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ETF Talk: Readying a Leveraged Short Play

October 13, 2010
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The stock market is in the unusual situation of rising in response to bad news. I personally have my doubts about how much longer this odd trend can continue. For those of you who want to be able to profit if the market falls, I suggest that you familiarize yourself with exchange-traded funds (ETFs) that are designed to rise when equities pull back. One fund that is intended to let you profit twice as much as the market dips is the ProShares UltraShort S&P 500 (SDS).

Let me tell you right now that I am not recommending this fund and I do not expect the market to crash the way that it did during the fall of 2008. But right now, unemployment is high and hovering close to 10%, consumers are wary about spending and many corporations are boosting profits by cutting costs rather than growing revenues. None of those developments typically is good for the market. One big factor that is credited with aiding the market is the Federal Open Market Committee’s (FOMC) stated commitment to use low interest rates and other policies to prop up a struggling U.S. economy.

At some point, the Fed no longer will be able to assuage investors. When this finally happens, stock prices may well retreat. To prepare, you’ll want to be ready to take a short position using an inverse ETF. If you really are convinced that the market will drop sharply, SDS lets you follow your convictions by doubling your potential reward. Of course, you also will assume twice the risk.

The ProShares UltraShort S&P 500 seeks a single-day return of -200% of its target index, the S&P 500. The fund includes a disclaimer that explains that it compounds daily returns, which may cause the ETF’s performance to differ in amount and possibly direction from the target return for the same period. To be sure, the chart below shows the importance of buying SDS at the right time to avoid riding it in the wrong direction.

Nonetheless, there are plenty of reasons to be concerned about the market. U.S. stocks fell yesterday morning as investors grew jittery about minutes of the last FOMC meeting slated for release in the afternoon, only to rally when the Fed confirmed it would keep interest rates low and take other steps to spur the economy. Despite the Fed’s policies, worries are growing about China’s efforts to cool its economy and its resistance to allow the appreciation of its currency, the yuan.

Next week’s meeting in South Korea of ministers and central bank governors from the group of 20 industrial and developing nations will be the next venue for policymakers to discuss currency valuations that distort trade. I do not expect any genuine progress to take place, based on China’s past intransigence.
Other negative economic indicators are giving me pause, too. The International Monetary Fund (IMF) is forecasting rising currency tensions and sharply reduced economic growth. The U.S. Department of Labor announced on Oct. 10 that the United States lost 95,000 jobs in September. And HSBC’s quarterly emerging market index reported last week that the rate of growth in emerging markets fell in the third quarter for the second consecutive quarter. An old investor’s saw is that the market always climbs a wall of worry. Well, those worries are mounting.

If you want advice from me about which ETFs to buy and to sell, I encourage you to sign up for my ETF Trader service by clicking here. As always, I am pleased to answer any of your questions about ETFs, so do not hesitate to contact me if you have one. To send your question to me, simply click here. You may just see your question answered in a future ETF Talk.