A Market Of ETFs, Not An ETF Market

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Includes: TQQQ, USD, UYG
by: Peter F. Way, CFA

Summary

What's the "market" outlook? Should that be as important as "What's the outlook for each of many market segments?".

It hasn't been for many price-leveraged ETFs, where the power of their derivative securities holdings (sources of the leverage) often pushes aside the weaker, more diffused S&P 500 index impacts.

Wealth-building investors look for capital gain opportunities, ones which greatly outweigh capital loss exposures. They frequently occur in leveraged ETFs, but only sporadically, requiring an active investing strategy.

That, in turn, needs regularly available forecasts of ETF prospects and measures of their credibility and reliability. Such have been derived daily since their market introductions, typically over five years.

Here is how some of them look now.

First, an illustration of leveraged price power differential

The non-leveraged SPDR S&P 500 ETF (NYSEARCA:SPY) is the most widely held ETF, with $185 billion currently invested. Here it is contrasted with its leveraged cousin, Direxion Daily S&P 500 Bull 3x ETF (NYSEARCA:SPXL). This is their parallel market tracks over the past 5 years, making it clear that a buy and hold of a leveraged ETF is not doomed because of its need to be revalued daily.

Figure 1

Click to enlarge

Source: Yahoo Finance

The price volatility of SPXL is being sought - when it is outperforming SPY. That can only be done when entry and exit points are adroitly managed. You and I can't accomplish such feats without some expert help. Fortunately, that help is available.

Where can help come from?

Transactions in stock markets need to be fairly continuous during market hours. In today's technology, that is accomplished by a high degree of automation, which works well - within limits. Those limits are regularly exceeded by large investment organizations having assets under management of tens or hundreds of billions of dollars.

The automated markets easily handle transactions involving tens or hundreds of thousands of dollars, but may choke over trades of tens or hundreds of millions of dollars. Yet, the big-money fund managers regularly need to deal in trades that size, in order to get changes made in their portfolios in any effective time, before opportunities they see move away from them.

So they rely on help from market-making [MM] firms to negotiate large "block" trades with other big-money managers where groups of buyers or sellers can be assembled to provide "the other side of the trade" to satisfy the transaction order initiated by the MM's client. Hundreds to thousands of these trades occur daily in many stocks and ETFs.

But it is fairly rare that enough "other side" commitments can be assembled at an acceptable single price for all the shares involved, in a time span tolerable to the order-initiating fund manager. To get the client's order "filled", the MM typically must put some of his firm's own capital at risk to balance the trade.

He won't do that unless the risk seen can be passed to a willing speculator, at a cost, in a hedging transaction. That cost has to be swallowed by the trade originator, or the trade gets killed, not filled. Most get filled. The prices of the derivative contracts making up the hedge reflect what price change potentials are seen in the subject security of the original trade order. So, we have a credible source of forecasts.

The forecasts are not single-point estimates, but ranges of price between likely-to-occur extremes. Those ranges, surrounding the market quote at the date of the forecast, provide both upside and downside price change prospects. Knowing the up-to-down balance is important, so a metric called the Range Index (RI) measures what percentage of the range lies below the market quote.

Comparing SPXL price changes with SPY price changes

I told you that story, so I can tell you this one. Instead of comparing price changes over the same calendar periods of time, it is important to be able to differentiate opportunities at various points in time. The forecasts by MMs and the RIs they represent do that.

Here is the approach: Take each day's forecast over the past 5 years and see how the price changes from the forecast day to various dates, 3-4 months later, one week at a time, progressively. See what they average in the aggregate. That gives the trendline rate of price growth.

Then separate the forecasts by Range Index size, rinse and repeat across the array of RIs to see where the performance occurs - not in calendar dates, but in distance from the forecast, and in size of the Range Index.

Ready? Here is SPY:

Figure 2

Click to enlarge

Source: Blockdesk.com

The blue row is the aggregate 5-year average CAGR price trend, with weekly measures up to 16 points of cumulative time, taken daily through the years. Each line above and below reduces the count of forecasts included, (in the #BUYS column) to progressively more extreme RIs, but fewer in number. There were no SPY forecasts with RIs smaller than 9 (10 to 1) in these 5 years, and only one of 100 or larger. Small samples are less credible.

