When The Elephants Dance, Chicken Investors Must Be Careful

 |  Includes: IWM, TQQQ, UWM
by: Peter F. Way, CFA


Put the market-makers and prop-desk traders on your side.

They tell what big-money funds are buying, how far those clients will push prices.

Not by what the sales types say, but by the way the block desk hedges its bets.

Likely price gains are today’s hedge-implied forecasts, worst-case price drawdowns are based on hundreds of prior hedges like today’s.

Hedges that are required in filling the volume stock-trade orders of elephant-sized funds and institutions thrashing about in the deep grass of a media savannah.

Whether might is right or not, small players can get hurt

Cut through the BS and investor relations hype, the accounting gimmickry, and "street" analyst assertions about value, to the heart of the matter. In the foreseeable future (next 3 months) how much higher can each stock's price go? Based on prior forecasts by Market-Makers [MMs] like today's, what is the worst downside agony you might have to go through to get there?

Today's prices are not all that matter, but they are where we have to start from. To get to what may be possible in profits, how scary may the dance get? Here are the very well educated guesses by some of the best-informed hunters on the veldt as they build shelters for themselves in the quest. Our first look is where the leverage elephants make the dangers most compelling:

(used with permission)

This simple map trades off 1) the prospective upside price gains putting at risk a Market-Maker [MM] who has to go short to satisfy the immediate-trade demands of a client buyer (horizontal scale in the green) against 2) the equally likely price decline that may occur (on the red vertical scale) while his price protection insurance contract is in force.

The cost-benefit tradeoff is, quite apparently at present, not seen as equal (the dotted diagonal) for all these leverage-accentuated investment alternatives. Big fear lives along the top boundary of the map. Greed, not so much on the right-hand boundary.

Which ETFs are the most at risk?

The Direxion Daily Gold Miners Bear 3X Shares (NYSEARCA:DUST) at [25], but they test the limits of both up and down most of the time. Tell me something I don't already know.

How about ProShares Ultra Russell 2000 (NYSEARCA:UWM) at [26], a 2x leverage of the leading small-cap stock index? Whoa!

Wait a minute! Is the market going schizoid? Look at [16], the ProShares UltraPro QQQ (NASDAQ:TQQQ). It is the most-favored ETF in the most market-sensitive set of ETFs, perhaps the most opposite of UWM, with prospective upside prices of +19% and past bad experiences of price drawdowns following prior forecasts like today's, of -6%, at their worst.

Still, while small-cap Russell 2000 (RUT), and big-cap Nasdaq 100 (NDX) are not the DJIA or S&P 500, they each do have their own identities. Here is a sector breakdown for each index:


Source: Yahoo Finance

NDX: The PowerShares QQQ Trust ETF (QQQ)

Source: Morningstar

Both have comparable consumer cyclical and healthcare segments amounting to about 25%+ of their totals, but the similarities stop at technology, which is dominant in the NDX-tracking TQQQ. Instead, the UWM splits up the difference among financials, energy, materials, and industrials.

So we could usefully take a deeper look at the small-cap ETFs, where an apparent anomaly exists, and for the present forget the tech-heavy NDX index. Let's consider a similar map containing only other variants of small-cap tracking ETFs:

What doesn't make sense here is the difference between UWM {$2bn AUM} at [4], showing a major fearful posture, and iShares Russell 2000 ETF (NYSEARCA:IWM) at [10] {$28bn AUM} and iShares Core S&P Small-cap ETF (NYSEARCA:IJR) {$14bn AUM} at [3], showing comfortable modest optimism. Both IUM and IJR are unleveraged, or +1x, show small -3% bad past experiences following prior forecasts like today's and +6% to +8% upside forecasts, while the +2x leveraged UWM apparently has a -25% downside exposure.

Our first reaction is to check our data for an overlooked stock split that could have created an artificial price decline, but UWM has had no such occurrence. But it did suffer severely in the 2008-2009 market plunge, dropping from the mid-50s to under 20 before recovering with the rest of the market. Why is this big downside exposure being forecast, when the IWM and IJR don't show the same experience or outlook?

A confirming clue that there is a problem comes from ProShares UltraPro Short Russell2000 (NYSEARCA:SRTY) at [6], a -3x short leverage of the RUT. If [3] and [10] are right, then [6] probably may show a strong decline and belongs on this map where it is, but why does it have the company of UWM?

Mystery solved

A closer look at the specific forecast history for UWM reveals why this logical inconsistency exists, and offers a good lesson in why "past experiences are no guarantee of future results."

Click to enlarge

The visual magic of color provides the answer, when the way we look for risk is understood, and is worth thinking about.

UWM's current forecast, shown in the lower right corner of the blue-background history picture, and in the data line below the picture, provides the hedging-implied price range that is totally above its current price. Our Range Index metric tells what percentage of the range is below the market quote at the time of the forecast. In this pathalogic case the measure is a -6.

In the larger blue picture above, the daily vertical price range lines usually surround the current market quote dot, giving a visual sense of the upside-to-downside balance. When the downside becomes dominant the line becomes yellow, or even red, and when the upside is prevalent, it turns green.

As those proportions change, the Range Index measure varies, and the little blue thumbnail picture shows what that distribution of RIs has been over the past 5 years of 252 trading days each. The current level of -6 is obviously an extreme event, all by itself except for one prior such experience. That makes any calculations based on the one quite suspect. So when we have fewer than a sample of 20, we mark that field red in the data line to warn folks.

When UMW's forecasts are more balanced and UMW's subsequent price experiences are more representative of what the future may hold, then there is more reason to take seriously what they offer in evaluating future investment action decisions. But for now, the message is: Ignore it.

Instead, take a clue as to the index's direction from [11], URTY, in the Small-cap ETF Reward~Risk map, whose more sensitive forecast history looks like this:

Click to enlarge

In our personal preference schema we like TQQQ, [16] of the first map, better because of its lower drawdown exposure and better Win ODDS. But they are both driven by the same underlying index, with the same degree of leverage.


With prices of medical technology stocks gyring around from day to day, there is reason to be alert to what the sensitive market indicators of Leveraged ETFs may be telling us.

For days and weeks we have been seeing ETFs that track the NDX index, like TQQQ, at promising prospects that, in comparison to other alternatives, are reassuring that the market as a whole is not ready to dive into a Marianas price Trench to look for some Malaysian aircraft.

Comparable measures like UDOW, UPRO, and SPXL continue to provide for further declines in the most widely followed market indexes and are less supportive of the market as a whole. ETFs relating to the NDX are far more supportive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.