Failure, 200 Day Moving Average Failure
The Indexes made the charge for the 200DMA and failed. The DOW and the S&P 500 both failed to reach the 200DMA on the recent rally. The QQQQ made the climb above the 200DMA however that failed quickly. We are currently below the 200DMA on these 3 primary indexes. What happens next?
These are bearish indicators. What happens next may be a potential change of character for the overall market.
Conditions are rife for selling to move in, the US Dollar is now at a 7 week low against the Euro and the Commodities are catching a bid.
The S&P500 has advanced +39.4% off the 667 low (3/6/09) and the extent of this move without any significant retracement to the 667 low has surprised many.
The Energy prices may rise and transports would suffer, however the usual trend may not happen this time. Gold and other precious metals could see gains here.
Primary focus sectors have been leaders such as energy, materials, and technology, and the strength in commodity sectors has been driven by the decline in the US dollar, as the USD is now trading below its 200 DMA, and is headed lower. This decline indicates that crude oil and gold will continue their upside moves.
This may not be a fast decent however the panic can spread fast, remember Stockshakers has held the belief that we could see the DOW reach the 5000’s. Stockshakers would hope to be wrong on this point and the current administration will hopefully do all it can to help us avoid this change of market complexion.
Keep an eye on GS Goldman Sachs has become one of the key financials to watch, if the financials fail here the market will follow.
Stockshakers favorite in the financial sector is Wells Fargo (Stockshakers will accumulate on the dips).
At what time is time to take some chips (Long term) off the table?
The market is showing signs of rolling over in a bear market rally and this rollover has the potential to wipe out some 24% gains + for many. Don’t let this happen to you. Be cautious before you are bold and exercise some caution. Stockshakers will hedge our positions with short positions and puts. The ultrashort ETFs will see STRONG inflows. The opportunity to capitolize on this move is too strong for us to ignore.
Watch volume and over all buying and selling the ratio is pointing to institiutions selling faster than the price is responding.
This is a key indicator we follow here at Stockshakers.com
ETF’s and leverage are an excellent tool, this is a great piece that may shed some light on the subject. Enjoy.
Gearing Up For Leverage: An In-Depth Review Of A Growing Market Phenomenon
We will borrow the British expression for leverage - gearing - to refer to levered, inverse and/or levered-inverse exchange-traded tracking products1 (ETPs). First, by using the expression “geared” we are attempting to refer to this group of ETPs - +3x, +2x, -1x, -2x and -3x exposure2 - in a more succinct manner. Let us hope that the gearing magnitudes do not increase any further (4x)! Second, we would like to differentiate between the leverage used by ETPs to magnify and/or invert a desired exposure, and the leverage used by closed-end funds to enhance their distribution rate. The first modifies the exposure, the second modifies the distribution.3
The market has embraced geared ETPs as measured by the growth in the assets that these tools have gathered in a relatively short period.
Too many users of geared ETPs do not fully appreciate the effect that excessive volatility has on their return. Many blame the tool, but we would argue that it is often the user who is not skilled enough. A trending market - a low volatility relative to return - could produce satisfactory returns, while a trendless index with excessive volatility is likely to produce substantial losses. A real example will help us illustrate the impact of volatility on the return of a geared ETP.
Geared ETPs may not be as tax-efficient as ETPs that track indices of stocks and bonds because they cannot take advantage of the tax-efficiency resulting from the creation/redemption process.
Geared ETPs are more likely to carry counterparty risk, which is non-existent in current U.S.-traded exchange-traded funds (ETFs) that track the simple exposure - one time beta - of stock and bond indices by holding the underlying securities.
We think geared ETPs are appropriate only for speculative investors and short-term traders who are truly familiar with all the moving parts that affect the total return of a geared ETP.
ASSET GROWTH
In the last few years, geared ETPs have expanded the arsenal of tools that allow market players to confront the markets. The market has certainly embraced these relatively new tools quickly and broadly as evidenced by the rate of growth in assets in those types of products. Since the first geared ETP was launched in the summer of 2006, there are currently $30 billion in more than 120 geared ETPs. The assets in geared ETPs have risen as the markets declined last year.
