Current
Signal Performance as of
Signal
Type |
Trade
Date |
Return
since issued |
|
|
|
World |
U.S. |
|
Nasdaq
100
(QQQQ)
|
Russell
2000
(IWM)
|
S&P
500
(SPY)
|
|
The main
averages managed to post solid gains this week, with tech stocks
leading the way. After an initial drop, markets rebounded Monday
following the release of a better-than-anticipated ISM index
of manufacturing activity for January. Stocks continued to climb
Tuesday, helped by better-than-expected earnings reports from
drug companies Merck and Schering-Plough and a 6.3% increase
in existing home sales for December, a number that was significantly
above projections. After an up-and-down session that left them
mostly unchanged Wednesday, the main indexes resumed their advance
the next day, buoyed by a rally in financial stocks on hopes
that changes in the accounting rules that govern the sector
would help large U.S. banks divest their bad assets. The Nasdaq
Composite
gained 2.1% during the session. The government released
its January employment report Friday morning. As the economy
continued to deteriorate, it showed that almost 600,000 nonfarm
jobs were lost last month, sending the unemployment rate up
to 7.6%. The dismal news could have triggered a stock sell-off,
but investors instead decided to focus on the likely approval
of the government's massive stimulus package and bank rescue
plan. All major averages rallied as a result, with the S&P 500
posting a 2.7% daily gain.
For the week, the S&P 500 (SPY) and the Russell 2000 (IWM) respectively
gained 5.01% and 5.58%. Both ETFs remain located below their
50-day and 200-day exponential moving averages (EMAs). They
were outperformed by the Nasdaq 100 (QQQQ), which posted a 7.95%
weekly gain as tech leaders were particularly strong. As a result,
the ETF has now crossed back above its 50-day EMA but remains
located well below its 200-day EMA.
For its part, our World portfolio posted a
5.31% gain this
week. The portfolio consists of the 5 top-ranked world ETFs
as of January 30, which marked the beginning of the current
4-week holding period. Please note that since we now have an
active Cash signal,
the World approach calls for selling your holdings
if you follow the "Long Only" or "Long
and Short" strategy. Only if you follow the "Buy
and Rebalance" strategy should you remain invested
in the top 5 ETFs, as the strategy calls for staying invested
at all times. Please go to the "Our
Service" page for all the details.
Our current Cash
signal remains in effect.
How much leverage should I use on my investments?
Imagine you have the ultimate market timing system which tells
you precisely when to be long and when to be short; why wouldn't
you bet all of your money, and as much of someone else's money
as they let you borrow? The main reason is that no one has found
the ultimate market timing system yet - we humbly recognize
that ours is not perfect and probably never will be. Still,
many investors are attracted by the lure of higher potential
profits associated with leverage. Leverage can be defined in
the investing lingo as a factor by which market gains (and losses)
are multiplied. In this article we will review the array of
leverage instruments and techniques at our disposal, and compare
their respective merits and weaknesses.
Before we get to the main topic we must deliver a public service
message which is: not to use leverage beyond reason. As always
we encourage strategies that place financial security first
through balanced approaches. We are often tempted by the impressive
long term return that can be achieved with a fully leveraged
Long and Short strategy, but no one wants to
look at the downside. How much drawdown can you take? With margin
you theoretically stand to lose more than you invest. For the
majority of investors we do not recommend leveraging more than
20% of their investment. A Long and Short with Margin
strategy in contrast, if applied to your entire capital, represents
100% margin, 5 times more than we advocate. Moreover, many investments
such as the top ranked World ETFs are typically
volatile and risky enough without applying further leverage.
For those not familiar with margin investing we would suggest
reading "Margin
trading explained". For those in more of a hurry we quote:
"To understand how margin trading works, let's look at a specific
example: if you have a margin account with $10,000 of your own
money, you could borrow up to the same amount from your broker
to purchase stock for a total portfolio of $20,000. That's what's
called being on full margin because from your perspective you
have borrowed a full 100% of your own capital. From your broker's
point of view you meet the maximum 50% initial margin rule because
you are on margin for 50% of your overall account value. If
the stock you purchased has increased by 30% in value by the
time you sell, your portfolio is now worth $26,000 and $16,000
of that is yours ($26,000 minus the $10,000 you borrowed from
your broker). This represents a net gain of $6,000, or a 60%
return on your $10,000 investment. Without the margin trade
you would only have gained $3,000.