Please note how concentrated the forecasts between RIs of 33 (2 to 1) and 50 (1 to 1) were, and how few there were between 50 and 67 (1 to 2). 94% of SPY's daily forecasts are with RIs between 25 (3 to 1) and 67 (1 to 2).

The CAGR payoffs, excluding the very brief 2-3 week periods right after the forecasts, peaked in the low RIs after 50-55 days from the forecast. The whiter numbers indicate statistical significance, often due to larger numbers of forecasts being measured.

Now contrast SPY's forecasts and subsequent price behavior with that of SPXL, the 3x leverage of exactly the same underlying market index.

Figure 3

Click to enlarge

Source: Blockdesk.com

First of all, the blue row trend average is just a bit under 3 times the CAGR of SPY. This may be due to some erosion arising from the daily rebalancing needed to maintain the 3x leverage of the ETF. But it is far from the fears of many who have never sought to quantify the concern.

Now note the wider dispersion of forecasts among their RIs in the #BUYS column. And of course, note the much higher CAGR payoffs in the lower RI forecasts. For opportunistic wealth builders, this is a bonanza.

These differences come partly from the 3-4 month time horizon of the tables, instead of the 5-year focus of Figure 1. The "time to take the donuts is when the tray is being passed" is made even more evident by Figure 1's SPXL price track volatility of the past couple of years. There is a reason the Chinese pictogram character for "Threat" and "Opportunity" is the same.

The power of time to magnify performance when used well and to detract from wealth-building results when ignored becomes evident when the SPXL CAGRs at the right margin of Figure 3 are compared with those in its 2-3 month holding periods. An active investor can overstay his/her welcome.

So, where is "the market" now?

Should we embrace or avoid SPXL? Does available capital need to wait a bit before being put to work?

One unmentioned clue in figures 2 and 3 is in the magenta counts of available (#Buys) forecasts. That color tells at what level the current RI values for both SPY and SPXL are - both are very near normal, with only a modest imbalance between upside and downside prospects.

At least that is the way the MMs see what interests their clients have in those securities.

What about other stocks and ETFs? Every day the MMs form opinions about some 2500 equity securities through their hedging, and all of those get reduced to RI measurement. A great bonus of the RI is that it provides "value" comparability to securities which, at their roots, are of very different natures. Figure 4 provides a frequency distribution of today's RIs for that population.

Figure 4

(used with permission)

An average RI of 25 for the population would imply this group of securities (five times as large as the S&P 500) has an upside-to-downside ratio of 3-to-1. It seems there are a large number of them with RIs at 20 (4-to-1) and even at 10 (9-to-1). Some couple of dozen are at left, off the scale, with negative RIs that mean current market quotes are below the coming worst now seen likely.

At the other end, how many issues have Range Indexes above 50, where more downside is seen than upside? Not many.

This kind of suggests that there are many price change potentials which may ignore what the "market average" index is likely to do next. Some in this population are other leveraged ETFs. Let's take a look at how their outlooks compare to SPY and SPXL.

Figure 5

(used with permission)

This map compares the upside price change between each ETF's end-of-day market quote and the upper limit of its price range today as its horizontal coordinate on the green "Reward" prospect scale. The red "Risk" coordinate, rather than being a forecast, is the actual experience (for each ETF) of typical worst-case price drawdowns in 3 months subsequent to prior forecasts like those being seen now.

The coordinate points for SPY are at (17) and for SPXL at (18). The dotted diagonal is where upside prospects are equally matched by prior drawdown experiences. Above it is where "long" investors don't want to be. They should like to be down, and right into the (5-to-1 or better) green area.

