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How to Use Leveraged ETFs

In this video, I’ll show you the right way to use leveraged ETFs.

Their high volatility requires a set of defined reactions.

Leveraged funds were first offered to investors in the early 1990s. The first leveraged ETFs appeared in 2006.

The idea behind leveraged funds is to increase an investor’s performance by magnifying the movement of an index.

For example, the SSO ETF seeks to provide twice the daily movement of the S&P 500. If the S&P 500 rises 1% on Tuesday, SSO should rise 2% on Tuesday. If the S&P 500 falls 2% on Friday, SSO should fall 4% on Friday.

Other ETFs provide 3x leverage. There’s also inverse 2x and 3x leverage, where the ETFs move twice and three times farther than the index in the opposite direction, thus rising when it falls and falling when it rises.

In all cases, the leverage is applied daily.

Eager investors drew the hasty conclusion that this doubling and tripling of performance could be applied to longer time periods. “If the market rises 10% this year, I could make 20% by just owning a 2x ETF,” they thought.

But it’s not that simple.

Because the daily performances of the index are magnified, the difference in the leveraged ETF’s performance over time will not be exactly 2x or 3x the index’s.

It’s easy to demonstrate why.

If an index starts at 100, and drops by 20% one day and 20% the next day, it’s down to 64. Would rising 20% each of the next two days take it back to 100?

No. It would take it back to just 92. Why? Because 20% of 64 is not as much as 20% of the initial 100.

Starting from the smaller place it ended up after falling, the index needs a greater percentage gain than the decline that preceded it, in order to return to its pre-decline value.

In total, the index needs to rise 56% from 64 in order to regain 100.

If this is the case, wouldn’t leverage magnify the problem? Sure it would, because all numbers are magnified, specifically by 2x and 3x on a daily basis.

Instead of falling 20% one day and 20% the next, a 2x leveraged ETF of this index would fall 40% one day and 40% the next. From a starting level at 100, this would take it down to 36.

To recover from 36 back to 100 would require a 178% gain, more than twice the 56% needed by the index.

Seeing this situation, the financial media made a different hasty conclusion about leveraged ETFs. They boldly declared that “Leveraged ETFs decay over time. They are not suitable for buy-and-hold investors.”

For example, look at this story in the Wall Street Journal on May 11, 2012: “Beware ‘Leveraged’ ETFs.”

[Story screen capture in the video, at 3:40.]

Here’s another, this one from Business Insider on September 21, 2016 titled: “Buyers Should Beware of This $3 Trillion Market.”

[Story screen capture in the video, at 4:05.]

These articles and many others like them warn that due to the daily tracking issue I just explained, investors should avoid leveraged ETFs.

While it’s true that leveraged ETFs are not for everybody and must be managed with care, the daily tracking issue is not a flaw that makes them unusable. There are two reasons why.

First, even though buying and holding leveraged ETFs is not the preferred way to use them, it actually does work out in most long-term time frames.

The market rises more often than it falls, and big crashes are rare, so while it’s possible to find time frames where the leveraged ETFs trailed their indexes, they usually come out ahead.

For proof, look at this shot from my website’s Strategies page, at jasonkelly.com/resources/strategies:

[Performance table in the video, at 5:05.]

The table shows the growth of $10,000 without dividends, just price change, from the end of 2002. This screen capture picks up at the end of 2004.

The first column shows the $10K’s growth in the plain Dow without leverage.

The third, titled “Double The Dow,” shows it in a Dow 2x fund. The fourth, “Maximum Midcap,” shows it in a Midcap 2x fund.

All of these are just buy-and-hold.

Were the Dow 2x and Midcap 2x funds a disaster, something to beware of? Not at all. After they were crushed along with everything else in the subprime mortgage crash of 2008, they roared back.

By the end of 2016, look how much farther ahead they were than the Dow:

[Performance table top row in the video, at 5:56.]

