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Why ultrashort ETF's might still suck in a deep recession

Recs

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April 02, 2008 – Comments (10) | RELATED TICKERS: SDS , QQQ

I am not going to buy ultrashorts, even though I think the economy is bad now and going to get much worse. "Why not?" I hear you asking. Well, quite simply, no matter how much the real value of the stock market goes down, the value of the dollar can go down just as much. "So?" So allow me to illustrate what will happen if you invest in QID (an ultrashort ETF promising double the inverse of the Nasdaq 100) and the real value of the Nasdaq 100 goes down 10%, and the value of the dollar goes down 10%.

You invest $1000 in QID at $50/share and get 20 shares. For the sake of argument, let's say the value of the Nasdaq 100 goes down 10%. So your QID is supposed to go to $60, right? Not so fast. What if inflation is 10%? Okay, so your 20% gain is like a 10% gain in real value, right? Again, slow down. It's more complicated than that. I said the value of the Nasdaq 100 went down 10%, not the price. So with 10% inflation, the notional value (or price) of the N100 stayed the same, even though in reality it is worth 10% less than it was.

Now, I may be mistaken, but I'm pretty sure that QID's moves are based on the change in notional value in the N100. That is, when the price of the N100 stays the same, it doesn't matter what the inflation rate did to the actual value, the price of QID remains relatively unchanged (except that it drops about 1% due to its expense ratio).

Well, that's not such a disaster, is it? Yes, it is. Remember the inflation? Your QID investment dropped only 1% (from 50 to 49.5), but your purchasing power dropped from $1000 to about $890. You just lost about 11% of your purchasing power.

Okay, okay, but what are the odds of 10+% inflation? I would say pretty good, considering that both Republicans and Democrats seem bound to keep uncapped entitlement spending growing at a rate that vastly outpaces GDP growth, and taxes are way less popular than inflation as a way of paying for it. Inflation, from a political point of view, also has a huge side benefit of making a stock market appear stable or growing, even as it is declining in real value. If the inflation is even steeper than the decline in real value in the underlying index, an investment in the underlying index (QQQQ) can decrease in purchasing power while QID loses purchasing power even faster, as the N100 makes notional gains.

That's why you won't see me investing real money in ultrashort ETF's, even though I believe we're in the early stages of one of the three worst recessions in a century. I'm going to be looking for foreign dividend stocks, gold and silver mining stocks, and especially dividend-paying foreign gold and silver mining stocks, unless someone like TMFBent or downwithinfidels has a better idea.

P.S. Even in a bad inflationary recession, individual domestic stocks that do business in, and report earnings in, the affected currency can nonetheless dramatically increase their owners' purchasing power. This is especially true of small caps with world-changing innovation and companies that profit from the government largesse that causes the stagflation.

P.P.S. Apparently CAPS doesn't like for articles to single out QID in the "Related Tickers" field.

10 Comments – Post Your Own

#1) On April 02, 2008 at 7:37 PM, kdakota630 (29.85) wrote:

When you find some stocks you like that fit your criteria, I hope you don't keep them a secret from the rest of us.

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#2) On April 02, 2008 at 10:07 PM, mandrake66 (82.37) wrote:

Why does your argument apply only to ultrashort ETFs? Wouldn't it be just as valid for short or long ETFs, or short or long individual stocks? I don't see how the trading gains from any of these would be less subject to inflation than others. Any asset you hold that is not indexed to inflation (like TIPS) is going to have its value eroded at the same rate. 

And it's not as though people invest in ultrashort funds for years. They do it for days, maybe weeks. Inflation costs are negligible for the duration.  

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#3) On April 02, 2008 at 10:55 PM, FleaBagger (28.84) wrote:

kdakota -

I already picked a bunch of gold and silver miners on CAPS, but I don't know much in particular about any of them. I'm looking at the big picture and picking the highest-rated of the individual stocks within that fold. I do know, however, that LMC and CDE are trading below the value of their gold and/or silver reserves at today's gold and silver prices (which I think are going to go much higher). Also DGP is an ETN issued by Deutsche Bank that seeks to return double the monthly return of gold's price movement plus a T-note yield, minus expenses, so that should be very good if inflation is bad.

mandrake -

I was making a case against buying ultrashort ETF's as a way to profit from the poor economic environment that has been harming the real returns of stock investing for about 6 years now, and will for at least another three, unless neither Obama, Clinton, nor McCain becomes president. (So the odds don't look too good.) If the stock market were in a stock bubble instead of an inflationary recession, ultrashort ETF's would be an excellent investment. If we were in a recession with minimal inflation (as I don't think will ever happen again), ultrashorts would be a good investment. But with politicians using inflation to tax the whole economy and prop up notional stock prices simultaneously, we have the awkward situation of index funds looking like a poor investment for the next few years, and the ultrashorts of those same indexes looking even poorer.