Players
The first mover’s advantage is usually quite strong in the ETP universe. Thus, it is not too surprising that ProShares, the first to launch geared ETPs, currently holds over 80% of the assets in geared ETPs. It is surprising though, that Direxion, the newest entrant in this universe after launching its first geared ETP as recently as early November, has quickly ramped up to be the number two player as measured by assets. Direxion holds over 10% of the assets in geared ETPs. One may argue that one of the reasons why Direxion gathered so many assets in such a short period, is because Direxion also had a first mover’s advantage - Direxion gears its ETPs three times, as opposed to only two times. At this point, no other geared ETP provider does that.
Some of the other players that offer geared ETPs are PowerShares/Deutsche Bank (5% of assets), Rydex (1%) as well as Morgan Stanley and UBS.
Gearing Magnitude
It appears that when market players employ geared ETPs, particularly when they have a view against the market, they are quite confident about their “bet.” That would explain why many more assets are held in geared ETPs that provide -2x exposure (46% of total geared ETP assets) compared to those with -1x exposure (only 6%), as shown in the pie chart below.
THE IMPACT OF VOLATILITY: THE IGNORED VARIABLE
While some blame the geared ETPs - the tools - for not producing the results that they expect, we argue that the problem lies with the users, many of which are not familiar with the variables - volatility of the underlying index in particular - that define the performance of a geared ETP. The other principal variable that defines the return of a geared ETP - the return of the underlying index - is quite obvious to users. Following, we will attempt to explain the difference between a “Simplistic Return Expectation” and the actual return of a geared ETP with a couple of real examples. Since exaggeration - 3x gearing as opposed to 2x gearing - often helps to clarify the relationship between a cause and its effect, we will use two Direxion ETPs - the Direxion Energy Bull 3X Shares (ERX) and the Direxion Energy Bear 3X Shares (ERY) for our illustration. The underlying index for both is the Russell Energy 1000 Index.4
The Ideal Period
The optimum outcome for a geared ETP is a period of high absolute return and low volatility for the underlying index, which is what some may refer to as a trending market - the underlying index goes far and it does so with few zigzags. Such was the case for the Russell Energy 1000 Index from 12/23/08 to 1/6/09 (the green dots in the chart above), during which it returned 14.8%. There was no “zigzagging;” the index went straight up.
The simplistic expectation for the return of ERX (+3x) would have been 44.3%, or three times the 14.8% return of the underlying index during the period. In fact, ERX returned more than that - 50.5% during the same period. The reason the actual return was higher than the simplistic return expectation is because the return was tripled every day, and every day the starting point was higher without exception. Bottom line, the return of the underlying index was high relative to its volatility during our Ideal Period, as shown in the Table below. If market players are able to successfully identify and anticipate such periods of trending markets, it is likely that users will be rewarded for their use of geared ETPs.
The Nightmarish Period
Investors should avoid periods when a market experiences a volatility that is too high relative to its absolute return. Such a period took place only a few days before our Ideal Period mentioned above. From 11/17/08 to 12/2/2008, the Russell Energy 1000 Index did “basically nothing” (the red dots in the Russell Energy 1000 Index chart above). Its return was almost zero - 0.1% to be precise. However, the index experienced tremendous volatility - sharp zigzags. Some would describe this period as trendless with high volatility. An uninformed investor may have initially presumed that ERX (+3X) and ERY (-3X) had similar returns as that of the underlying index, i.e. a return close to zero during the same period. Yet, that was not the case. ERX returned -15.6% and ERY returned -27.2%! Users of geared ETPs must be extremely cautious during periods of high volatility. In order to maintain a constant gearing ratio, the geared ETPs are basically reducing their exposure after the underlying index has declined, and increasing their exposure after the index has risen. It is somewhat akin to constantly buying high and selling low. Geared ETP users could lose their shirt, and much more, without close and frequent monitoring of the positions.
In summary, high volatility relative to the absolute of the return of a geared ETP’s underlying index is crucial for positive returns among geared ETPs. Too many users incorrectly assume that accurately guessing the direction of a geared ETP’s underlying index is sufficient. It is not! Correctly guessing a low enough volatility is necessary as well. The Table below summarizes the return and volatility - for the holding period and annualized - of our Ideal and Nightmarish Periods and the consequences on the returns of the corresponding geared ETPs. Standardized returns of the ETPs mentioned are on the last page of this report.