The Dow ended 2016 having grown $10,000 to just $23,472. Double the Dow, or Dow 2x, grew it to $39,394. Maximum Midcap, or Midcap 2x, grew it to $60,984.

Dow 2x didn’t perfectly double the Dow’s balance, but it delivered a much bigger performance than the Dow’s and that’s good enough, certainly within the spirit of what the leverage is supposed to do.

So, while it’s a fact that setbacks become magnified in the leveraged funds, it is not true that they are certified disasters over time periods longer than a day.

The second reason why media warnings against leveraged ETFs need to be understood in context, is this: If the ETFs are used the right way, the daily tracking issue becomes a strength, not a weakness.

Leveraged funds are simply more volatile than non-leveraged. They follow the index’s same directional moves, but rise more and fall more.

That’s all. If you react appropriately to these rises and falls, then they work for you, not against.

I use a 2x and a 3x ETF in The Kelly Letter within a predefined framework of reaction to their magnified moves.

On a quarterly basis, so just four times per year, I look at their prices in relation to a growth target line.

If they’ve delivered surplus profits above the target, I sell the excess and put it in a safe bond fund. If they’ve fallen short of the target, I buy the shortfall with money from the bond fund.

This process works with both leveraged and non-leveraged funds, but the higher highs and lower lows of leveraged ETFs can make it work better. The reason is straightforward: they present bigger profits and bigger bargains due to their wider zones of fluctuation.

This is the right way to use leveraged ETFs.

To sum up, while the media are right to warn investors about the dangers of higher volatility in leveraged ETFs, they are wrong to state that the ETFs cannot work over the long term due to “performance decay.”

In fact, they can work even in a buy-and-hold approach spanning years.

But a much better way to use them is with an automated system of extracting excess profits and buying excess bargains, both of which are delivered by leverage.

I hope you found this to be helpful. If you did, please like and subscribe.

You can learn more about the way I use leveraged ETFs in The Kelly Letter at jasonkelly.com.


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Thank you for watching!

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Why My Signal System Uses Bonds

In this video, I’ll show you why my Signal system uses bonds for safety.

Each permutation of my Sig system uses just one stock fund for growth and one bond fund for safety. For background on how the Sig system works, please see my video, How My Signal System Works.

In recent years, and again now, pundits have warned about a bond market crash. For an example of this, see my video, Should You Avoid Bonds, which defuses the latest warning from Bill Gross at Janus.

These bond warnings have led some investors to abandon bond funds in favor of riskier assets or dead cash.

But bonds have been around a long time, and have served their main purpose as income-providing, safe alternatives to stocks for many decades.

Let’s take a look at the history of stock bear markets and the bond market, with help from Ben Carlson, the director of institutional asset management at Ritholtz Wealth Management.

In a February 6, 2017 article on Bloomberg View, Carlson provided this table listing the 15 bear markets in the S&P 500 since World War II:

[Chart shown in the video, at 2:18.]

Would bonds have helped you through these bear markets? Absolutely.

Carlson provided this table listing the performance of 5-Year Treasuries through those same 15 bear markets:

[Chart shown in the video, at 4:05.]

This historical relationship between stocks and bonds is why they are the only asset classes I use in my Signal systems, and it will keep working.

Do not sell your bonds. Use them the way I do, to keep buying power ready for deployment into stocks during the next stock-market bear. It will greatly improve returns.


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The Effectiveness Of My Signal System

SUMMARY:

In this video, you’ll see the effectiveness of my Signal system.

Starting with $10,000 in 2001 and making employee contributions to a 401(k) account, The 3% Signal system (3Sig) returned far more than dollar-cost averaging into the S&P 500 (SPY), and dollar-cost averaging into a portfolio of Morningstar medalist actively-managed funds, as follows by year-end 2016 balance:

$332,091 in 3Sig
$263,874 in DCA SPY
$209,070 in DCA Medalists

This shows 3Sig beating both the unmanaged stock market and top-quality managed funds.

