Financial Sector Ultra-Shorts: Must Have Protection Against Banking Sector Madness

Is the banking sector rapidly disintegrating into some real-life version of The Mad Hatter’s tea party from Alice in Wonderland?

Forget the volumes of technical debate on the current moves to save the banks. Let’s just step back and use common sense. Consider just a few recent events:

Suspension of Mark to Market Accounting

Using this method, mortgaged backed securities were valued just like any other asset for which there is an active market - as of the latest sale prices for similar assets on the open market, just like you would determine a fair price for a house, car, business, or toaster. Prices of various kinds of debt have been reasonably discounted severely because there is now increased risk of default, just like used car prices drop with age and mileage because of the increased risk of loss from repair costs.

With the suspension of “M2M”, the banks and government are attempting to inflate the value of banking assets based solely on current cash flow. By this logic, because GM bonds are current on interest payments, they should be valued at 100% of par rather than the 10% or less that reflects the risk of future default.

It’s like saying that critically ill patients on life support are as healthy as anyone else as long as they continue to breath.

The Fed Accepting Lower Quality Collateral

Instead of just top-rated sovereign debt (admittedly no longer risk free), the Fed now accepts, in certain cases, investment grade corporate bonds and commercial paper, residential and even commercial real estate loans.

• Residential Real Estate loans: Increasing joblessness (even at a declining rate of growth) means more mortgage defaults. Also, remember that employment is a lagging indicator, and thus will not improve until later in a still unseen recovery.

• Commercial real estate loans: As I’ve noted earlier, the bankruptcy of General Growth Properties (GGP), the largest mall REIT, casts genuine doubt on the stability of retail property valuations for the foreseeable future.

• I haven’t even begun to discuss the manipulations needed to achieve the illusion of earnings improvements. Too technical for now.

What Investors Can Do

Because I believe critique without a practical remedy is of limited value for readers, I leave you all with one simple strategy to protect your portfolios for the day when the banking sector façade falls away:

Short the Financial Sector

In sum, by one means or another, short the financials.

One simple idea: The Ultrashort Financials (SKF). As the chart below shows (click to enlarge), these are at multiyear lows that are not justified by the above noted facts in the banking sector. Given that these are at multi-year lows, you’ll know quickly if this support won’t hold, so you can set sell stops within 10% below these levels to keep your risk low. Given the recent highs, the possible risk / reward makes this a worthwhile trade.

Obviously there are other means, like shorting individual banks.

Risks

Given the manipulations already seen, it is not far-fetched to assume other “extra-market” manipulative means might be used to artificially prop up the banks or other assets. Government imposition of “bank holidays,” currency controls, extraordinary “emergency” legislation have all been used in the past and could be used again. We may be right in our analysis, but still not profit.

Conclusion

Based on the evidence we have, the optimism for the financials is overdone, and the SKFs are a good way to play that, at least for a short term hedge. Of course, if the financials swoon again, so will the rest of the market, so other ultrashorts like ProShares UltraShort S&P 500 ETF (SDS), ProShares UltraShort Real Estate ETF (SRS), and ProShares UltraShort Russell 2000 ETF (TWM) are ideas to consider as well.

Readers know I’m more of a buy and hold investor for income, not a short term trader. However, a good investor must be flexible and be willing to look at the facts, draw conclusions, and take appropriate action, even if it goes against one’s nature.

Disclosure: I have positions in most or all of the above mentioned securities.

Comments

[Vittorio:]

the multi year lows of SKS (and for FAZ also) is explained by the technical feature of these instruments. In a volatile market as this, the value of the leveraaged short ETFs will decline in the medium term (by mathematical reasons). So I think it's best not to advice these instruments for purposes other than day-trading.

Apr 24 05:41 AM

[Amouna:]

Your articles are always of good added value. Thank you!

Apr 24 05:41 AM

[Toeser:]

The mark-to-market accounting rules were insane, and drove a big part of this crisis. You cannot have mark-to-market rules for illiquid instruments, without devastating effects during bad times. Investors and depositors need to be protected from firms that would "cook the books", but this method of protection is a cure that's worse than the disease.

And the previous comments were right. You cannot rely on ultrashort funds. Some have tracked very poorly, if at all.

Apr 24 07:31 AM

[Cliff Wachtel:]

Thanks for your kind words. Cliff


On Apr 24 05:41 AM Amouna wrote:

> Your articles are always of good added value. Thank you!

