SSO: Tread Carefully For Now

Summary

  • I advocated buying SSO a few months ago, as I saw the correction in the S&P 500 as an opportune time to buy large-cap U.S. stocks.
  • This play did work out, and SSO delivered out-sized returns due to its leveraged nature. However, gains have cooled since then and my forward outlook now is not as rosy.
  • Consumers remain under pressure from inflation, with costs soaring for everyday items, fuel at the pump, and discretionary travel.
  • Forecasts for U.S. growth keep on declining, driven by geo-political concerns, inflation, and action by central banks to slow price rises.
  • This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

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Laurence Dutton/E+ via Getty Images

Main Thesis / Background

The purpose of this article is to discuss the ProShares Ultra S&P500 (NYSEARCA:SSO) as an investment option at its current market price. This is a fund I follow closely, but buy selectively, because it is a leveraged ETF that can be highly volatile. Specifically, it is designed to offer a "return that is 2x the return of its underlying benchmark for a single day, as measured from one NAV calculation to the next". This benchmark is the S&P 500, so SSO is the right move for those expecting large-cap U.S. equities to rise. This was precisely my belief back in February, and SSO has indeed registered a decent return since that time:

SSO Performance

SSO Performance (Seeking Alpha)

While this gain seems attractive, readers should note that SSO has seen some pressure in a shorter time frame. Yes, SSO is still in positive territory since that article was published, but over the past month the fund has trended south, wiping away what was an even bigger return:

1-Month Performance

1-Month Performance (Seeking Alpha)

In fairness, I would expect more volatile moves from SSO given its leverage. But the short-term weakness has prompted me to take another look at my macro-thesis and led me to believe there is room for caution here. Simply, there are some major headwinds that I think could pressure equity returns in the months ahead, so fading exposure in a leveraged bull play like SSO is probably going to be the right move. I will discuss those reasons in the following paragraphs, to support my decision to reduce my rating from "buy" to "hold" on this fund.

Let's Talk Reasons For Concern

To begin, I want to emphasize that I am not typically a trader or one necessarily looking for short-term moves. My prior articles and regular readers surely understand this. That said, when it comes to SSO (or any other leveraged fund for that matter) that thesis goes a bit out the window. Most of my investing is done with a buy and hold mentality, with the option to reduce or amplify my exposure gradually as conditions change. But I use SSO selectively, in moderation, and in more of a swing trading fashion. This is because the fund's high expenses and amplified S&P exposure make it an inherently more risky play. While I like to use it when the broader market drops to amplify gains on a potential rebound, I don't often hold this over time because when the market drops the losses can be painful.

Case in point right now. I am a bit worried about valuations, the forward outlook, and Fed actions. Do I want to outright sell most of my positions? Of course not - that is not my style. But on a market rebound like the one we have seen since the lows in Q1, I don't see the value in holding SSO. If the market drops, this fund is going to see a lot of pain, and I would rather be patient and wait for a better entry point, holding on to my non-leveraged equity positions instead, in case my market timing is off.

With this backdrop, let us know focus on some of the reasons why I think being caution now is the right move. When evaluating SSO, I have to consider the broader macro-environment. This is a U.S. large-cap play, so what is going on across the economy is extremely relevant. In this vein, there are reasons to be a bit less optimistic given current index levels. The first of which is that forecasts for economic growth in the U.S. keep getting revised in one direction - down. This has been a consistent theme since the year started, and lower growth is likely to make its way into corporate earnings, as well as the multiples investors are willing to pay for forward earnings:

Median U.S. GDP Forecasts

Median U.S. GDP Forecasts (Bloomberg)

This is a pretty straightforward takeaway. The consensus is growth in the U.S. is going to be lower than previously thought. This typically translates to lower corporate earnings, and it also dings investor confidence to the point where valuations can become a little less optimistic (meaning the P/E investors will pay may decline a bit to account for the slower forward growth). All things being equal, this is not a positive development, and it supports a bit of a downgrade in future stock returns.

Consumers Are Under Immense Pressure

My next point touches on the state of the U.S. consumer. As investors know, the U.S. economy is largely consumer-driven, so sentiment, wages, and inflation are all key to evaluating how equities are going to perform. Fortunately, consumer spending held up extremely well over the past few years despite a very challenging pandemic. While the pandemic is not "over", consumers are facing an arguably more difficult situation now - inflation.

Inflation has been around for a while now, even since the rebound started in 2020. Yet, it was not a major headwind because employment remained robust, stimulus checks were in the mail, and consumers largely thought things would get better, not worse, in the future. Fast forward to today and that situation has deteriorated. Stimulus has largely faded, and inflation has been accelerating, not declining, as 2022 has gone on:

Inflation

Inflation (JPMorgan Private Bank)

Of course, the S&P 500 is comprised of many companies that can benefit from inflation - such as Energy, Financials, and Industrials. But there are also companies in the index that won't. Further, while the S&P 500 is Tech heavy, we should not discount the impact the consumer picture has on the index. Importantly, Consumer Discretionary is the third largest sector weighting in SSO's portfolio. Further, when we couple that exposure with Consumer Staples, we see the fund has over 18% of its weighting directly tied to U.S. consumer plays:

SSO Portfolio

SSO Portfolio (State Street)

In my view, the U.S. consumer is in a tough spot, and that is going to have an impact on the S&P 500, and SSO by extension. Yes, wages and employment are up, but as the above graphic shows, inflation is up by more. Further, as we enter the busy summer travel season, American households are facing a steep jump in prices for all things vacation. This includes fuel prices, airfare, hotel stays, rental vehicles, and dinners out:

Travel Costs Rising

Travel Costs Rising (S&P Global)

All this adds up to a climate where investors need to recognize that consumer spending power is much lower than it has been in the past. While consumers may be willing and able to travel and absorb those costs highlighted above, there is going to have to be cutbacks elsewhere. This means investors may want to be more selective on what consumer exposure they amplify going into the summer, and broad funds like SSO may not be the best option.

