August 13, 2019 - 7:00pm EST by
2019 2020
Price: 30.85 EPS 0 0
Shares Out. (in M): 32 P/E 0 0
Market Cap (in $M): 999 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 999 TEV/EBIT 0 0

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  • For the 3 asset managers who cannot use e-minis
  • Topic masquerading as an idea
  • Value Boyz Playing Macro
  • Time to fade the dip


Long Proshares Ultrashort S&P 500 (SDS)

I expect this idea to get a relatively low rating because it is not a value-based, buy and hold recommendation, but rather a security that I believe could be a timely addition to a portfolio of value ideas based on the current macro and technical setup.  

The VIC tends to respond coldly to these ideas.  The two most recent ones received low ratings and significant pushback.  Miser’s IAU recommendation on 6/2/18 was rated 3.7 and slapped with a “topic masquerading as an idea” tagline.  Defy_Augury’s QQQ short recommendation on November 4, 2018 received a 2.7 rating and a very pointed post highlighting the inappropriateness of posting macro ideas on a value investors’ forum (see post 2 entitled “Value Boyz Playing Macro”).

Nonetheless, I have found these recommendations to be very useful and often timely additions to the portfolios I manage.  They diversify my portfolios, adding alpha by altering an overly homogeneous return profile and dampening volatility. Value ideas can go through long periods of underperformance that challenge the patience of even those most committed to the strategy.  Further, timely macro ideas tend to be more liquid and, depending on the idea, can be implemented in greater size in a portfolio because their risks tend to be less idiosyncratic.  

I’ve noticed that when the rare macro idea appears on the VIC, the timing tends to be pretty good.  Perhaps this is because our kind is so instinctively opposed to these things that we only dare to post them when we have very high conviction.  It’s notable that Miser’s IAU idea is up 16.5% since it was posted, versus the SPY up only 7.9% over the same period. Defy_Augury’s QQQ short would have captured an 8.7% downdraft through the end of 2018 if held for the two months since it was posted.


What is SDS?

SDS is an exchange traded fund (ETF) sponsored by the Proshares fund family.  It seeks to deliver a return on a daily basis that is twice the inverse of the percentage return generated by the S&P 500 index.  For example, if the S&P 500 is up 1.5% on a given day, we should expect the value of SDS to fall by 3.0%. If the S&P 500 is down by 1.5% on a given day, the SDS should be up by 3.0%.  SDS achieves this by using index derivatives. The tracking error over long periods can be quite significant because of the imperfect matching of the derivatives, the 90 basis point expense ratio, and the daily reset, which will be discussed in more detail below.


SDS has an NAV of approximately $1 billion.  It is fairly liquid, trading approximately 6 million shares, or $180 million dollar value, per day. 

The Daily Reset


SDS is designed to deliver the 2x inverse return on a percentage basis each day.  It is therefore not a static portfolio like most index ETFs or closed end funds.  This can result in performance that diverges greatly over time from what would be expected from directly shorting twice the nominal dollar value of the S&P 500 index.  As discussed below, the holder of SDS should expect to be worse off than shorting twice the index in volatile but non-trending markets, and somewhat better off in trending markets.  


To illustrate this, let’s look at the mechanics behind the daily reset using an assumed starting NAV of $30 per SDS share, first in a volatile, but non-trending market, then in a trending market.

Effect of Daily Reset in a volatile, but non-trending market


Suppose on Day 1 the S&P 500 falls 2.5%.  SDS has been set up with an equity value of $30 per share backing a $60 synthetic short position in the S&P 500.  So at the end of Day 1, the value of the short position has fallen 2.5%, or $1.50 per share (equal to $60 x .025).  SDS’s value has moved up to $31.50, which is up 5%, as intended.  


However, its synthetic short position in the S&P 500 is now only worth $58.50 per SDS share.  This is inadequate to generate a double inverse percentage return on Day 2 because the short position will have to be double the SDS value of $31.50 to achieve this.  So SDS’s managers have to synthetically short $4.50 per SDS share more of the S&P 500 before Day 2 begins to set up for the 2x inverse result. After the additional short is put on, Day 2 begins with SDS having an equity value of $31.50 per share and carries a synthetic short position of $63 per share.


