The Wagner Daily | February 6, 2009

Commentary:

We concluded yesterday’s newsletter by saying, “Be alert and prepared for continued indecision in the short-term.” Yesterday’s swift reversal that followed Wednesday afternoon’s ugly sell-off was a good example of why we signed off with that advice. Keeping traders on their toes, the Nasdaq took another stab at moving above its 50-day moving average yesterday morning; this time the rally held up (at least for the day). Though the major indices opened approximately 1% lower, the bulls immediately stepped in to the provide support. Stocks subsequently trended higher throughout the morning, logging substantial gains by mid-day, then consolidated in a sideways range into the close. Maintaining its recent show of relative strength, the Nasdaq Composite climbed 2.1%. The S&P 500 advanced 1.6% and the Dow Jones Industrial Average gained 1.3%. The small-cap Russell 2000 and S&P Midcap 400 indices finished higher by 1.5% and 1.6% respectively. The main stock market indexes finished in the upper quarter of their intraday ranges.

Volume in both exchanges surged to its highest levels in weeks, helping to invalidate the bearishness of the previous day’s distribution. Turnover in the NYSE zoomed 17% above the previous day’s level, while volume in the Nasdaq similarly ticked 15% higher. The sharply higher volume enabled both the S&P 500 and Nasdaq Composite to score a bullish “accumulation day” for the second time within the past four days, but don’t forget the other two sessions were bearish “distribution days.” With the broad market seesawing between higher volume losses and higher volume gains throughout the week, it’s been a tricky environment for technical traders. Nevertheless, it’s positive that both days of higher volume losses were immediately followed by even higher volume gains. It’s particularly notable that yesterday’s trading was the busiest in weeks. This tells us institutions may be starting to “dip a toe in the water” of the buy side.

Yesterday, we analyzed a potential play that was setting up in UltraShort Oil and Gas ProShares (DUG), and subsequently discussed the “Short” and “UltraShort” ETFs in general. Thereafter, we received an e-mail from a subscriber, asking if we were aware of the long-term underperformance of some ETFs in this group. Since we trade ETFs every day, we were indeed already aware of this problem, but, for the sake of simplicity, chose not to discuss the issue because we felt the problem had little relevance to the type of short-term, momentum-based trading this newsletter is focused on. But upon further contemplation, we decided it would actually be a good idea to make sure subscribers are aware of the shortcomings of some of these inversely correlated ETFs.

Put simply, several of the sector-specific “Short” and “UltraShort” ETFs have had an extremely low inverse correlation to the underlying sectors they represent. While they were originally designed to simply move in the opposite direction of the industry sector, this has not been the case over the long-term. Perhaps the most well-known example of this has been the lack of any long-term correlation between UltraShort Financials ProShares (SKF) and the overall performance of the financial sector. To illustrate this, take a comparative look at the full-year 2008 performance of SKF versus S&P Financial SPDR (XLF), a popular ETF proxy of the overall financial sector:

Last year, XLF lost 54.3% and SKF lost 7.9%. Since SKF is inversely correlated to the financial sector, and leveraged as well, it should have yielded a positive gain that was greater than XLF’s loss of 54.3%. Yet, it failed to even net a gain. In a nutshell, this anomaly is caused by the fact that the portfolio of SKF is rebalanced daily, using a complex formula of derivatives, and even derivatives of derivatives. The share price of XLF, on the other hand, is simply derived from the aggregate price movements of underlying stocks that comprise its portfolio.

But if this is such a huge problem, why even bother trading in the UltraShort ETFs? The answer is that this group of ETFs still provides an acceptably close inverse correlation to the underlying sector in the short to intermediate-term. On the chart above, for example, observe the big declines of XLF in June/July and October/November. During those periods, notice the price of SKF actually rallied sharply, as it was designed to do. It was when XLF subsequently began to rally that the corresponding declines of SKF were much greater than the inverse bounces in XLF. Since the ETF trades in this newsletter are intended to be short to intermediate-term plays, there is still a benefit to trading in the UltraShort ETFs with a lack of long-term inverse correlation, just as long as we don’t stick around too long. In addition to SKF, UltraShort Real Estate ProShares (SRS) and UltraShort Oil and Gas ProShares (DUG) also showed year 2008 losses, despite large drops in the real estate and energy sectors.