Apr 24 07:43 AM

[Cliff Wachtel:]

Maybe a bit longer than that. What's tempting about them now is that they're holding at multi- year support, so if they tank more we'll know quickly and can get out with small losses. thanks for your input, cliff


On Apr 24 05:41 AM Vittorio wrote:

> the multi year lows of SKS (and for FAZ also) is explained by the
> technical feature of these instruments. In a volatile market as this,
> the value of the leveraaged short ETFs will decline in the medium
> term (by mathematical reasons). So I think it's best not to advice
> these instruments for purposes other than day-trading.

Apr 24 07:44 AM

[Cliff Wachtel:]

Very good point, true enough, these rules need modification because they can start an unfair vicious cycle. The problem is that by removing them and substituting them with valuation based on current cash flow is even worse for reasons I describe. Need some valuation method that deals with the problems you and I mention. Thanks for your comments, Cliff


On Apr 24 07:31 AM Toeser wrote:

> The mark-to-market accounting rules were insane, and drove a big
> part of this crisis. You cannot have mark-to-market rules for illiquid
> instruments, without devastating effects during bad times. Investors
> and depositors need to be protected from firms that would "cook the
> books", but this method of protection is a cure that's worse than
> the disease.
>
> And the previous comments were right. You cannot rely on ultrashort
> funds. Some have tracked very poorly, if at all.

Apr 24 07:49 AM

[Cliff Wachtel:]

As mentioned in another reply here, skf is an interesting short term trade because it's holding at multi year support. We can set sell stops not far below in case that support fails, and not suffer too much of a loss, thus while a trade, a low risk high potential reward trade (barring more manipulation - a very real possibility-to prop up bank share prices). thanks for your comments. Cliff


On Apr 24 06:33 AM User 305589 wrote:

> the premier risk with your investment is that the levered etfs suck
> nig time. They are strictly daytrading vehicles. For instance, FAS
> and FAZ both lost a ton of value over the past 12 months - even though
> one is double long financials etf and the other one a double short.
> leveraged etfs only make money for the issuers of these crappy instruments

Apr 24 07:52 AM

[AndrewBaker:]

Firstly, FAS and FAZ are triple leveraged, not double. UYG and SKF are doubles. Both will lose money over the longer period due to the math behind their construction. FAS and FAZ should be day-traded only, but can be held for maybe two, or three days max, if the market goes against you and you are very confident in your choice of direction. UYG and SKF can be held for a week and some (very few) times longer if the same reasons above apply. However, for a longer term view on the banks, choose a non-leveraged financial ETF, where there is no loss due to the cost of the derivitives and other instruments that are bought on a daily basis to give the leverage, which itself is only valid on a day basis. Great stocks to trade, but not to hold.

Apr 24 09:28 AM

[Fabien Hug:]

Thank you for the good article and for the good comments about the trickiness of these ETFs. For instance, FAZ was worth $ 50 some 3 months ago when the banking index was as the same level as today.

Apr 24 09:54 AM

[Fabien Hug:]

Forgot to write that when FAZ is trading in the $ 8 and $ 9 range, I feel comfortable to buy and hold for a while. I'm long FAZ.

Apr 24 10:28 AM

[YoYoMama:]

Those who bought FAZ in November bought it in the $100 - $200 price range. Now it's at $8. What does that tell you about being "long" on FAZ?

Already lost money holding FAZ just a couple of weeks. Not going there again. Regarding financials, just avoid.


On Apr 24 10:28 AM Fabien Hug wrote:

> Forgot to write that when FAZ is trading in the $ 8 and $ 9 range,
> I feel comfortable to buy and hold for a while. I'm long FAZ.

Apr 24 06:52 PM

[Erick Tippett:]

I hear commentary along the lines the FAZ has had quite a drop
since last November, but no one to my satisfaction in these
commentaries has explained why FAZ reached the levels it did
and remained there for a hell of lot longer than two or three days!
What's math got to do with it?

EDT
Chicago, Illinois

Apr 25 04:11 AM

[MattZN:]

You gotta be kidding. Those 2x and 3x ultra funds, short or long, are a HORRIBLE way to play the market. They all lose money for anyone trying to use them for anything other then a day-trade. It doesn't take a rocket scientist to see it, just run a 6 and 12-month comparative graph of an ultra short fund against its equivalent ultra long fund.

I'm actually playing with these funds a bit myself... by shorting BOTH the short and long funds in equal dollar amounts. I'm sure a lot of other people are doing the same thing. The only problem is finding shares to borrow because the ultra-short funds tend to have daily volumes in excess of their net assets. That is, of course, because only an idiot actually buys an ultra fund with the intent to hold onto it for more then a day.

-Matt

Apr 25 06:10 PM

[Ludovici:]

AndrewBaker and MattZN: If I understand you right, these funds -- I'm thinking of SRS and SKF here -- are heading inexorably toward zero. Is that right? Or do you just mean they won't peak again as high as they did in the past?

