January was the worst month for stocks since the September 2002 bear market. Losses rained down on ETF investors in energy, small caps, and most of all, financials. When will this torrent of ETF turbulence end? I speculated in my January 14th blog that it was still too early to jump in the deep end of short ETF financials, but I'd be standing on the side of the pool watching very closely…

Now, I don't know if I happen to have God's ear, or because of the anticipation that the Federal Reserve would cut interest rates drastically, but on January 18th, the Financials SPDR (XLF)–the most liquid ETF in the sector–bottomed out at $25.50. The next day it began to rally and finished the month at $29.14… up 2.6%, having belly-flopped 19.2% just last year.

The Fed did indeed slash interest rates, implementing a reduction of 75 basis points on January 22 and a further 50 points on January 30–the biggest such cuts since August 1982, which marked the birth of the biggest bull market of our lifetimes. The entire market shot up after the rate cuts, with the financial sector leading the way.

The Bernanke Bailout

Federal Reserve Chairman Ben Bernanke has virtually guaranteed that the central bank will slash interest rates to combat recession later this month. Early in my career, I worked for the Federal Reserve Bank of St. Louis, and served on its internal Open Market Committee, which advised the president of the bank how to vote on rate decisions at the Federal Open Market Committee, or FOMC. Now, we central bankers referred to aggressive interest rate cuts as "pushing on a string." Go ahead and push as hard as you want… but the other end won't move. The Fed can make credit cheap, but the problem is, it can't make people borrow.

In January, I stated that last year's turbulence in the financial sector was probably not over…yet. Banks were still proving reluctant to pick up the string, because they're afraid if they use the money to extend new loans, these loans may go sour.  No surprise there. But what did surprise me were the number of contrarians that were starting to dive into financials, including a number of actively managed mutual funds, which got me wondering… maybe some of us can see the bottom after all.

Three Contenders to Count On

In the March 2008 issue of the ETF Insider, I review nearly two-dozen financial ETFs and discussed a few top contenders that contrarians are swimming out to get. The first couple are fully diversified within the financial sector, owning banks, asset managers, insurance companies, and other well-known names like American Express. But only one of the two has a clear advantage: pure liquidity.

Liquidity matters if you're an ETF investor because it impacts the bid-ask spread, and the speed with which the trade closes. For example, let's say ETF #1 trades a respectable 171,000 shares on the average day. Not bad. But ETF #2 is a close competitor in the same industry–trades 182.5 million. ETF #2's trades will be filled faster and closer to the price you have in mind when you decide to trade.

Now, more adventuresome investors will be drawn to my top contender. This bank-industry ETF has decent trading volume, an average of 4.3 million shares a day. Yes, it was down 21.9% last year but has already bounced back an astounding 6.9% in January 2008. As usual, the worst possible decline implies the strongest possible rebound. Come December 31, 2008, I expect all of these top contenders to be among the year's big winners!

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