To sum up, ultrashorts are supposed to be a way for investors to profit from a falling stock market, but the coming inflation might destroy their real returns as the stock market's real return is negative as well. But you are right that inflation will slam regular short and long ETF's, I was just pointing out that bears need to be wary of mindlessly buying "bear" ETF's, even if they are right about the real direction of the economy.

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#4) On April 02, 2008 at 11:47 PM, TDRH (99.68) wrote:

Interesting, so investing long in sectors you did not outline will be doubly bad-I have a lot of pain ahead.   Never had good timing with gold-buy too late and sell too early.  Scared away from silver by the Hunt Family.  

  I have had a Heineken on an empty stomach so forgive me if I missed it, but you did not mention oil or oil service?    Many of this companies have global operations, ie Noble Drilling and RIG drilling in Brazil.   In the last five years day rates have doubled in dollar terms.  What about oil companies like BP who are working to diversify into solar technologies and wind as well.    Not to paper your blog with plugs (I own none of these companies) but I need something more than gold and silver to invest the cash position.

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#5) On April 03, 2008 at 12:46 AM, FleaBagger (28.84) wrote:

TDRH -

I don't know why the King of CAPS (for a day, Fool for a Lifetime) is bugging me for stock picks, but I can take flattery in stride.

I did not mean for "foreign stocks and precious metals" to be comprehensive. As with all my posts, I just rambled on until something forced me to end it abruptly, so I was in a hurry while writing that last part. You may also notice I said individual small caps could have such returns as to leave inflation in the dust (perhaps MVL or BOLT). And oil, like copper, is probably going to be good, I just don't have the same level of confidence in it to resist the recession part of the inflationary recession that I'm expecting. That is, I don't think it is quite as safe for the next 3 years or so.

As for the Hunts, if someone tries to pull a stunt like that in the next few years, silver investors could make huge profits being among the last to sell (out). Or gold investors, if the shoe is on the other foot. Or it could be platinum this time. Nobody talks about platinum, but it's way up too.

Remember I said foreign dividend stocks, not just gold and silver. I don't know what the construction business is like in Mexico, or the other foreign countries where Cemex does business, but CX should be a very good one by the time 3 years have got behind us.

I doubt drybulk is going to suffer as much as it's priced to, and Greek shipper Euroseas (ESEA) seems particularly undervalued to me.

I like Chile, and I like financial services companies that aren't 21st-century American financial services companies, so Provida (PVD) is appealing to me at this point.

Non-dividend paying Chinese car parts maker SORL (SORL) could be a very big winner, combining huge growth potential and modest valuation. 

Also, Rule Breakers pick Immersion (IMMR) and Hidden Gems pick Hurco (HURC) look excellent right now, despite having to face stagflation.

By the way, part of me wishes my CAPS scorecard were this concise. These are my very favorites.

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#6) On April 03, 2008 at 3:55 PM, FourthAxis (< 20) wrote:

(whistles to self)  Now do the math with cash or SPY.  Point = Moot.

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#7) On April 04, 2008 at 10:36 AM, FleaBagger (28.84) wrote:

Axis -

My point is to pick individual stocks very carefully, or at least buy foreign stock mutual funds or gold. Not a moot point.

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#8) On April 04, 2008 at 11:35 AM, abitare (93.63) wrote:

FleaBagger,

I read and gave you a REC yesterday. We are aligned mostly.

I posted on 26 Mar 08 about the inflation: 

Shouldn’t The Stock Market Be Down A Lot More Than It Is? It should – and it is.

Where we disagree is the Real Estate and Finance have had their own asset bubbles. They have been popped, the FED will unlikely be able to reinflate those two bubbles, as people are scared of them (still). The money will flow to the next asset bubble. My WAG is it will be solar, alternative energy, food and commodities etc... 

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#9) On April 04, 2008 at 7:02 PM, FleaBagger (28.84) wrote:

Thanks for the rec, abit.

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#10) On May 18, 2009 at 8:07 PM, ChrisGraley (29.97) wrote:

I agree and i'm looking at the same things.

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