Looking for Signs of Weakness in the Markets

Even though some of us may have been wary of the continuing strength of the markets for a few months now, over the past week, we may have been getting the feeling that some signs of weakness are beginning to show in the markets. In a standard margin account we could consider shorting assets to take advantage (make money) in a potential downturn, but many investors are uncomfortable doing this. In addition, shorting is not permitted in most registered retirement accounts. However, we can always consider buying inverse (short) ETFs that similarly benefit from downturns.

I thought it might be interesting to look at the ranking of a selection of inverse ETFs. These rankings (using the normal ranking spreadsheet) are shown in the figure below:

If we look at the absolute acceleration in the right hand column, we note the strong positive numbers of the top three assets (indicating increasing weakness in the underlying index). These top 3 assets are RWM (short Russell 2000 small caps), SEF (short Financials) and DOG (short Dow 30). I was a little surprised to see PSQ (short Nasdaq 100) so far down the list (since I am long the QQQs in the Hawking Portfolio and they’re looking very weak at the moment). However, the PSQ ranking is impacted by the highest volatility of all assets in the list even though the absolute acceleration is the most positive in the group (higher than the top 3 identified above). This has led me to consider whether, for inverse ETFs, the (volatility) ranking order should be reversed from what is being used for long (non-inverse) ETFs (i.e. higher volatility is ranked higher – lower rank number – than lower volatility). Intuitively, this seems sensible since we are looking for bearish indices (long inverse ETFs) to show high rankings (small rank number) and volatility tends to increase as asset prices decline.

The following figure shows the overall rankings with the ranking order of the volatility component reversed:

Now we see PSQ 2nd in the list and the rankings more in line with the absolute acceleration numbers. In addition, whereas no ETFs were previously ranked higher than SHY, now we see 5 assets ranked higher than SHY (and possible candidates for inclusion in a portfolio). Further supporting this change in ranking measurement is the strength seen in the EMA data although none of these inverse ETFs are yet trading above the 195EMA.

Note: Although it may still be attractive to include inverse ETFs in a portfolio do not expect them to behave in an exact inverse relationship to the underlying index. This is due to issues such as compounding and tracking errors resulting from constant re-balancing of holdings within the ETF and dividend adjustments that are reflected in the price of the (inverse) ETF. Although we are long the ETF we are short the underlying holdings and, as such, liable for paying dividends on these assets. Inverse ETFs will perform best during strong down moves over short periods of time – they are less attractive as a long-term holding.

David