UNDERSTANDING THE UNDERLYING INDEX: REALLY!
Individuals should fully understand the underlying index of a geared ETP. Initially, this may appear to be an obvious, and unnecessary, statement. Yet, we would like to underscore its importance, especially with certain geared ETPs whose underlying indices track commodities.
The underlying indices of most geared ETPs are fairly straightforward, but a few may not be. An example of a straightforward index would be the underlying index of the UltraShort Financials ProShares (SKF) - the Dow Jones U.S. Financials Index. Even without viewing the top holdings of the Dow Jones U.S. Financials Index, one could easily imagine which they are, and how the index would likely behave as financial stocks trade.5 However, some of the underlying indices of geared ETPs are not as straightforward as most investors may suspect. The underlying index of the ProShares Ultra DJ-AIG Crude Oil (UCO) is a good example. UCO tracks +2x the daily
return of the DJ-AIG Crude Oil Index. If the term structure of oil futures is in heavy contango, as was particularly the case in December, the DJ-AIG Crude Oil Index will likely produce negative returns (assuming minimal changes in spot.) In other words, rolling futures positions during contango will burden the return of a commodity index, if all else remains equal. If an individual is unaware of the burden that contango may have on the return of an index,6 and accurately anticipated an increase in the spot price of oil, he may still be disappointed at the return of UCO. Refer to the discussion of contango7 in our 1/26/09 report titled Oil Exchange-traded Tracking Products.
BUYING BETWEEN RESET PERIODS: WHAT DID I BUY?!
Most of the geared ETPs reset their desired exposure on a daily basis - all ProShares and Direxion at this point - in order to maintain a constant gearing ratio. Yet a few do so on a monthly basis - all geared PowerShares reset their exposure on a monthly basis. One reset frequency is not necessarily better than the other; however, individuals must understand that if they purchase or sell the shares of a geared ETP between resets, the geared ETP may end up experiencing a different gearing magnitude during the holding period. In other words, an ETP with a daily constant gearing ratio of +2x may effectively end up experiencing a +10x or -2.5x gearing magnitude depending on the entry point, as we illustrate in the example below.
In our hypothetical example above, if one had bought the shares of the geared ETP, which happens to have a +2x constant gearing ratio, at 11:00 a.m. - when the underlying index reached 8 or its bottom for the day - the effective gearing ratio for the holding period, i.e. from 11 AM until the end of the day, would have been an amazing +10x. On the other hand, if one had bought the shares when the index peaked between resets - at 2:00 p.m. - the effective gearing ratio would have been a -2.5x. In other words, the bullish geared ETP behaved like a bearish geared ETP from 2:00 p.m. to the close!
Our hypothetical example could just as easily be applied to a geared ETP that resets on a monthly basis. Simply convert the hours of the trading day into days of the month.
DO NOT CALL IT TRACKING ERROR: IT’S NOT THAT!
Many individuals talk about geared ETPs having significant “tracking error” when they really refer to the divergence between the “simplistic return expectation” and the actual return on the geared ETP. This divergence is not tracking error! In fact, most of the geared ETPs, especially if they use total return swaps (see below) as opposed to futures, experience minimal tracking error. Tracking error is defined differently - it is the difference between the NAV return of an ETP and the return of its underlying index. The returns may be calculated on a daily, weekly, monthly, quarterly or yearly basis. The time frame evaluated may vary as well - last year, first quarter, etc.
POTENTIAL TAX INEFFICIENCY
During certain market environments, some geared ETPs may not be as tax-efficient as most of their peers. One of the most significant advantages of exchange-traded funds is their tax-efficiency - they historically have rarely distributed capital gains at year-end. However, not all ETPs always enjoy such an advantage. Especially during a period when markets move significantly in one direction, as was the case last year, some geared ETPs may end up paying a taxable distribution, which could be a substantial amount of its assets and is likely not able to be offset with capital losses. For example, after most markets declined significantly last year, several inverse ETPs paid out distributions that ranged from 1% to almost 80% of their net asset value.