Even more impressive, the example pits an imperfectly run version of 3Sig against perfectly executed dollar-cost averaging plans, but 3Sig won anyway. In real life, 3Sig does even better against the mess that is most people’s portfolios.

Get your financial future on the Signal system ASAP!

TRANSCRIPT:

Hello, I’m Jason Kelly. Thank you for joining me.

In this video, I’ll present the effectiveness of my Signal system in the stock market.

For background on how the system works, please see the video “How My Signal System Works.”

In The 3% Signal, I showed how an investor named Mark used the plan to greatly outperform two of his colleagues earning the same income and directing the same percentage of their income to 401(k) accounts.

On page 291 in the book, you’ll find this chart:

[Chart shown in the video, at 0:34.]

This chart shows in the y-axis on the left the balances of their accounts over time. The three investors are named Garrett, Selma, and Mark. Mark is the main one we care about. He’s the one running The 3% Signal.

It starts back in 2001 and ends in June of 2013. Notice there, “The 3Sig Advantage.” That stands for 3% Signal. We can see that at the end of this run Mark’s plan greatly outpaced the balances of his colleagues, Garrett and Selma.

Notice also that the comparison in the book ends in June 2013. What happened after that? Let’s have a look.

At my website, jasonkelly.com, click on Resources and then Compare Investing Strategies to see the comparison extended to the present.

To jump straight to the page, visit:

jasonkelly.com/resources/strategies/

On the Strategies page, I compare Mark’s 3Sig plan with two others: DCA SPY and DCA Medalists. I’ll explain each of the three plans:

Mark’s 3Sig
This is Mark’s plan run with IJR and VFIIX (Vanguard GNMA bond fund) as shown in the book, beginning at the end of the fourth quarter of 2000 with $10,000 and the salary history shown in the book, then his salary increasing 3% annually in the years after 2013 (where tracking ends in the book).

His quarterly contribution to VFIIX in 2013 was $1,815; in 2014, $1,871; in 2015, $1,927; and in 2016, $1,983. Mark also contributed $13,860 in new cash during the subprime mortgage crash, per the signal’s guidance. Notice the low expense ratios: IJR 0.14%, VFIIX 0.21%

DCA SPY
This plan runs the same $10,000 invested at the end of 2000 and with Mark’s same salary history shown in the book, with the same quarterly contributions after 2013.

The only difference is that all capital goes into the S&P 500 as represented by the SPY ETF. This is dollar-cost averaging into SPY with Mark’s quarterly contributions. Mark’s $13,860 in new cash is distributed evenly across the first 50 quarterly contributions (Q101-Q213). Notice the low expense ratio here, too: SPY 0.09%

DCA Medalists
This plan is the same as DCA SPY, but using a portfolio of Morningstar medalist actively-managed funds, initially allocated as follows: 30% Longleaf Partners (LLPFX) large-company stock fund, 20% Wasatch Small-Cap Growth (WAAEX) small-company stock fund, 20% Artisan International (ARTIX) international stock fund, and 30% PIMCO Total Return (PTTDX) bond fund.

All are featured in the book, and all are still highly-rated. Contributions are divided by the initial allocation percentages; holdings are not rebalanced back to target allocations. Notice the high expense ratios: LLPFX 0.92%, WAAEX 1.21%, ARTIX 1.17%, PTTDX 0.75%

So, how did the three plans fare? Have a look:

Chart at 5:20 in the video, showing that at the end of 2016 Mark’s 3Sig plan had amassed a balance of $332,091 compared with $263,874 in DCA SPY and $209,070 in DCA Medalists.

Keep in mind: Mark’s 3Sig plan was not run perfectly because he skipped one buy signal, but the DCA plans are shown here being run perfectly.

In real life, almost nobody runs a perfectly executed DCA plan or restricts their portfolio to just medal-winning mutual funds!

Yet, in this table we see an imperfectly run 3Sig plan performing much better than two perfectly run dollar-cost averaging plans.

Compared with the real-life mess that most people’s portfolios turn into over time, the Signal system does even better than it’s shown doing against these perfect DCA plans.

