Think Oil Peaked? Here's How to Play Your Hunch

So if you're an oil bear, what's the best way to position your portfolio? The most basic thing to do is trim commodities holdings and increase your allocation to stocks. Stocks have an inverse relationship with oil prices. As we've noted, since the 1970s higher oil prices have hurt the stock market whereas a decline in oil prices leads to better equity returns.

Simeon Hyman, equity strategist of the portfolio advisory group at Lehman Brothers' private investment management arm, says they're currently lighter on commodities and "fully invested" in stocks. That's not a full-throated endorsement of equities, but if you're underweighted on stocks now is a good time to put more money in, Hyman says.

"Our view is predicated on a fairly bearish macro outlook. I'm not sure a modest decline in energy would cause us to get much more bullish on the equity market because energy isn't the only headwind facing the economy," Hyman says.

David Reilly, director of portfolio strategies at Rydex Investments, which runs several leveraged and inverse funds designed to magnify or hedge portfolio positions, also says just increasing your general exposure to stocks is the "most conservative" route. But if you're feeling bolder, consider areas likely to benefit from an energy pullback, such as transportation and consumer-discretionary stocks.

"They've been beaten up very badly and oil prices play no small part in that," Reilly says. A cheap and straightforward way to do this is with ETFs such as iShares Dow Jones Transportation Average (IYT), which tracks the Dow Jones Transportation Index. Despite the tough market, the fund is up 19% through May, thanks to several major companies in the fund being able to pass higher costs to customers.

Oil bears also might consider investing in Japan, which "is the most oil-dependent of all major economies," Reilly says. As such, as crude prices retreat the benefits to the Japanese economy should be magnified. iShares MSCI Japan (EWJ) owns well-known blue chips such as Toyota Motor (TM), Canon (CAJ) and Nintendo.

Scott Wren, senior equity strategist at Wachovia Securities, says he's advising clients to start positioning for better economic times ahead. "For us, commodities are likely to be flat to down over the next year or so, and falling oil prices are going to help the better economic scenario we're projecting," Wren says. After peaking last week above $138, oil futures pulled back to about $132 on Thursday.

This means going more cyclical, favoring a value approach vs. growth as well as small-cap stocks vs. large caps, Wren says. Sector-wise, lean toward consumer discretionary and industrials stocks and shy away from consumer staples and health care.

Of course, the most direct bear play on oil is to short it, betting directly that prices will go down. You can buy an "inverse" ETF such as UltraShort Oil & Gas ProShares (DUG), which is designed to perform twice the opposite of how the Dow Jones U.S. Oil & Gas Index does. Recently it's been among the more popular ETFs by volume. Rydex also has one, debuting Thursday, called the Rydex Inverse 2x S&P Select Sector Energy ETF (REC).

But Morningstar analyst Jeffrey Ptak doesn't recommend these for most investors. "You're doubling down, getting 200% exposure. For a certain kind of very aggressive, high-conviction investor a strategy like that might make sense, but they're not for the vast majority," Ptak says.

Indeed, one of the more high-profile ETF embarrassments of late is the MacroShares Oil Up (UCR) and MacroShares Oil Down (DCR) funds. While most rival ETFs rely on futures contracts to track the up-and-down movements in crude prices, the MacroShares' funds were more complex, mimicking oil prices by shifting assets between the two portfolios. However, because oil more than doubled in price since the funds launched, Oil Up effectively ended up with all of the assets on its books, leaving Oil Down high and dry. The unanticipated development is forcing the funds to be dissolved on June 25.

A better strategy is to short a basic oil ETF such as United States Oil (USO), which tracks futures contracts for West Texas Intermediate light sweet crude, as traded on the New York Mercantile Exchange. Shorting involves selling borrowed shares with the hope the price will fall and they can be bought back cheaper. Keep in mind, "it's still not a strategy for the faint of heart given the volatility we've seen in the crude oil market and the sharp run-up in crude prices," Ptak says. "You certainly want to be cautious."

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