telefonica (TEF) - Get Free Report. This ETF also provides a modest 2.4% yield.
  • Stick with energy. Our portfolio invests in this sector through the iShares Dow Jones U.S. Energy (IYE) - Get Free Report.
  • Think defense. We're adding the PowerShares Aerospace & Defense (PPA) - Get Free Report in place of the iShares Morningstar Small Core (JKJ) - Get Free Report.

But be more careful with sector funds in 2007. Whether you measure what has happened over the last two weeks through a sophisticated metric like the Volatility Index or just by looking at your lower balances on your monthly brokerage statement, it is painfully evident that 2007 will not be a repeat of 2006.

Rudy Martin is the director of research for Ratings. In keeping with TSC's Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

In keeping with TSC's Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Martin cannot provide investment advice or recommendations, he appreciates your feedback;

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