ETFs To Buy With Correction Fear In The Air

August was not kind to investors. For most of the major stock market indexes, the month saw the worst performance in three or four years, which has raised all manner of questions: Is this a buying opportunity? Or is this the start of a steeper decline and a bear market?

The bears argue that a protracted pullback in the market is overdue. After rallying for six-straight years, the stock market is "long in the tooth," say the bears.

On the flip side, bulls say that this correction will end like all the others seen in recent years: with stocks quickly rebounding and rallying to new record highs.

Only time will tell which side is correct, but for now, the U.S. and other developed-market economies seem to be weathering the storm in China and other emerging markets.

Bull Blip?
The bulls are counting on that to continue. If it does and they're right, then the peak-to-trough 12.6 percent correction in the S&P 500 will turn out to be a blip in the longer-term bull market.

Investors buying now must contend with the potential for more volatility, negative news flow from China, September seasonal weakness and Fed uncertainty. But if the dust settles without a major economic shock, those investors will be glad to have bought when others were fearful.

Here are the some of the areas that could rally strongly if and when the market turns around.

7. Commodities
Perhaps the most beaten down area of the market is commodities. Down four-straight years heading into 2015, hopes were high that the asset class could finally bottom out. Instead, the sell-off accelerated, with most commodities now at the lowest levels in years or even decades.

While questions remain about whether commodities have more downside in store, bold investors could begin to wade into the pool. After all, many commodities are now below their cost of production, suggesting that such prices won't last over the long term.

The United States Commodity Fund (USCI | D-33), which weights its holdings to mitigate "roll costs" from contango is one of the best ETFs for commodity exposure. It's down 12.8 percent year-to-date and 42.5 percent from its highs.

YTD Return For USCI

6. Energy
One specific area within commodities that's done poorly during the past year is energy. In fact, it's the worst of the major U.S. stock market sectors. Based on last week's low, the Energy Select Sector SPDR (XLE | A-93) dropped more than 40 percent from its highs, while the SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-57) lost more than 60 percent.

Keying in on signs that U.S. production is topping out, crude staged a furious rally in recent days, helping to lift energy ETFs from their worst levels. The sector looks attractive if prices pull back toward recent lows.

If the oil cycle shifts in late 2016 or 2017 as expected, most of the energy equity ETFs will do well. XLE and XOP offer broad exposure to any rebound in the stocks of oil and natural gas producers. Another fund to consider is the PowerShares Dynamic Energy Exploration & Production ETF (PXE | B-76), which is a smart-beta product with a track record of outperformance.

YTD Returns For XLE, XOP, PXE

5. Health Care, Japan & Europe

While focusing on the biggest losers is one way to play the potential stock market bounce, another strategy is to buy the former winners.

The hottest areas of 2015 through the first seven months of the year, U.S. health care, Japan and Europe have not been left out of the recent global stock market rout. In fact, these were some of the worst-hit areas during August.

U.S. health care was the worst-performing sector of the S&P 500 in the month, losing 8 percent. The Health Care Select SPDR (XLV | A-94) which followed suit with an 8 percent loss of its own, may now be ripe for a purchase.

More aggressive investors could consider the iShares Nasdaq Biotechnology ETF (IBB | A-45), an ETF that tracks 150 Nasdaq-listed biotech stocks. It fell 11.6 percent in August, but is still up 11.7 percent year-to-date.

YTD Returns For XLV, IBB

Meanwhile, Europe and Japan—the two countries that saw soaring stock markets for much of 2015—reversed fast and hard in August. Still, both markets remain supported by quantitative easing from central banks and may be quick to recover if investor risk appetite returns.

The currency-hedged and export-tilted WisdomTree Japan Hedged Equity ETF (DXJ | B-64) is a solid option for Japan exposure, while the WisdomTree Europe Hedged Equity ETF (HEDJ | B-49) is the equivalent fund for Europe. After August's sell-off, both ETFs are barely in the green for the year after having been up nearly 23 percent at the highs.

YTD Returns For DXJ, HEDJ

4. High-Yield Bonds

High-yield bonds sagged to their lowest level in three years last week, lifting their yields to 7 percent or more. While default rates are trending higher, ETFs like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) look compelling at these prices.

Moody's estimates that junk bond defaults will remain below long-term averages, even after accounting for the turmoil in the oil patch. Thus—barring a full-blown recession—ETFs like HYG, the Market Vectors Fallen Angel High Yield Bond Fund (ANGL | C-49), or the actively managed First Trust Tactical High Yield Fund (HYLS | D) may be poised to rebound while offering juicy yields at the same time.

Year-to-date HYLS and ANGL have delivered positive returns, while HYG has lost only 1 percent as interest payments offset price declines.

YTD Returns For HYG, ANGL, HYLS

3. Defensive Sectors

Investors who want exposure to the markets, but are concerned about the storms brewing in emerging markets, could opt to overweight the U.S. defensive sectors of the market.

These are the "safe haven" sectors like consumer staples and utilities, represented by ETFs like the Consumer Staples Select SPDR (XLP | A-94) and the Utilities Select SPDR (XLU | A-88).

Other options include smart-beta products like the PowerShares S&P 500 Low Volatility ETF (SPLV | A-60), that hold the least-volatile stocks within the market to limit losses during periods of market stress. Currently, SPLV's portfolio is heavy on financials and consumer staples.

YTD Returns For XLP, XLU, SPLV

2. Broad-Market

Rather than pick and choose individual areas, if all else fails, an investor can simply buy a broad-market ETF for exposure to any market rebound. The SPDR S&P 500 (SPY | A-99) is highly liquid and transparent as the world's largest ETF.

Perhaps even more appealing is the SPDR S&P MidCap 400 (MDY | A-84), which has trounced SPY over the long term.

YTD Returns For SPY, MDY

1. Emerging Markets

The epicenter of current global woes, emerging market stocks have been absolutely decimated. But China, which dominated in the headlines in recent weeks, isn't even the worst performer.

The Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-53) is down "only" 16.6 percent year-to-date.

Compare that to with iShares MSCI Brazil Capped ETF (EWZ | B-95), down nearly 33 percent, or the iShares MSCI Turkey ETF (TUR | B-100), down about 30 percent. Both Brazil and Turkey have been hit hard by political crises, plunging currencies and high inflation.

Buying emerging markets amid such turmoil is a foolish bet―or is it? At some point, these downtrodden markets will have priced in all the bad news and a bottoming process can begin. Picking and choosing which market will do well is an option, but a risky one.

Alternatively, an investor can simply buy a broad-based fund like the Vanguard FTSE Emerging Markets ETF (VWO | B-88), which offers cheap, diversified exposure to emerging markets.

YTD Returns For ASHR, EWZ, TUR, VWO

Contact Sumit Roy at [email protected].