As with short selling there are costs, restrictions and risks.
The costs are mostly in the form of broker fees and interest
on the borrowed money. You will first need to open a margin
account or convert an existing account depending on the broker.
In addition to the maximum 50% initial margin rule discussed
above, the SEC also defines a maintenance margin of at least
25%. Your broker may be more restrictive than that and require
a maintenance margin of 30% or even 35%. The maintenance margin
is the minimum account balance you must maintain before your
broker issues a margin call. Whenever the equity in your account
(value of the stock minus what you owe the broker) falls below
the minimum maintenance amount (value of the stock multiplied
by the maintenance margin) your broker will force you to either
liquidate your stock position or add more cash to the account.
Using the previous example, if instead of increasing by 30%
the stock you purchased loses 25%, the equity in your account
would be $5,000 ($20,000 minus 25% = $15,000, minus the $10,000
you borrowed = $5,000). This $5,000 is about 33% of your $15,000
portfolio value, which would satisfy a maintenance margin requirement
of 30%, barely."
To add to the complications and limitations of margin trading,
it is prohibited in qualified retirement accounts such as IRAs.
Luckily, there have been alternatives available and the table
below compares them.
Leverage instruments and techniques
|
Maximum
leverage |
Risk |
Cost |
Ease
of use |
Other
issues |
Margin
|
2x |
High |
High |
Low |
Not
allowed in IRAs |
Leveraged
mutual funds |
2.5x |
Medium |
Medium |
High |
Slippage
(end of day trading) Negative compounding |
Leveraged
ETFs |
up
to 3x |
Lowest |
Low |
Highest |
Negative
compounding |
Options |
10x+ |
Highest |
Low |
Lowest |
Not
allowed in IRAs by
certain brokers |
Sophisticated investors have always exploited options to create
leverage. Because of their complexity and leveraging power options
can be deadly for the non-initiated, which is why they earn
the highest level of risk of all the alternatives. Yet, in the
hands of an expert, they can yield actual risk levels substantially
lower than other approaches. A series of four Weekly
Updates from June 27 to August 8, 2008 (6/27/08, 7/11/08, 7/25/08, 8/8/08),
described an option strategy which can achieve performance comparable
with that of equity based strategies with a much smaller portion
of capital at risk (say about 10%). This means options let you
apply much more leverage than margin does, and by applying them
wisely your overall market exposure can be decreased substantially.
For a long time, the only way to simplify all of this and side-step
many of the issues, and circumvent the no margin trading in
retirement accounts rule, was to instead use the leveraged mutual
funds that seek to achieve the same results as margin trading.
Fund families such as ProFunds and Rydex have been around for
years and have made Long and Short strategies
practical for hundreds of thousands of investors.
Even easier to use these days are leveraged and inverse ETFs.
They go further in addressing investor concerns than any of
the alternatives. They are by far the simplest to use and trade
like stock at any time during the day. Their lower costs and
risks make them the hands-down winners for most investors. Plus
these days there are plenty to choose from, in all flavor of
leverage like with the DirexionShares family that is now offering
several Bull/Bear 3x ETFs (see the FAQ below
for more details). The only remaining drawback is the negative
compounding effect which under certain market conditions will
negatively impact performance (See our article from two weeks
ago: "What to expect from Inverse and Leveraged ETFs?").
As a final note, we want to remind everybody that leveraged
ETFs are powerful, and as such that they need to be used with
caution. By committing only a fraction of his/her capital, one
could expect to match the performance of a strategy that would
otherwise have exposed the whole portfolio.
Question: What are the latest leveraged ETFs?
Here is a short list of some of the latest index leveraged and
inverse ETFs that we are aware of. This is certainly not exhaustive
as the Financial sector is flooding the market with new ones
almost on a daily basis:
ETF
Long / Short |
Reference
Index |
Leverage |
Fund
Family |
|
Nasdaq
100
|
2x |
|
|
Dow
Jones Industrial
|
2x |
|
|
S&P
500
|
2x |
|
|
Russell
2000
|
2x |
|
|
Russell
1000
|
3x |
|
|
Russell
2000 |
3x |
|
|
Russell
Midcap Index
|
3x |
|
Warm wishes
and until next week.
The TimingCube
Staff
|
|