An early rally fizzled yesterday as the markets realized that two stimulus programs are coming to an end. The “Cash for Clunkers” program ended late Monday while the “Cash for Shelter” plan is still scheduled to run until November 30th. That program provides tax credits for home purchases.

Of course, stimulus is nothing more than robbing Peter to pay Paul, which is a different way of saying that future sales have been brought forward. This brings up the question how the markets will behave when stimulus is no longer used to elevate economic results.

One strategist evaluated recent market behavior this way:

Recent market gains haven’t led to a lasting pullback, despite data last week that showed a weaker consumer and a rattled China. But the market is as emotional as it is rational, says Jeffrey Saut, chief investment strategist at Raymond James.

“Indeed, fear, hope and greed (are) only loosely connected to the business cycle,” he wrote in a note to investors. “And, at session 30 in the ‘buying stampede,’ we are clearly in the ‘greed phase.’ We continue to invest, and trade accordingly.”

What that simply means is that you need to be prepared for a directional change in the trend whenever it occurs. Those without a plan to exit the market will very likely get broadsided – again.

I found this abstract on leveraged ETFs:

Leveraged and inverse Exchange-Traded Funds (ETFs) have attracted significant assets lately. Unlike traditional ETFs, these funds have “leverage” explicitly embedded as part of their product design. While these funds are primarily used by short-term traders, they are gaining popularity with individual investors placing leveraged bets or hedging their portfolios. The structure of these funds, however, creates both intended and unintended characteristics that are not seen in traditional ETFs.

This note provides a unified framework to better understand the underlying dynamics of leveraged and inverse ETFs, their impact on market volatility and liquidity, unusual features of their product design, and questions of investor suitability. We show that the daily re-leveraging of these funds can exacerbate volatility towards the close. We also show that the gross return of a leveraged or inverse ETF has an embedded path-dependent option that under certain conditions can lead to value destruction for a buy-and-hold investor. The unsuitability of these products for longer-term investors is reinforced by the drag on returns from high transaction costs and tax inefficiency.

Just because leveraged ETFs are available does not mean you should use them. To me, they are designed for the sophisticated investor and generally not for Main Street.

Several readers have written in on the subject lately and complained about the lack of promised returns when using leveraged ETFs. My very limited experience confirms that. When testing my SimpleHedge concept during the past 1-1/2 years, I included some of these ETFs, namely SDS.

While SDS performed OK in general, I encountered periods where it did not give me the 200% performance I had expected, and which was necessary for the successful outcome of that particular hedge.

My view is that most investors should stay away from using these products and focus on an investment strategy where leverage is not a necessary ingredient. While maximizing returns is important, the increased risk in today’s volatile and uncertain market environment make using leveraged ETFs a questionable approach.

One anonymous reader submitted the following PBS video, which revisits the 1929 market crash. To me, there are some eerie similarities to today’s environment especially when looking at the total disconnect between Wall Street and Main Street.

Can it happen again? Sure, only time will tell. However, it was not the crash that was devastating; it was the years that followed. To be clear, I am not making any predictions here, but I find it worthwhile to occasionally revisit history to see if there are any obvious parallels to current conditions.

The WSJ reports that “Bond ETFs Draw A Surge Of Funds:”

Investors burned by the stock-market meltdown are piling into bond exchange-traded funds in an effort to tone down risk and generate stable income.

“Investors are looking for some way to protect against inflation,” Mr. Tucker said. “ETFs provide pure, diversified exposure to the TIPS market.”

The reason for pointing to this story is that we are continuing to live in a highly volatile investment environment. As last year has shown, many of these ETFs mentioned in the story took quite a beating. Not as bad as the S&P; 500, but enough to wipe out the dividends received and then some.

If you are investing in any of these instruments, you are well advised to treat them no different than equity ETFs by using a trailing sell stop and actually executing it when it gets triggered.

Unfortunately, an investment that can be held without worry that the principal will not be adversely affected at one time or another does not exist.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Despite a sharp Monday sell-off, the major indexes recovered, and the bulls came out in full force.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +6.16% keeping the current buy signal intact. The effective date was June 3, 2009.



The international index has now broken above its long-term trend line by +15.20%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.



[Click on charts to enlarge]

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

Thanks to reader Robert for sending in this little story on basic economics:

An economics professor at a local college made a statement that he had never failed a single student before but had once failed an entire class.

All failed, to their great surprise, and the professor told them that socialism would also ultimately fail because when the reward is great, the effort to succeed is great but when government takes all the reward away, no one will try or want to succeed.

Could not be any simpler than that.