The good news is that not all of the UltraShort ETFs have this problem. Comparing the performance of the Semiconductor Index ($SOX) with UltraShort Semiconductors ProShares (SSG), the former lost 48%, while the latter gained 109%. Since the UltraShort ETFs aim to move in the opposite direction of the underlying sector, and at a rate of double the percentage movement of the sector, SSG suitably accomplished its intended goal last year. There are others as well. We’ve also noticed that some of the regular “Short” (unleveraged) ETFs have also done a better job of inversely tracking the sector than the “UltraShort” (leveraged ones) in the long-term. An example of this can be found by comparing the performance of Short Oil and Gas ProShares (DDG) and S&P Energy SPDR (XLE). Since DDG is less than one year old, we only looked at the price change in the last six months of 2008. During that period XLE dropped 46%, while DDG gained 32%. It still failed to gain as much as XLE dropped, but at least had a rough correlation. Ironically, DUG, which is inverse and supposed to gain twice as much as the sector, underperformed DDG during that period; DUG gained only 20%.

It’s also our observation that the broad-based Short and UltraShort ETFs that follow indexes such as the Nasdaq, Dow, or S&P 500 generally do a better job of inversely following their corresponding indexes than the sector-specific ETFs such as SKF, DUG, SRS, etc. In 2008, the S&P 500 SPDR (SPY) lost 38%. The Short S&P 500 ProShares (SH) gained exactly the same percentage. This is shown on the chart below:

Even the UltraShort S&P 500 ProShares (SDS) did a relatively decent job of returning a gain that was greater than the loss of the S&P 500. It failed to double the gain, but at least the gain was larger than that of SH:

Finally, it should be noted that technical analysis is best done on the underlying index itself, NOT on the Short and UltraShort ETFs. If you identify a sector index that looks good for selling short, use that information to buy the Short or UltraShort ETF, then continue to monitor the actual sector index thereafter. In the case of SRS, which we bought a few days ago, it was the chart of the DJ Real Estate Index ($DJUSRE), more than SRS itself, that prompted our entry (which we later scratched).

In summary, the ProShares Short and UltraShort ETFs still offer traders benefits that were formerly impossible. Taking bearish positions in an IRA is one such benefit. However, the benefit is greater to traders who actively manage their IRA accounts with short to intermediate-term trades, not long-term investments, UNLESS you stick to the broad-based inverse ETFs, which meet their intended goals. Just be careful with the tricky sector-specific, UltraShort ETFs such as SKF.

Today’s Watchlist:

There are no new setups in the pre-market today. DUG has been removed from our watchlist due to yesterday’s breakout in the Nasdaq. As always, we’ll send an alert if we enter anything new.

Daily Performance Report:

Below is an overview of all open positions, as well as a performance report on all positions that were closed only since the previous day’s newsletter. Net P/L figures are based on the $50,000 Wagner Daily model account size. Changes to open positions since the previous report are listed in red text below. Please review the Wagner Daily Subscriber Guide for important, automatic rules on trigger and stop prices.

Open positions (coming into today):

unrealized P/L = + $1,593

GDX long (150 shares from Dec. 26 entry) –

bought 31.40, stop 26.48, no target (will trail stop), unrealized points = + 3.30, unrealized P/L = + $495

IBB long (150 shares from Feb. 3 entry) –

bought 72.12, stop 68.52, target 78.80, unrealized points = + 1.82, unrealized P/L = + $273

UGA long (200 shares total — 100 from Jan. 29 entry, 100 from Jan. 30 entry) –

bought 23.42 (avg.), stop 21.48, target 30.45, unrealized points = (0.09), unrealized P/L = ($18)

Closed positions (since last report):

Current equity exposure ($100,000 max. buying power):

$29,845

Notes:

We’ve raised the stop in UGA, in case it stalls at resistance of its January 30 high. Since UGA failed to follow-through on its recent breakout attempt, we are playing the stop a bit tighter in order to minimize risk.
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Edited by Deron Wagner,
MTG Founder and
Head Trader