The numbers don’t lie, folks. The Signal system works, and this is just one version of it. In addition to 3Sig, I also run 6Sig with 2x leverage and 9Sig with 3x leverage.

This boosts profit potential even more while using the same trusted Signal framework.

There’s just no better way to go! Get your financial future on the Signal system ASAP. That’s my recommendation to you.

Thanks for watching.


To review the performance of Mark’s 3Sig plan, please visit my Strategies page.

Want more videos like this? Subscribe to The Kelly Letter YouTube channel.

Thank you for watching!

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How My Signal System Works

SUMMARY:

In this video, you’ll learn how my signal system works to change the way you see the stock market.

Instead of listening to pundits commit the narrative fallacy of weaving news into a story explaining why the market went where it went or, worse, why they think it will go a certain way in the future, you’ll come to see the market as a meaningless series of changing numbers.

This controls emotion and allows for rational reaction to price changes. You won’t care why the numbers went up or went down, you’ll just react in a predetermined manner to the change by selling fluctuations above a signal line and buying fluctuations below it.

In this manner, you will beat the market with no stress from indecision and no more time wasted listening to pundits make up stories from the news.

TRANSCRIPT:

Hello, I’m Jason Kelly. Thank you for joining me.

In this video, I’ll show you how my Signal system works.

I’ll demonstrate the power of reactive rebalancing to a signal line, the concept behind all three of my market-beating Signal strategies. They are:

3Sig using 3% quarterly growth and no leverage,
6Sig using 6% quarterly growth and 2x leverage, and
9Sig using 9% quarterly growth and 3x leverage.

While each of the three uses slightly different parameters, they all operate within the same Signal framework I’m about to show you.

Stock market moves are unpredictable, as you probably know. Guessing where the market will go next is a fool’s errand, but remains an obsession of the financial media just the same.

The Signal system discards entirely such guessing in favor of reacting to where the stock market already went. It can even work within test beds of randomly changed numbers, not even real stock-market numbers, showing that the method is robust.

The idea is simple. I use just one stock index fund and one bond index fund in each one of the plans. I specify a quarterly growth pace that I want to compare stock-market movement to, and then react to where the market went in relation to that signal line. That’s what I call it: the signal line.

If the stock fund rises to a level above that line, I sell the surplus and put it into the bond fund. If the stock market does not rise above that line, so it’s down here, maybe, I use the money from the bond fund to buy the shortfall distance. This requires no guessing about what’s going to happen, just reaction to what already did happen.

In The 3% Signal, there’s a helpful chart on page 39 showing this process in action. Take a look:

Now, you can see in this chart, we have on the y axis, the vertical axis on the left, the different balances of the fund or levels of the stock market. In the bottom, the x axis, we have the different quarters, so Q1-4 in the first year, Q1-4 in the second year, on this particular chart.

Now, on the left, notice there’s a 10,000-dollar or 10,000 level marked above and below the signal line. That shows you the line has no thickness, it’s just made thick on the chart so you can see clearly where it is, and it’s labeled “The Signal Line.” Can’t go wrong with that.

Notice, we see the movement of the stock market above and below this signal line over these eight quarters, and along the top of the chart, circled in white, we see the signal line balances along the way. This is it just growing at 3% per quarter. So, we have 10,300 then 10,609 then 10,927 and so on.

So, that’s where we want to rebalance our fund back to each quarter along the way. So you can see in the beginning, Q1, Q2, and into Q3, the stock market was doing well. It was rising above the signal line, and we would sell those respective amounts at the end of Q1 and Q2.

Later, let’s look into the second year, you can see the stock market over Q1, Q2, and into Q3, fell down below the signal line. So, you see indicated on the chart, “Buy This Amount,” buy that shortfall below the signal line.

That’s how it works. Very straightforward isn’t it? It takes away all the guessing games.

It helps to stop thinking of the stock market in terms of the stories that pundits tell every day using the news. There’s a term for making up stories to explain stock-price movement: narrative fallacy.