Apr 26 11:30 AM

[Rod Raynovich:]

SRS Ultra Short Real Estate is only for "extreme traders" who like volatility of 5-10% per day. Do a search and you'll see that it is a very controversial ETF that does not track real estate equities and in fact may actually affect the very REITS they are supposed to track! Before trading SRS read the prospectus and read this:

The most excellent "Zero Hedge" Web site has done your REIT homework for you...
zerohedge.blogspot.com...

Apr 27 10:50 PM

[Lee Eugene ...:]

I agree with some of the comments about the mega ultra death ETF's. I trade SKF's all the time and there are some serious tracking issues. The concept is solid, but investors need to know their lunch may be eaten away by negative compounding and repricing of the swaps the managers use to get the inverse effect. I would beware as a long term investor.

Apr 28 11:58 PM

[User 305589:]

Cliff, there is no such thing as multi-year support for these levered etfs. One may have different opinions about the concept of "tecnical support levels" anyway, but as a matter of fact, for vehicles like skf and FAZ it is their NAV and the way they are functioning that matters and tat means that they will keep sinking even in the face of banking stock declines. Their construction makes them strictly daytrading (or at best a few day'strading) vehicles and long term I could prove to you mathematically that the ultra shorts as well as the ultra long etfs are ALL headed to ZERO!

You do not want to 'protect' your account with stuff that has a 100% certainty to fall to zero, no matter what the market does!
Buy bull-put spreads, sell call-spreads, short banking stocks or short unleverd banking etfs - whatever, all these are better than these ultra-imploding etfs.


On Apr 24 07:44 AM Cliff Wachtel wrote:

> Maybe a bit longer than that. What's tempting about them now is that
> they're holding at multi- year support, so if they tank more we'll
> know quickly and can get out with small losses. thanks for your input,
> cliff

Apr 29 05:03 AM

[debtacid:]

Bad advice because it makes too much sense. My last FAZ trade netted only a 8% gain. Too small for the risk. The fed is the only significant player in this market and their bias is on the up side. They put the market in a neat little box and I don’t think they are going to allow the 4 to 6% percent plunges of the recent past. Interesting to note that the last two down days had volume well under 300 mil.

Apr 29 10:51 AM

[jswede:]

I agree with the author: go LONG the leveraged financials as opposed to day trading. the "attrition risk" in a sideways market is dwarfed by the upside when financials run out of accounting tricks. you don't want to be day trading and run the risk of not owning FAZ/SKF etc when these take off by 50%+ in a day.

Apr 29 11:55 AM

[jswede:]

go long the levered INVERSE financials, that is.


On Apr 29 11:55 AM jswede wrote:

> I agree with the author: go LONG the leveraged financials as opposed
> to day trading. the "attrition risk" in a sideways market is dwarfed
> by the upside when financials run out of accounting tricks. you don't
> want to be day trading and run the risk of not owning FAZ/SKF etc
> when these take off by 50%+ in a day.

Apr 29 11:55 AM

[levin70:]

I don't believe that reccomending leveraged short ETF for investment purposes is a good idea as they are essentially by their nature and construction trading vehicles. If you look at the SKF and looked at the price on Jan 1 of 2008 and Dec 31, 2008 you actually lost money even though there was a complete and utter devastation to the industry. I would suggest you change your article to more clearly articulate the fact that leveraged short ETF's are really only suited for intra-day trading only.

Kind Regards

Apr 29 12:25 PM

[j_remington:]

SKF is a wonderful trading vehicle when you are TRADING. Very profitable when you find proper entry points, both long and short.

Apr 29 12:30 PM

[r davis:]

I'm one of those idiots who didn't know FAS was only for day trading. Bought at 4.90 on Mar. 13. Sold for 9.15 on Apr. 17. Too stupid to tell if I made money or not. Lots of money, or not.

Apr 29 01:03 PM

[Whippet:]

FAZ and SKF are nice to play with options- open interest is high, and liquidity is good. Directional, low (or even positive) theta positions such as ATM/OTM vertical or ratio call or put spreads give you more upside potential with lower capital exposure. Straight, one leg options plays are too expensive given the enormous IVs. Covered stock positions also work well as a speculative play- the positive theta more than pays for the whipsaw risk. As a hedge, you can sell one ITM puts and buy OTM calls for large positive gamma. Stick to the near month options- everyone's right who has posted that these are not for buy and hold.

