Where Is The Market Headed Now? Leveraged ETFs Tell The Story

 |  Includes: TQQQ, UDOW, UPRO, URTY
by: Peter F. Way, CFA


A 5-year, long-toothed recovery makes many investment observers fearful of a serious price “consolidation”.

A near-50% gain in the last 2 years heightens the concerns.

The Economic data indicators offer a usual chop-suey of alternatives in terms of little reliable correlation to stock market indexes.

Market professionals making daily $ billion bets on the indexes’ coming actions have a much more price-sharpened outlook.

"Sell in May, stay away..." may be a panacea for those with limited income pressures, limited ambitions or future goals. But for many investors building wealth, the thinner markets of June-July-August often provide rewarding capital accumulation price swings.

Why the seasonal price volatility potential?

Lower trading volumes arise from vacation schedules at major funds and other institutional investment organizations as they typically put their "B" team - the second in command and their troops - or parts of it, temporarily in charge. It is an opportunity for the bosses to see what the career strivers are made of and how well they can do under fire, while the department heads are on vacation.

Risks to the organizations are bounded, because the bosses are watching, even if from a distance. If things start to get seriously out of balance, they will return and right the ship ASAP. Hence the swings noted.

Our professional contribution to the investment business is the debunking of "long-term investorship" as a prudent policy. In this globally competitive day of rapidly advancing technologies and worldwide instant communication, such a policy is really long-term speculation, not investment.

By providing specific price sell targets on selections guided by the self-protecting actions of the best-informed players in the game, we offer our readers a means of comparing investment choices according to the factors that are truly meaningful: Return and Risk.

You mean Risk isn't what they claim?

When we say risk, we don't mean uncertainty. We mean the likelihood (odds) of getting hurt. Not of possibly having pleasant surprises, as occur occasionally and unpredictably from uncertainty.

We temper the prospective return possibilities with the odds of both positive rewards and the inevitability of losing capital from time to time. And we note not only the average loss experiences, but the scale of the worst ones experienced on the way to the payoff sell target that closes out the position at risk. Both need be there for your consideration, since accepted losses at times of most emotional strain can be the greatest danger.

It is, after all, your capital at risk. So it should be your call as to what chances you want to take with it. We try to make it easier for you to make those decisions between specific commitments.

So much of what is called "research" in this business is really just story-telling about fuzzy notions of what might happen out there in the multi-year future. It is sometimes dressed up with impressive models of possible earnings, perhaps with an analyst's or a quant's hypothesis of what such earnings might sell for.

What's different now from times past?

When we started out in the game, 50+ years ago, actually interviewing top corporate managers in order to generate our own reasoned notions of future earnings, in the days before "corporate guidance," you could learn things that others did not know. Valuable things.

Information travels much faster these days, and gets integrated into market reactions in ways previously impossible. Miss Information is often found in the company of her pesky evil brother Dis. It's hard to keep them apart.

The other problems with the "research" sales staff is that the skin they have in the game may only be how much of yours they can abrade.

We prefer to see how the guys with huge bonus prospects take care of the firm's own capital on the "prop" desk, and at their partners' stations, the block desks. What they will spend in hedging and arbitrage to keep out of trouble and lock in unconscionable profits tells the true story of what their long, sharp experience suggests might really happen.

We know how to read their footprints in the market mud. They wouldn't give up that much of their trade spreads unless they thought that big a hurt might come their way. So they buy insurance to cover real exposures. In both up and down price directions, as needed.

Things that trade actively repeatedly need help in getting orders filled. Pressures of either time or size make for profit opportunities by these market-makers [MMs], who get very good at their business. We just piggy-back on their developed skills.

So, where do these "in-the-knows" think we're headed?

Which brings us back to the question of how to compare the prospects between various ETFs. What research operation is really going to make judgments about the separate future prices of 500 contents of SPY? Or 100 parts of QQQ? Or many other ETFs?

There are reasoned value actions being continually taken by market-makers on most of the S&P500 stocks. But I doubt that those get assembled and updated moment-by-moment by any street research operation for the benefit of institutional clients.

For our purposes, and yours, we don't need that. Because both SPY and the SPX themselves have insurance twins that provide the market-makers' intuitive judgments as to how they may behave in coming days, weeks, and months. So do all of the several hundred ETFs we cover.

But the ones that provide a more sensitive gauge of where the balance between likely coming greed and fear are those that are structured to have price moves three times (3x) that of the underlying index. For many reasons you may not want such hyperactivity in your portfolio, but they are the most sensitive canaries in the goldmine. Regular attention to them can greatly assist your perspective.

The 3x ETF that has been most helpful in our multi-year experience has been ProShares UltraPro Dow 30 ETF (NYSEARCA:UDOW). It figures, because the 30 Dow-Jones mega-cap stocks that are its components are ones that are heavily owned by the MMs' clients and are the subject of continuing active negotiations. Here is a picture of how a once-a week sample of the index's daily outlook implied geared-up price range forecasts for UDOW over the last two years.

(used with permission)

Its vertical lines show what is believed by the MM community to be the likely possible range of prices in coming weeks and months, inferred from what they are willing to pay for hedging insurance against getting hurt by such moves. The heavy dot in each range is the market quote for the ETF (the index equivalent) at the time of the forecast.

