Disclaimer: This post is for informational purposes only and should not be construed as financial or investment advice. The investment tools discussed below carry significantly more risk than standard assets.
Recently, several big-picture signals have emerged that point to a rapidly declining market.
Let’s break them down and use them as a springboard to explore a unique set of tools called Inverse and Leveraged ETFs.
Four Signs of Downturn
When experts discuss the market, they often refer to specific signals to gauge its health. Here are a few recent ones, explained in plain terms and supported by context:
Inverse Yield Curve
The yield curve inversion happens when short-term loans, like 3-month government bonds, offer higher interest rates than long-term loans, such as 10-year bonds. This is unusual because longer-term loans typically carry greater risk and, therefore, higher rates. An inverted yield curve often signals investor concern about the near future, as it indicates people are prioritizing safety over returns. Historically, every U.S. recession in the past 50 years was preceded by a yield curve inversion. As of now, this signal is flashing red again, raising concerns about an economic slowdown (source).
Buffett Indicator
The Buffett Indicator, named after Warren Buffett, measures the total value of the stock market against the country’s economic output, or GDP. A ratio over 100% suggests the market might be overvalued, and at over 200%, it’s at one of the highest levels ever recorded. This has led many analysts to warn about a potential market bubble—a situation where stock prices become unsustainably high compared to the economy’s underlying health (source).
Volatility Index
The VIX (Volatility Index) measures how much movement investors expect in the market. A recent spike in the VIX indicates rising fear and anticipation of sharp market swings. Historically, a doubling of the VIX over a short period, as we’ve seen, has often preceded periods of extreme volatility or even market corrections (source).
10-Day Trend
Lastly, the stock market’s worst 10-day trend since 1974 underscores just how pessimistic investors have been recently. Broad-based declines of this magnitude, particularly in a concentrated time frame, suggest significant economic or geopolitical pressures at play (source).
These signals aren’t guarantees, but they suggest a declining market. For those looking to navigate this kind of environment, let’s explore one tool that can help: Inverse and Leveraged ETFs.
Responding to Market Decline
When markets begin to decline sharply, there are several strategies investors might use. Some prefer to hold cash and wait for opportunities once the dust settles, effectively sitting out the downturn. Others shift their focus to defensive assets like utilities, healthcare, or consumer staples—sectors that tend to perform better in recessions. Safe havens like gold or bonds can also provide protection during downturns. For more active investors, trading tools like inverse and leveraged ETFs offer a way to engage directly with market declines and potentially profit.
What Are Inverse ETFs?
An Exchange-Traded Fund (ETF) is like a basket of investments—it holds a collection of assets, such as stocks or bonds, and tracks the performance of an index. An index measures the performance of a group of investments, like the S&P 500, which tracks 500 large U.S. companies.
An inverse ETF is designed to move in the opposite direction of the index it tracks. For example, if the S&P 500 falls by 1% in a day, an inverse ETF like $SH (ProShares Short S&P 500) would rise by approximately 1%. These ETFs achieve this inverse relationship using financial contracts, such as swaps and futures, which allow them to profit when the underlying index declines. By holding an inverse ETF, you essentially bet against the market’s performance.
Inverse ETFs are popular for their simplicity. Unlike shorting stocks, which involves borrowing shares to sell and later repurchase, inverse ETFs allow you to profit from market declines without the need for margin accounts or complex strategies. However, they’re not without risks. These ETFs reset daily, meaning their performance is optimized for short-term movements. Over longer periods, compounding effects can cause their returns to deviate significantly from the index’s performance. Additionally, inverse ETFs often carry higher management fees compared to traditional ETFs, which can eat into profits over time.
What Are Leveraged ETFs?
Leveraged ETFs amplify the daily performance of an index, either positively or negatively. A 3x leveraged ETF, for example, aims to triple the daily return of the index it tracks. If the S&P 500 rises by 1%, a 3x leveraged ETF like $SPXL (ProShares UltraPro S&P 500) would rise by 3%. Conversely, if the index falls by 1%, the ETF would drop by 3%.
These ETFs achieve their magnified performance through the use of borrowing and derivatives, such as swaps and futures. This leverage makes them powerful tools for traders looking to capitalize on sharp market declines, but it also makes them much riskier. Small changes in the market can lead to significant gains or losses, and their daily reset means they’re not suited for long-term strategies.
Using Leveraged Inverse ETFs
Let’s consider an example. Suppose you believe the market is headed for a significant downturn. Your first step would be to set a clear goal: are you trying to hedge against losses in your existing portfolio, or are you looking to profit from the market’s decline?
If your goal is to hedge, you might buy an inverse ETF like $SH to offset potential losses in a portfolio heavily invested in S&P 500 companies. For example, if your portfolio value drops by 10% due to a market downturn, the gains from your inverse ETF could help balance those losses.
If your goal is to profit, you might consider a leveraged inverse ETF like $SPXU, which amplifies the S&P 500’s losses by 3x. Let’s say you anticipate a 20% market drop. To manage risk, you could plan to sell portions of your investment at milestones: selling half your position after a 10% decline, another portion after a 15% drop, and the remainder if the full 20% drop materializes. This approach, often called scaling out, helps lock in profits while leaving room to capture additional gains if the market moves further than expected.
Throughout this process, monitoring market signals is crucial. Indicators like the VIX, sudden shifts in the yield curve, or significant changes in trading volumes can confirm whether your strategy is working or needs adjustment. Since leveraged and inverse ETFs reset daily, you’ll need to regularly evaluate your position to ensure it aligns with your goals and the market’s current state.
Final Thoughts
Inverse and leveraged ETFs can seem like attractive tools for navigating a rapidly declining market, but they come with significant risks. These instruments are highly complex and are best suited for experienced traders with a solid understanding of their mechanics. The daily reset feature means they are optimized for very short-term strategies, and holding them longer can lead to unexpected and often unfavorable results due to compounding effects.
The leverage involved in these ETFs amplifies both potential gains and losses, making them extremely volatile. For many investors, the risks outweigh the rewards. If you decide to use these tools, proceed cautiously, with a clear plan. Always monitor your positions closely and be prepared for sudden shifts in the market. For most, simpler and less risky strategies, such as holding cash or investing in defensive sectors, may be more appropriate.
Posted Using InLeo Alpha