As the stock market continues to ramp back up, this contributor believes prices are lofty, and recommends a hedge against any immediate downturns.
The ProShares UltraShort S&P 500 (SDS)
from Sound Advice
We have noted that the breadth of the market began deteriorating in May. This was problematic because a healthy bull market will have broad participation among a wide range of stocks. However, participation will narrow as it runs out of gas. Near major tops, the largest capitalized stocks continue to rise because they are the easiest places for money managers and mutual funds to put incoming cash. This causes popular market averages to continue rising because they are heavily weighted by the stocks of the largest companies.
However, the overall breadth of the market will be deteriorating. The breadth of the market is revealed by tracking the number of stocks that advance on the New York Stock Exchange, and subtracting the number that decline. The cumulative total is the “advance-decline line” or ADL. Since then, we have not seen any significant divergence between the S&P 500 and the ADL, although some negative divergence appeared during the last week of October.
From this perspective, we can conclude that stocks in general are dangerously high, particularly with rising interest rates on the horizon and our Diffusion Index of Lagging Indicators flashing caution. Accordingly, it is an appropriate time to include in our portfolio an ETF that will benefit from a declining stock market.
The ProShares UltraShort S&P 500 (SDS) is a reverse ETF that is designed to produce two times the daily fluctuations of the S&P 500 index. A decline of say, 1.0 percent in the S&P 500 will cause SDS to increase by 2.0 percent. Conversely, an increase in the S&P 500 will cause SDS to decline in the same fashion. We have been tracking SDS and confirmed that it performs as it should, with daily premiums and discounts within 0.5 percent. It is also very liquid.
As with any reverse ETF, SDS will erode slightly over a long period of time because it will decline slightly more than it will increase with an equal movement in the S&P 500. The erosion factor is nominal in comparison to normal market movements, but it can add up over an extended period. The 2:1 leverage amplifies this erosion factor as well.
Accordingly, SDS is not a long-term holding proposition. However, for the near term, it will serve as a counter-balance to the rest of our portfolio in a general market correction. The 2:1 leverage factor means that it will better serve this purpose without making a large investment.
Gray Cardiff, Sound Advice, www.soundadvice-newsletter.com, 800-825-7007, November 2, 2015