Now suppose on Day 2, the S&P 500 rises exactly back to where it started on Day 1.  This requires a 2.564% increase on Day 2. SDS’s synthetic short position is now worth $64.615 per SDS share and SDS’s equity value declines by $1.615 from the $31.50 Day 2 starting value to be worth $29.885 at the end of Day 2.  Thus, over the two days the S&P 500 has not moved at all, but whipsaw has caused an 11.5 cent erosion, equal to 38 basis points on the starting value, in SDS’s NAV. If this non-trending movement continues, the effect of SDS having to continually “buy high and sell low” to maintain its targeted levered exposure will dissipate its NAV considerable relative to a static short position.

Effect of Daily Reset in a trending market


Suppose Day 1 occurs exactly as above, with the S&P 500 declining 2.5%, the equity value of SDS rising 5% from $30 to $31.50, and SDS’s managers increasing the S&P short position increased from its $58.50 Day 1 closing value to $63 per share before Day 2 begins. 


However,  in this scenario the S&P 500 falls another 2.5% on Day 2.  SDS’s synthetic short position is now worth $61.425 per SDS share and SDS’s equity value increases by $1.575 from the $31.50 Day 2 starting value to be worth $33.075 at the end of Day 2.  Thus, over the two days the S&P 500 has fallen by 4.9375%, but SDS’s equity value has risen by 10.25% over the two day period. A static 2x short would have increased the security’s equity by $2.9625 or 9.875% but the releveraging increased it by $3.075 per share, or 38 basis points more off the initial NAV.  Here, maintaining SDS’s leverage on a daily basis tends to boost NAV relative to a static short position. This math works in SDS’s favor relative to a static 2x static short position in when the S&P 500 is trending upward as well, in that the nominal short position is reduced with each up day in the S&P 500 and has less impact on SDS’s NAV as the S&P 500 trends upward than the static short would.

Why am I recommending this particular security?


I’m recommending using SDS to hedge out some market exposure for several reasons:


  1.  The fact that it is an ETF means that it can be used in more traditional accounts.  This security can be purchased, held, and valued like any stock in a typical brokerage account.  Other market hedges like index futures, swaps or other derivatives typically require more sophisticated account arrangements and often higher account values to deploy.


  1. The security is liquid, is adequately capitalized, and trades with a tight bid-ask spread.  There are many other ETFs with similar features, but most are undercapitalized and illiquid.  SDS has a billion dollar equity capitalization, trades $180mm in value per day, and usually has a penny bid-ask spread.


  1. The expense ratio is not onerous.  The expense ratio is 90 basis points, which isn’t wonderful, but since it’s double levered, it requires half the value held to offset each unit of risk.  In other words, you’re paying 45 basis points in expense per unit of risk offset.


  1. The daily reset feature is actually a benefit over most market outcomes. As mentioned above, the daily leverage reset feature tends to dissipate NAV in volatile, non-trending markets and supportive of NAV in trending markets.  The reality is that markets have a greater tendency to trend than not. It is interesting to compare the performance of the 2x inverse SDS security with that of the 1x inverse SH security over the last 5 years.  Between July 31, 2014 and July 31, 2019, the S&P 500 is up 71%, the SH 1x inverse is down 43.3% and SDS is down 70.6%. Both are down less than a static short would have been, and SDS offered double the hedge at initiation and would have cost less than a 1x static short over the period and somewhat less than twice the cost of the 1x reset SH did over the period.  Note that I am not expecting this position to be held over a multiyear timeframe, but it is instructive to see what the impact would be if it were held should an attractive exit point not appear or somehow be missed over this period.


  1. The value dissipation of the double leveraged SDS in non-trending markets is much more manageable than that of the triple short ETFs.  If we look back at the relatively volatile but non-trending period between March 31, 2015 and March 31, 2016 when the S&P 500’s price moved up and down quite a bit but ended very close to where it started, we can get an idea of the potential cost of this hedge in an environment highly unfavorable to the daily reset feature:


Period Cost per Unit

Security Return Leverage of Risk Offset

SPY +1.70% 1.0x -1.70

SH -4.90% 1.0x -4.90

SDS -11.16% 2.0x -5.58

SPXU -19.45% 3.0x -6.48


As the table above demonstrates, none of these ETF solutions is particularly good relative to an outright short of SPY, but SDS is only marginally more costly (at 5.58 percentage points versus 6.48 percentage points) per unit of risk offset than the 1x Inverse SH ETF.  Note, however, that this outcome would only have unfolded if the hedge was not taken off when the opportunities presented themselves. There were two separate multi-week drawdowns of over 12% during this period.

