Looking to Hedge? Forget Bitcoin, Consider Inverse ETFs
(2-3 Minute Read)
With all there is to worry about in today’s financial (stock, real estate and bond bubble) and geo-political landscape (North Korea, debt ceiling, Harvey) it makes sense to play defense with your portfolio. Adding traditional safe havens such as defensive stocks, Treasury bonds, gold, VIX futures and cash is a perfectly valid strategy. But bitcoin is a stretch as a hedge.
While we have been rooting for digital currency adoption for years now, the fact that crypto-currencies are already so appealing to the middle class already is cause for concern.1 Bitcoin, the first and most prominent digital currency, is now a topic of conversations at social gatherings, with stories readily available on the home page of major mainstream news sites.
And let’s face it; bitcoin has been a phenomenal investment. The price of one bitcoin rose from 6 cents circa 2010 (before anyone had heard of it) to above $5,000 recently. Yes, this outgains the tulip mania of the 1700s. Unfortunately, it will probably end the same way. The hedge has turned into wild speculation itself.
In a recent tweet, Peter Schiff shared that a client had instructed their firm, presumably against Schiff’s advice, to cash out all the stocks and exchange traded funds in their IRA to purchase bitcoin. This level of wide-eyed optimism clearly harkens back to the late 1990s. It’s easy to get sucked up into such manias, especially when the mainstream media picks up on them.
We’re not here to debate the merits of digital currencies; they will have value down the road. We’re just saying that the train has obviously left the station for buying them (bitcoin, litecoin, ethereum, et al.). A bitcoin inverse etf could be one of the best inverse etfs if/when it is created. We’ll keep you posted.
Inverse ETFs Can Combat a Frothy Market
If you’ve been using digital currencies as a hedge against our fragile financial system, their current levels make the hedge scarier than the global markets themselves (and that’s saying something). We offer another idea, one that’s certainly closer to the ground floor- inverse ETFs.
These securities are designed to go up as markets (or whatever the benchmark) move lower. The question is, why now? Aren’t markets going higher? They certainly have been, but the current risk-reward for equities is atrocious.
We have written before about our worries regarding U.S. equity markets, yet the markets have largely shrugged off our concerns. But today’s levels are back at prior mania peaks.
According to data from Sentiment Trader, mutual fund investors are historically bullish, having plowed $4.75 into stock mutual funds than in money market funds (a cash proxy). The current 4.75 to 1 ratio bests historically frothy periods 2007 (3.39 to 1) and even 2000 (3.09-to-1).
When this ratio gets high, it means that investors have already committed the bulk of their capital to stocks. In other words, everyone is sitting on one side of the canoe.
There’s no longer about what ‘inning’ this bull market is in-it’s the bottom of the ninth. The only question is ‘how many outs are there’?
So, what’s the best way to play defense in this market? We have identified the NASDAQ 100 which has three unique risks- overconcentration, extended outperformance and regulatory worries:
Nasdaq 100 Inverse ETF
Outside of maybe the XLF, there aren’t many major ETFs with this high a concentration. The top 10 holdings account for nearly 52% of the weighting of the entire 100-stock ETF.2 In fact, just the top five holdings (Apple, Google, Microsoft, Amazon and Facebook) account for over 42% of the weighting. This concentration increases the potential for another flash crash type collapse like we saw in the QQQ in August, 2015. And if something goes awry with Apple (12.5% by itself), look out below.
Getting Long in the Tooth
The Nasdaq 100 has risen nearly 6-fold since its Financial Crisis lows, topping 6,000 for the first time ever on September 1st. This rebound dwarfs those of the Dow Industrials and Standard & Poor’s 500. In fact, the NDX has grossly outperformed the S&P 500 by such an amount, it led Goldman Sachs to comment on another tech bust back in June.3
You can see the beginnings of anti-tech rhetoric from this administration from Trump and his comments on Amazon/Washington Post. This echoes Microsoft with its anti-trust issues that began in the late 90s, signaling its top. But it’s not just domestically- the EU has already attacked large U.S. tech names including Google and this protectionist behavior is likely to continue. Governments target the money.
Hedging the NASDAQ 100
There are a number of different inverse ETFs for tech indices but we’ll mention just a couple. The PSQ is the PowerShares single inverse NASDAQ 100 ETF. Keep in mind, the top two counterparties for PSQ’s swap agreements are Citibank and Soc-Gen, which account for roughly half of the derivative contracts.4 For thrill-seekers, there is also the SQQQ, which is the triple levered inverse QQQ, also from ProShares. Check our inverse ETF lists for other options.
While inverse ETFs are by no means the perfect investment for all investors, they do offer a variety of inverse ETF benefits. And if there’s an extended market selloff, there is significant upside potential for these financial contracts. They can increase by multiples if timed correctly. Is this easy? No. But, it can and probably will happen. Who thought digital currencies would be investable just a few years ago? Don’t wait until it’s obvious.