When a pundit says why stocks rose or fell, or worse, why he thinks they’re going to rise or fall, he’s committing the narrative fallacy.

He simply doesn’t know why prices went the way they went, and certainly doesn’t know where they’ll go next, and neither does anybody else — including me.

But the key takeaway is that it doesn’t even matter. Why should you care why stock prices went where they went?

The Signal system helps change your view of the stock market away from prices meaning anything or bearing any relation to the news, and being mere numbers meaning nothing. Sometimes the string of numbers gets bigger, sometimes smaller. That’s all.

If you react appropriately to the number changes, you will profit. How to react? As you saw earlier in the chart: by selling surpluses over the signal line, and buying shortfalls under it.

Let’s see how this works with even random numbers.

To generate the numbers we’ll flip coins to create random increases and decreases of a line, then react appropriately to them.

On page 44, you’ll find this chart:

[Chart shown in the video, at 5:19.]

In this chart, what’s happening is I’m increasing and decreasing this line by flipping coins. In the upper right corner of the chart you can see white is heads, and that increases the line by 5%. Gray is tails, which will decrease the line by 5%.

No, this is not a true indication of how the stock market works. It’s not the greatest randomizer, but it’s simple and you get the idea: random changes. We’re just going to flip these coins.

So, you can see along this line how we did. We had three head flips in the beginning, sending the line higher, then we got a couple tails in there, and we progress through 50 coin tosses and the line moved along this route to end at a balance of $10,382 after it started at $10,000 even.

Alright? That’s how it works.

Now that we have our simplified version of a random price line, let’s add a simplified version of rational reaction to it.

When the line rises, we’ll sell 5% of our stock position. When the market falls, we’ll use our cash balance to buy a 5% increase in our stock position. Let’s see how that went.

On page 48, you’ll find this chart showing the result:

[Chart shown in the video, at 6:32.]

We have here in gray, we see the coin toss balance. It’s the same line you saw in the last chart but with the coins taken away so you can just see the movement there. In black, we see the reactive balance, the result of our taking those rational reactions along the way.

Notice that as time goes on, our black line deviates from that gray line and we end up growing our balance more by just reacting rationally to where the market went along the way. So, the ending balance of the market is $10,382 but our ending balance by reacting rationally is $10,661.

Again, yes, simplified, things work a little bit differently in the real stock market, but it shows that you don’t even need to care about any story behind the numbers. You don’t have to care what news might or might not move the market, you just have to react rationally to the actual numbers the stock market serves up, and discard all the narrative fallacy of the pundits on TV.

Alright, now you know the basics of how the Signal system works. In the next video, you’ll learn how well it works in the real stock market.

Thank you for watching!


To check the performance of my stock/bond signal system, please visit my Strategies page.

Want more videos like this? Subscribe to The Kelly Letter YouTube channel.

Thank you for watching!

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Mirhaydari: Dow 20,000 Party Won’t Last

“[T]here are reasons to be cautious.”

[Relays warnings by Sam Stovall at S&P, Andrew Garthwaite at Credit Suisse, and David Rosenberg at Gluskin Sheff.]

“[U]nder Presidents Ronald Reagan, George H.W. Bush and George W. Bush, the Fed was tightening policy early in their first terms or had just completed tightening campaigns, resulting in economic weakness and stock market declines.

“By this metric alone, stocks look set for a difficult path under Trump. …

“Put simply: Unless Trump can convince Fed Chair Janet Yellen to ease up on the rate hikes — or replace her with someone more cooperative — the bull market could soon end.”

— Excerpt contributed by Jason Kelly

_____________________________________

Z-val: Anthony Mirhaydari
Via: The Fiscal Times
Date: 1/25/17
Disposition: Medium-Term Bearish
S&P 500 on 1/25/17: 2298
S&P 500 on 7/25/17: TBD
Change: TBD
Judgment: TBD

Z-val definition and more forecasts in The Z-val Zone.

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