It looks like there are several present-day alternative leveraged ETF investments in that direction, like (14) the ProShares Ultra (2x leverage) Financials ETF (NYSEARCA:UYG), or (11) the ProShares UltraPro (3x leverage) QQQ ETF (NASDAQ:TQQQ), or (10) the ProShares Ultra (2x leverage) Semiconductors ETF (NYSEARCA:USD). Perhaps we might take a more detailed look at each of these.

Recent MM expectations trends in specific ETFs

Here is what UYG has been looking like to the MMs over the past 6 months:

Figure 6

(used with permission)

This and following pictures show daily updated MM forecast price ranges as vertical lines split into upside and downside prospects by their market quotes (the heavy dot) at the date of the forecast. The most recent forecast is made explicit in the row of data between the two blue pictures. The thumbnail blue picture is a distribution of Range Indexes, not of the population, but of this security during the most recent 1261 days of its 5-year or longer market experience.

That history is also contained in the data row where the typical drawdown experiences of the 42 prior days with RIs of ~12 are indicated as -4%. Recovery from those drawdowns occurred in 9 of every 10 of the 42 to produce a net gain, including the 10th instances, of +8.9%. Using a standard time-conservative risk management portfolio discipline, average holding periods of six weeks and a market day produced CAGRs of +100%. Comparing the achieved +9% gains to an offered (not promised) +11% produces an encouraging 0.8 credibility ratio.

Let's compare this to TQQQ and USD, shown in Figures 7 and 8.

Figure 7

(used with permission)

TQQQ's batting average on recoveries from even larger price drawdowns is about as good as can be had, with profits in 71 of 72 prior experiences. Thankfully, that 1 helps hold back the TGTBT critics. With a +16.8% payoffs achievement record and a +17% upside prospect, credibility for the outlook is quite high. And the +6-week compounded CAGR of +248% make it look (for most wealth builders) worth taking a chance. Not as good as the Powerball, perhaps, but much better odds - worth risking a buck or two.

Figure 8

(used with permission)

Here again, we have an attractive reward-to-risk ratio of +18% to -9%, with a current price of the investment candidate $1 below its "deserved" price range low. The RI distribution thumbnail shows that hasn't happened often. As is the case with such extreme Range Indexes, there tend to be few examples from which to draw comparative data. We normally like to have history samples of 20 or more, which is why the sample size box is red-flagged as a caution, not a rejection.

The win odds of 93 suggest one of the 15 failed to recover to a profitable price, as evidenced by the payoff average of +11.4%, compared to current expectations of +18%. But many wealth builders might be sufficiently attracted by the CAGR created by a 7-week hold history to be willing to take a repeat shot at this candidate if their first one turned out to be the second loss out of 16.

No, ETF prices don't march like North Korean military paraders

Fortunately, our equity markets are marvelously diverse, reflecting an economy far broader than that typically in the vision of talking heads, politicians, consultants, and many economists.

It pays to go to folks with real skin in the game when risk is part of the equation. The MMs are constantly betting their enviable jobs hundreds of times a day in order to make markets work and keep employers happy (and richer). They behave quite rationally when forced to take risks (which is the case with most block trade orders), and show their arbitrage skills when competing with peers for needed protections. Most have been doing it daily for enough years to be well up on the learning curve. None are God, so restrain your faith in them, but be open to profitable differences of opinion.

Conclusion

Leveraged ETFs of UYG, TQQQ, and USD all have appealing prospects for wealth-building investors, particularly in comparison to conventional ETF alternatives.

Additional disclosure: Peter Way and generations of the Way Family are long-term providers of perspective information (earlier) helping professional and [now] individual investors discriminate between wealth-building opportunities in individual stocks and ETFs. We do not manage money for others outside of the family but do provide pro bono consulting for a limited number of not-for-profit organizations. We firmly believe investors need to maintain skin in their game by actively initiating commitment choices of capital and time investments in their personal portfolios. So our information presents for their guidance what the arguably best-informed professional investors, through their own self-protective hedging actions, believe is most likely to happen to the prices of specific issues in coming weeks and months. Evidences of how such prior forecasts have worked out are routinely provided. Our website, blockdesk.com has further information.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TQQQ over 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.