Apr 29 01:55 PM

[Bill S. Friend:]

I have gotten killed using these ETF's. I was short the day Bernake threw one trillion dollars at banking... The manipulations the government is using has distorted the market to a point unrecognizable to common sense trading. Gone are the buy and hold days trying to build wealth for retirement, in both stock market and real estate.

Apr 29 05:52 PM

[aarc:]

Lets do some math, shall we?

FAZ went down from 115.50 to 7.83 on this most recent Mar2009 to Apr2009 stock market rally for a total of 93.22% harcut or 93.22% profit assuming perfect trade which is not impossible but extremely improbable. This is just for computational purpose. Trading performance will vary from person to person (or computerized trading for that matter).

Likewise FAS went from 2.32 to 10.05 trough to peak or a price appreciation of 333.20%.

Now, who said holding them for more than 3 days will only result in loss of potential profit. That's 333% potential profit over six weeks man!

OK, let's see how XLF performed over the same time period from trough to peak. It ran from 5.88 to 11.33 for a price appreciation of 92.69%.

Who said 3xETF does poorly when held more than a day?

FAS was able to appreciate almost 3.6x against that of the XLF for over 6 weeks. Should we call FAS a 3.6xETF? How about in 6 months? Better yet, how about 6 years just in case we have a sustained rally over 6 years? Nobody knows. Perhaps go for 60 years?

How could this happen?

FAS has a bigger compounding effect on the day by day basis than that of XLF since it is a 3xETF. The incremental gains over the previous days are added to the succeeding days in case of a fairly sustained rally with a minor consolidation such as the one we just had from Mar to Apr 2009.

Example of long-term compounding effect is Dow Jones. It went up from 42 in 1929 to 11,750 in year 2000 - almost 28,000% price appreciation over 68 years or basically an average profit of $172 per year on an initial investment of $42. But then no withdrawal during that period in order for compounding to work it's magic.

We know how compounding works. In the case of FAS, I assume that compounding works much less than theoretically possible since they perform daily price resets or rebalancing that may or may not have deleterous effects on compounding results. Specially if the markets go into prolonged consolidation range such as the 1965 to 1980 period. Despite that, Dow Jones was able to make 28,000% over 68 years.

Apr 29 08:36 PM

[aarc:]

Somebody said Dow Jones compounding was 8+% per year from 1932 to 2000 or from 42 to 11,750 over 68 years. That 8+% compounding per year results in 28,000% price appreciation over the same period with initial $42.

Forgive me but I can't find the compounding formula in my spreadsheet. Please verify if you will.

Apr 29 08:47 PM

[todd120proof:]

The author is a hack. You cannot identify support or resistance levels for a leveraged ETF due to the mathematical decay inherent in the instrument.

If a stock or index drops 20% in a day (from $1 to $0.80), then rallies 25% the next day (from $0.80 to $1.00). A 3X ETF tracking the same index would drop 60% the first day (from $1.00 to $0.40), then rally 75% the next day (from $0.40 to $0.70). So even if the stock has returned to a significant resistance level, the chart for the leveraged ETF is in a totally different place. You cannot trade ETF's based on support or resistance levels determined from that ETF's chart. You must do your technical analysis on the underlying index's chart (RIFIN.X, for example).

Take FAZ, the 3X version of SKF. Since its inception at the end of 08, every time it has touched the $32-$40 area it rallied impressively. Using Cliff's logic, when FAZ reached $32 on March 18th, you could have bought in, and if you hadn't set a stop, you'd be down 75% today.

Sorry it just grinds my crank every time somebody tells me about a support or resistance level on a 2X or 3X instrument.

Apr 29 08:59 PM

[DumbAss:]

Reconciling all points, SKF & FAZ may be good multiday in a more-or-less straight-up scenario, but if there is any whipsawing, the daily leverage reset causes then to leak. The slower resulting net trajectory them also becomes a worry.

That's my take on it anyhow.
The other thing about SKF & FAZ in my conspiratorial view, is that the big players always hold enough to slap them down. And they will do it to deliberately break a technical trend in order to punish you for even thinking about it.

Apr 30 06:38 AM

[DumbAss:]

Twice in the past month I tried daytrading FAZ, and each time, lucky me, after a 1.5 day drift-upward trend I got in JUST a few seconds before the slapdown started. In one of them I managed to get out after 10 min, 97cents down.

Those were my first two attempts at day-trading

I also purchased SDS (S&P 2x bear) the night before the rally began on 9 March, and being bearish in nature, chose to keep it as a hedge. Hopefuly I've used up some bad karma here.