Why now?

I think many VIC members would agree that after 10 years of extraordinary central bank policies, the distortions that have accumulated in the system are well beyond historical norms.  Over $15 trillion of the world’s debt (25% of all bonds outstanding) now trades at negative yields - levels that my undergraduate economics textbooks from long ago stated were impossible. 


An unimaginably large swath of risk averse investors have been pushed out of their natural investing habitat into securities that they are likely to recognize as wholly inappropriate for their needs if the prospect of permanent loss rears its ugly head.  They are very likely to become forced, price insensitive sellers in this scenario. The negative feedback loop of falling prices could easily bleed into an already fragile real economy, instigating further declines and a bigger economic impact, etc.  


Valuation support is miles away.  The current Shiller Cycle Adjusted Price to Earnings Ratio (the CAPE Ratio) has only been exceeded in history by the Dot Com Bubble.



Still, we all know these value-based indicators are ineffective timing tools.  We have been here for years already, and things have been fine so far. I would look to more technical timing tools to determine whether there is something actionable on the horizon.  


Warning: now we are going to start looking at voodoo things like divergences and charts.


The table below summarizes the performance of some of the broadest equity indices over the past 10 years, 5 years, 1 year and year-to-date, as of July 31, 2019:


10 year

5 year

1 year



S&P 500







MSCI World







Russell 2000







MSCI Emerging Markets








While a lot can be gleaned from this, what jumps out at me is the S&P’s higher p/e and significantly greater return over all these periods relative to the other indices.  The S&P 500’s one year return of positive 8%, in particular, is notable in contrast with the negative 4.5% of the Russell 2000. A similar divergence in trailing 12 month returns occurred for the period ending November 30, 2007, with the S&P 500 up 7.8% and the Russell 2000 down 1.2%.   Over the next two months, the S&P 500 fell 42.7% and the Russell 2000 fell 41.2%.


Possible topping formation?


Most VIC members seem skeptical about the merits of technical analysis.  I have a mixed view on many of the complex patterns and waves that guide its proponents, but I think it’s undeniable that markets tend to move in trends.  Further, my experience has been that once certain triggers are breached, markets tend to move more on sentiment than on more rational factors like probabilities and discounted cash flows.


One very simple indicator that I’ve used is where prices are in relation to a relatively long term (350 day) moving average.  As long as we’re trading above this level, investors in aggregate seem content with the notion that stocks as a whole may wiggle up and down over short or even intermediate periods but the long term trend is always up, and stocks a great source of wealth generation over the long run.  However, it seems they begin to question this notion after 18 months or so of flat to negative returns. Looking at charts around the major selloffs over the past 25 years illustrate this notion.


Below is a chart of the S&P 500 around the bursting of the dot com bubble:



After a long run above that 350 day moving average through the 1990s, stock briefly breached the trendline twice through Bill Clinton’s impeachment and the unwinding of Long Term Capital Management in 1998.  The fallout from this initial breach was staved off, perhaps through Alan Greenspan’s aggressive intervention with both rate cuts and direct oversight of the LTCM impact, but, as the chart shows, gravity eventually won out when the moving average was breached again in the second half of 2000 and remained resistance through the cathartic bursting of the dot com bubble. 


The moving average was reclaimed and it was smooth sailing until the long term moving average was breached again at the end of 2007, per the chart below.



The market’s inability to move above the moving average line in early 2008, which became what technicians call resistance, precipitated the profound loss of confidence that coincided with the Global Financial Crisis of 2008-2009.


And now here we are today.   



Above is a chart of the S&P 500 from August 2011 showing a steady uptrend after moving above the Magical Moving Average at the end of 2011.  


The line was breached twice in late 2015 and early 2016, which possibly could be viewed as a warning shot across the bow, analogous to the breach in 1998 that preceded the dot com breach.  Then we had the breach at the end of 2018 that was stemmed by Powell’s very aggressive pivot from hawkish hiker to dovish deflator. Time will tell whether that pivot will be enough to send us upward and onward into the horizon.  If the political will isn’t there within the Fed to keep encouraging investors that they’ve got their back, I believe it’s likely gravity will take us below the moving average once again, which I would then expect at a minimum a retest of the 2018 lows, if not a much larger correction.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Breach of 350 day moving average on S&P 500.  Central bank intervention coming slower than needed.

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