Recession Risk - But Don't Get Overly Alarmed

Another aspect to monitor when looking at large-cap equities is the chance of a recession. With so many macro-concerns - whether it is Russia and Ukraine, inflation, or rising interest rates - headlines continue to flash "recession risk" at an increasing frequency. Fortunately, we continue to see economic growth in the U.S. and, while growth is supposed to be more modest this year, it remains positive for 2022 so far. Yet, the probability of a recession keeps on rising, as economists and investors fret about all the factors I have highlighted:

Recession Probabilities

Recession Probabilities (Northern Trust)

With recession risk rising, I think this again supports taking a less aggressive stance on equities. This is why I divested my SSO, and will look to build that position back if equities do drop going forward.

Of course, recession probabilities are just forecasts, and not absolute guidance. Further, I want to shy away from being too alarmist on this note. Can a recession occur? Absolutely. Can this send stocks lower? Absolutely. Will it? Maybe not.

It is in this vein that I am going to continue being net-long on U.S. equities. I do think being less aggressive makes sense, but I am not going to liquidate the majority of my holdings here. In truth, I rarely ever do that, and the macro-climate is not weak enough to suggest doing that now either.

Furthermore, recession predictions do not necessarily translate to negative equity returns. If we do a historical look-back, we see that in the twelve months leading up to a recession, the S&P does register more modest returns, but they are positive returns nonetheless (on average):

S&P Historical Returns

S&P Historical Returns (Guggenheim)

So what does all this mean? For the most part, retail investors should probably not make major adjustments. A recession may be a long ways off, or it may not happen at all. Even if it does, the consensus is we are still 6 - 12 months away from one. While that may cause some jitters, history suggests S&P 500 returns will still be positive in this backdrop. In my view, there will probably be accompanying volatility, meaning that leveraged bets like SSO should be done selectively. But it also means investors should be looking for down days to buy in, and shouldn't be exiting the market too aggressively or all together. This supports my modest downgrade of SSO to "hold", not "sell".

Fed Planning To Act, Sooner Than Later

My final point looks at the interest rate picture. Going into 2022, it seemed pretty clear the Fed was going to raise interest rates in a move to tame inflation and get yields back to more normalized levels. While we have seen movement from central banks across the globe, and the Fed has indeed already acted, the result so far in the U.S. is just a .25 basis point move. Considering we are 4 1/2 months into the year, this is a pretty dovish backdrop. Yes, Fed "speak" has been getting hawkish, but actual action has been limited.

Looking ahead, the days of all talk may be ending. Just this past week Federal Reserve Bank of St. Louis President James Bullard said the central bank needs to move at a faster pace to raise interest rates, with a target around 3.5% by year-end. As reported by Reuters, this means not ruling out increases of 75 basis points at a time.

The impact of this sentiment is that the benchmark rate is expected to near now hit the 2.5 - 3.0% range by year-end, which is quite a big jump from where we sit today:

Fed Dot Plot

Fed Dot Plot (Bloomberg)

Ultimately, this also isn't an alarming signal. But it does suggest the Fed is trying to cool growth, which is probably part of the reason why U.S. GDP estimates have been on the decline. This forward outlook can pressure Tech and growth names in particular because investors become less willing to pay a premium for future earnings in a rising rate environment. With SSO extremely sensitive to the Tech sector (over 29% of total holdings), this is another reminder of why investors need to be careful with new positions here.

Bottom-line

When the markets sell-off, it makes sense to get aggressive. One way to do so is through leveraged equity funds, such as SSO. This is my preferred option to capitalize on corrections, or bear markets, and I use it for short-term trading to amplify my overall portfolio returns. However, with this leverage comes risk, and the potential for sharp losses if positions are not well-timed. As a result, after I see reasonable gains, I tend to liquidate this holding or at least stop adding to it, in order to make sure I protect the gains I made. Unlike other index funds, SSO moves quickly and with more volatility, so it doesn't take much of a correction to wipe away short-term gains.

In this light, I think fading away from my prior "buy" recommendation is prudent at the moment. The market has seen a nice little bump off the March lows, and locking in some profit here seems prudent. We are facing lower GDP growth, a difficult consumer environment, and a more aggressive Fed. All of these situations suggest some equity pressure could be forthcoming, and I will wait for that to materialize before getting bullish on SSO once again.

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This article was written by

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CEF/ETF income and arbitrage strategies, 8%+ portfolio yields

Macro-focused investor, working for a major U.S. bank. I grew up in New York, but escaped to North Carolina. I was a D1 athlete in college (men's tennis) and compete competitively to this day. My Bachelor's and MBA are both in Finance.

I provide reasoned, fact-based analysis of different funds and sectors. I list my portfolio here so readers can gain insight into what I am buying/holding, what I'm not, and how that lines up with the views I present in my articles. 

Broad market: VOO; QQQ; DIA, RSP

Sectors: VPU / BUI; VDE / UCO; KBWB; XRT

Non-US: EWC; EWU; EIRL; EWA

Dividends: DGRO; SDY, SCHD

Municipals/Debt Funds: NEA, BBN, PDO, BGT

Stocks: WMT, JPM, MAA, SWBI, MCD, DG, WM

Cash position: 25%

Disclosure: I/we have a beneficial long position in the shares of VOO either through stock ownership, options, or other derivatives. 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.

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