Apr 30 06:48 AM

[Delojozafado:]

Patience grasshoppers! I am long the AGQ, and the DGP. I have made a nice little profit on the AGQ and am just about even or down a tad in DGP. However I am buying partials in these on weakness in their markets. Silver and gold. I am long the un-levered PTM and just added another partial @$13.40 as the ETF is about to be launched. I am seriously thinking about paying that extra commission to get a large position in LALP.L as a trade.
These funds have been great in laying off some risk associated with the interest risk of owning of some long term bond funds that I have disposed of for a nice total gain in the last 3 weeks. While paying out some pretty nice distributions BDF & ICB had their prices supported & advanced on the market rallying. I have now taken a partial in LQD against some of the funds generated from the sales. I am now also looking at the CSJ as also being relatively safer than the funds I have sold out of which also included a very small total return loss on some VTA, distressed bank debt. I am maintaining my positions in partial sovereign debt med term MIN and the med term utility related DUC which I am also looking for opportunities to add to. I would hope to see the Ten year bond weaken just a little further this week as I am several thousand dollars ahead in my position in (TBT) and would like to take a little off here. Another poster commented about Fed actions. A chart will show you how volatile some of these levered but long term effective levered ETFs sometimes are and do misbehave. We saw the AGQ make an intra-day low of $33.12 on the day in March when the FED after their meeting adjourned announced the "Q" easing. AGQ shot to over $38 by the end of the day and tacked on a couple dollars more the next day. A pretty nice jolt & intra-day range to the DGP as well. In contrast the TBT tumbled and not in any panic I swooped in and took a partial position below $44.00. All of my partials in TBT are below that price. There is no power on heaven or earth that can keep the double short leveraged ETF (TBT) down below $45 for more than a day and a half. That is the chart for the last 4 months! At plus $50 I think it would be prudent to lighten up some but long term it is headed higher just as the TLT is headed for a big sell off. I will be patient and see if gold can work it's way back down to below $850 and if it does, I will gladly pay $17.50 for another 100 shares of DGP. There will be a time for BDD & DAG as well. They are working for someone over more than a day or two as well! The Nasdaq has so far led in this bully bear market leg. Let it continue let it increase. Tech never does well over the summer months, it just NEVER does! Being patient we must see if the rally can continue here even though it has stalled for more than a week now in the 865-880 SP level. I will start taking my partial positions in (TYP) shortly and add to (SRS) should it break below $22. Time here to get a lot off the table and take a few short partial positions incrementally. Ghost malls and people's unemployment benefits running out are what is going to kill commercial real estate. General Growth and Centro are just the New Century and Thornburgs of last year's residential real estate melt down. Banks still have 1.7 trillion of bad debts to write off, I burned 3 credit card notices from BAC this morning about how they are increasing fees and limiting my credit. Nothing that affects me personally or anyone else who can actually pay their bills on time. Coincidentally another American icon American Express, last week had it's credit rating downgraded to junk. The Ten year has breached 3.2% so sub 5% fixed rate 30 yr mortgages are about to go down the tubes as well, just as the Treasury will be back this week selling another 75 billion in debt. TBT will be at $60 in less than 2 years. A 60/40 blend of LQD/CSJ may not produce much of a total return over that period but you will still have most of your principle and the yields will by then have jumped to 10.5% & 6.75% respectively from the current 6.7% and 4.2%. The TBT hedge will produce a very decent combined total return. The throwing of the Chrysler bond holders under the bus with the preferred shareholders of Frannie-Mac and the share holders of Wachovia is just a warm up act for the fiasco coming for GM and eventually fall out to Ford Credit as well. This market is now running higher if it does, on fumes and the buyer stampede of the chumps coming in too late thinking they have missed it. These then the chumps, and their brethren mutual fund and pension fund administrators will be left holding the bag and be deserted by the professional traders who will take their profits and go away to play another day in another season. There will be no buyers just panicked sellers once more as we move through July to October. None of this will stop or hamper the Treasury from continuing to dump debt on the global market even as their own "TIC" reports have ominous overtones. Millions of tons of copper are being stockpiled on thousands of acres in China even as China builds a strategic Pet Reserve three times larger than our own. But they just have to buy our debt! don't they? I imagine China approaching the US debt issue as the Treasury and the Fed approached Frannie Mae. To paraphrase Pauly the Rat and Ben the Dollar Slayer in what they often reiterated, "We see the debt relationship with China essentially being maintained in it's current structure". Or was that what they meant on GSE's? Then Sheila the Beard knocking off Wachovia to less than a $ on a weekend mob hit. Oh didn't she first ask Wells Fargo what they thought it was actually worth. When the Chinese just say no thanks and continue stockpiling commodities from Australia, Latin America, South Africa, and Canada, "they" will just have to buy our debt instead?

May 03 02:14 PM