Some of those vertical lines are colored based on the imbalance between the upside and downside prospects, measured from the market to each opposite extreme. Yellows are cautions, greens imply buying opportunities.

Still think markets can't be timed? The market makers would like you to think so, rather than having you get in their way. Their insights may have a far shorter time horizon than yours, but your risk management needs should be well shorter (in time) than your investment goals and action decision horizons.

Risk management tools and decisions are a separate topic, but to be effective, they need to have continuing attention.

It is never advisable with equity investments to rely on only one source of guidance. Fortunately, in the leveraged ETF index world there are several. At present they do not all agree, because they each have differing subjects of focus.

In addition to the DJIA there is the S&P 500 with the ProShares UltraPro ETF (NYSEARCA:UPRO), the Nasdaq 100 with ProShares UltraPro QQQ ETF (NASDAQ:TQQQ), and the Russell 2000 small-cap index with ProShares UltraPro Russell 2000 ETF (NYSEARCA:URTY). Their past 2-year forecast history pictures follow:

Some of these ETFs display better defined price moves to their extremes than others, and they are not all synchronized in time. For example, UDOW and URTY are at quite different stages, as is made clear in their current 6-month daily forecast pictures:

Comparing these alternatives

Here are the data summaries of the forecast history performances over the past 4-5 years for UDOW, UPRO, TQQQ and URTY, along with the S&P500 market-proxy ETF, SPY:

Click to enlarge

A quick explanation of the less-obvious numbered columns: (5) is the % change between (4) and (2). (12) tells, out of the total number of forecast days available, that sample number of those days with Range Indexes like the present. The Range Index (7) is the percentage of the forecast range (2 to 3) that lies below the forecast day market price (4). Using the prior sample in (12) to follow a standard, simple time-efficient holding discipline, (8) indicates the percentage of them that were profitable, (9) the average net gain on all such holdings, (10) tells how long on average the samples were held, and (11) the rate created by (9) and (10). (13) measures the credibility of (5) given (9), and (14) compares (5) to (6).

Please invest the time and effort it may take to understand the dose that is inflicted by all of those ( )s in the prior paragraph. The data does provide a useful way to compare some not-so-simple, but realistic, investment considerations.

For example, the critical starting point in each is the benefit being offered by each forecast in (5), largest for URTY, smallest for UDOW. Past experiences of (9) say UDOW's small +3.6% is most credible of the group, and those of TQQQ is the least believable.

But implicit in those comparisons is that each is drawn from a similar, adequate number of experiences. That's not so in (12) for URTY, with only 4 prior experiences, although it has lived through the same 1040+ forecast days (4+ years) of all the others. Why so small a sample? Blame it on the Range Index of -14, meaning that its price now (4) is below the bottom (3) of the forecast range. Typical of most Range Index distributions through time, they get sparser out at the extremes, which is where this one is in URTY's experiences.

So we could use some reassurances that URTY is more real than its evaluations in the table on (8) and (13) suggest. One way to get that is a visual check of the green appearances in both the 6 month and 2-year Block Trader Forecast [BTF] blue-background pictures.

Another is to look at a tabulation of URTY's price changes following forecasts at varying levels of balance between upside and downside price change prospects. Here is that table over that past 4 years, with the average for all forecasts on the blue row at the middle, cumulated from top and bottom.

Click to enlarge

The current forecast, with a Range Index of -14 gets put in the 100-to-1 row, as indicated by the magenta 50 in the #BUYS column. All but three of the progressively longer holding time spans - out to +80 days beyond each forecast date - show rates of return, in that 100:1 row, higher than the blue row average, with some majestically larger. Perhaps there is better credibility to the URTY forecast than the small sample suggests.

Coming back to the other leveraged ETFs, they all show rather good odds for higher prices with winning experiences under discipline some 2/3rds to 90% of the time. In the case of UDOW, its upside is pretty small for a 3x ETF, at only +3.6%. To me, that says if you already own it, its chances of going higher are pretty good, 7 out of 8, but maybe by not much higher. UPRO with bigger upside and very good odds looks better as a buy.

UPRO indicates that the S&P 500 still has a fair amount of opportunity in it here. It is too early to be scared of how long it has been since the March 9, 2009 bottom, as the MMs evaluate what is likely next. With a 39 Range Index they have reached 9%+ higher targets 9 out of every 10 times, and have done it in over 100 starts. This might be one of the tenth times, but those look like pretty good odds for a market bet.

Small-cap index URTY offers a bigger payoff potential, half again as much as UPRO, with a history of slightly smaller worst-case price drawdown exposures.

The Nasdaq is a different story, because the odds on TQQQ are only 2 out of 3, and the present +12.5% upside is far more ambitious a prospect than has been achieved from mid-range RIs in the past. So maybe those stocks will be carried on for a while by the broader market, but the heavy lifting is likely to be done elsewhere, in most cases.


But nowhere do we see any outlooks being expressed by market pros that suggest that it's time to cash out your chips and seek shelter. On the other hand, a bit of protection bought when it seemed unnecessary might be had on pretty good terms and at what could turn out to be attractive prices. The idea is worth checking out. Remember, time is a form of money and urgent protection could get expensive.

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.