Market Rally Saturation Nearing; Warning By Leveraged Long ETFs

| About: ProShares Ultra (UGL)


In this article, we present the message first, and the explanation follows.

Market experts with skin in the game of firm capital and professional reputation are broadly behaving as though the odds are shifting towards a market correction stage.

Present momentum may provide good temporary exit opportunities to avoid noise-level (6-10%) declines in many major market indexes.

Long-term buy-and-holders unconcerned with market wiggles likely will shake off decline and subsequent recovery with "see we told you so".

Active investors have the opportunity to add another increment to their cumulative performance advantage over buy-and-holders by taking appropriate actions.

Leveraged long ETFs now are widely at Risk-Reward disadvantages

Here is their current Reward-Risk Tradeoff map:

(used with permission)

Virtually all of these ETFs are being viewed by their volume market-makers (MMs) as offering far less upside price change opportunity now than the actually experienced price drawdowns that have previously been experienced following prior MM forecasts like today's.

How should the map be read?

This map has two directional coordinates. East-West is known by geeks as the X coordinate. Its scale is across the horizontal in the green area at the bottom. The other direction - North-South - has its scale along the map's left (WEST) side in the red area that the geeks call Y. The X-Y coordinates indicate each stock's shared reward-risk tradeoff at today's price and MM forecast.

So stocks or ETFs with big returns and small risks head SE to reside, not in Florida, but in the green. Bad boys with lots of risk and little return promise go NW towards that perhaps hotter-colored place on the map. The Mason-Dixon dotted line tells where the balance shifts from equal-opportunity to the real, unfair world, depending on whether you are long or short. (The map assumes long.)

We have labeled the ETFs numerically, with a few occupying the same spots, like at (10), (12), and (14). Check the blue rosetta stone for identities you may recognize. The number sequence has no significance in the mapping.

A word about the risk dimension. Forget about beta and CrAPM. The risk being measured is how badly (the worst possible) an investor holding the stock might be underwater from cost, in all prior forecasts like today's balance between upside and downside prospects. Those are the times investors are most likely to emotionally cave in, sell, and lock in losses that often, usually, recover and turn into profits.

The reward dimension is taken from the current-day hedging-derived MM forecast, where the top of the range of foreseen coming prices is taken as a sell target, and its upside from the contemporary market quote is the relevant measure.

What's the R-R map telling us?

Of better than two dozen actively-traded leveraged long ETFs, only two are being viewed by the volume market-making community as having an attractive tradeoff of likely future upside-to-downside price changes in the next several weeks to few months. Ominously, neither one is tracking any major market indexes; one is the 2x leveraged ProShares Ultra Gold ETF (NYSEARCA:UGL). A common presumption (not always correct) is that the price of gold might increase during a period of marked equity issue price declines. The other MM-favored ETF is ProShares Ultra DJ-UBS Natural Gas ETF (NYSEARCA:BOIL).

The remaining ETFs largely do track the Dow Jones 30 stocks (DDM, UDOW) the S&P 500 (SPXL, SSO, UPRO), small-cap indexes (SAA, TNA, UCO, URTY, UWM), mid-cap indexes (MVV, MIDU, UMDD), and the Nasdaq 100 (QLD, TQQQ). Also included are several technology ETFs (SOXL, TECL, ROM, USD) and many ETFs with an international focus (DZK, EDC, EZJ, LBJ, ULE, XPP, YINN).

So the negative attitudes are rather widespread, including several industries, sectors, and geographies. Here are recent 6-month daily perambulations of MM expectations for two 3x ETF illustrations, the ProShares UltraPro Dow 30 ETF (NYSEARCA:UDOW) and the ProShares UltraPro QQQ ETF (NASDAQ:TQQQ):

The vertical lines in these pictures are forward-looking estimates inferred each day of the likely range of coming prices for the subject, based on what market-makers were willing to pay to protect firm capital that had to be exposed to future price risks in order to fill big-money-fund client portfolio adjustment trades. The heavy dot in each line is the market quote on that forecast date. It splits each forecast range into upside and downside prospects.

That split in the case of UDOW is compressing its upside and lengthening its downside. For TQQQ, the recent rapid climb and today's pullback are doing the same, although not yet at as critical a stage. Others in the group like the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO) are following the same path.

Using the same kind of behavioral analysis, here is what market-maker expectations for the CBOE Volatility Index (VIX) has shown weekly during the past two years.

This index measures the implied uncertainty for the principal equity index, the S&P 500, as reflected in its options trading. Our analysis of that index (the heavy dots in the MM forecast ranges) shows how the market professionals typically react when markets are strong - the VIX declines and is recognized as being low. Its present level is about as low as it typically gets. In effect, this is a measure of the market-makers' expectations of the market's expectations. Its price swings can often be more than double (or one half) in a week or two.

Typically the low-VIX uncertainty gets followed by market mini-panics, and uncertainty rises as market fear spreads. The periodicity of these cycles is irregular, but not erratic.


The markets are pretty full now, but are likely to get a bit more so. That may provide individual investors time and price room to set up defenses against a coming decline. The many possible avenues to do so are beyond the scope of this article.

A principal message is that the leverage structures that are created to magnify price moves in ETFs produce a heightened sensitivity on the part of market-makers as they hedge their firm's capital that must be put at risk to fill client orders. That makes these ETFs particularly useful in sensing overall equity pricing surroundings.

The foregoing forecasts and underlying analyses are the results of observations made by Investment Professionals other than ourselves, and their opinions are subject to change without notice. Any forward-looking opinion is necessarily constrained to the available data in hand at the point in time of such opinions; further, there can be no guarantee that such opinion is accurate or complete. No warranty, express or implied, is made that any such opinions can or will be profitable. All liability for damages or loss, direct or consequential, including but not limited to the use, misuse, unavailability of service or from other causes rests solely with the user. Reproduction of charts and graphs is allowed for the exclusive use of the subscriber only. Distribution in whole or in part by any means without prior written consent is not authorized.

Copyright © 2014, Peter Way Associates. All Rights Reserved

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.