The creation/redemption process of a geared ETP does not allow it to minimize or avoid distributing capital gains. Unlike most exchange-traded funds, the creation and redemption process of geared ETPs takes place with cash, not in-kind, because total return swaps - not underlying stocks or bonds - are used to provide the desired geared exposure. Thus, a geared ETP cannot displace any gains during the redemption process. Furthermore, a geared ETP’s relatively high portfolio turnover ratio requires it to realize gains, and as a registered investment company, it is required to distribute at least 90% of realized gains. Not only were the 2008 distributions a taxable event, but it later turned out that they were not capital gains that may have been able to be offset by capital losses.
Shareholders of geared ETPs did not have advance notice of the substantial distributions - there was no wiggle room between announcement and declaration dates. Had they declared the distributions ahead of time, the relevant geared ETPs would have probably traded at substantial discounts to their net asset values as holders would have likely sold their shares to avoid a tax consequence. The Direxions avoided distributions last year partly because they carefully timed their launch - they were launched in early November, only days after the October 31 deadline when funds have to account for year-end distributions.
COUNTERPARTY RISK
Most geared ETPs achieve their desired exposure through total return swaps, which add an additional layer of risk: counterparty risk. In simple terms, a total return swap is an agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the total return of a reference asset or index. If one of the counterparties suddenly (or not so suddenly) becomes unable to deliver its share of the contract, it will default on the swap.
There are several ways in which geared ETPs have attempted to mitigate counterparty risk. First, geared ETPs use swap providers with only the highest of credit qualities. (Unfortunately, the recent past has evidenced several examples of financial institutions whose credit quality deteriorated quite rapidly). Second, a geared ETP that enters into swap agreements may diversify its counterparties. In other words, an ETP may enter into swap agreements with various counterparties instead of using only one counterparty. Unfortunately, an ETP with few assets is probably not able to afford more than one counterparty at a time. Third, a geared ETP may decide to enter into short-term swap agreements such as a 1-day or 30-day swaps instead of a 1-year swap agreement in order to minimize its exposure to the counterparty. Fourth, a geared ETP may use futures instead of swaps to minimize counterparty risk. However, futures may exacerbate an ETP’s tracking error. Instead, swaps allow a geared ETP to control more precisely the targeted return. Finally, ETP providers may enter into tri-party agreements: (1) ETP, (2) swap provider, and (3) custodian. In a tri-party agreement, the collateral that must be posted for the swap agreement is segregated into an account with the custodian. Without a tri-party agreement, the swap provider would hold the collateral, thus only two parties would be involved. With a tri-party agreement, in case the swap provider defaults all of a sudden, only the overnight mark-to-market would be at risk, not the collateral. As one would expect, a tri-party agreement carries a slightly higher cost, but it is another measure that helps reduce counterparty risk.
It should be noted that some of the geared ETPs are Exchange-traded Notes. In particular, all the PowerShares that gear their exposure are exchange-traded notes. In general, an ETN carries the credit quality risk of its issuer. In the case of the geared PowerShares currently in existence, that would be Deutsche Bank.
SUITABILITY
Given all the complexities of geared ETPs, we think they are most appropriate for only speculative investors and short-term8 traders who truly understand all the moving parts that affect the total return of geared ETPs. Such users should monitor positions carefully and frequently, and should be ready to rebalance positions as a geared ETP’s underlying index changes. The higher the gearing ratio of an ETP, the nimbler and more cautious the user needs to be. This report has attempted to clarify most of the major moving parts that affect the total return of a geared ETP, yet note that a few additional moving parts such as a changing premium/discount to net asset value and tracking error are universal to all ETPs - geared and non-geared.
ETPs include different structures such as Exchange-traded Funds, Exchange-traded Notes, Grantor Trusts and others.
Alternatively, some refer to their gearing as +300%, +200%, -100%, -200% and -300%, respectively.
It should be noted that a side effect of enhancing a closed-end fund’s distribution with leverage is a magnification of its exposure as well.
This index, as well as others tracked by Direxion ETPs, were created for the ETPs.
Some users may believe that SKF’s underlying index is the S&P 500 Financials Index, which has a high correlation to the Dow Jones U.S. Financials Index, but may not experience exactly the same return over a specific period.
Such an investor may have incorrectly assumed that the DJ-AIG Crude Oil Index was an “oil spot” index.
A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity.
By short term, we are referring to hours and days, maybe weeks.
Stockshakers is prepared to hedge the potential bear resumption.
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