Big Bets on Small Caps, Metals, Techs

02/02/2011 11:55 am EST

Focus: ETFS

Peter Way

Founder and CIO, Peter Way Associates

The market makers’ recent option trades are bullish for several leveraged ETFs, writes Peter F. Way in Block Traders’ ETF Monitor.

Everyday price “noise” in the marketplace continually offers opportunities that pay off at return rates usually regarded by long-termers as impossible to capture. But in fact, it is the job of market-makers to identify and capture those potential profits, usually at the expense of the long-term-investor types.

We report what the active investors see as opportunities, when they see them, as telegraphed by the self-protective actions of the market-makers. It is done in terms of the expected price changes, both up and down, within a time horizon that can reasonably be forecast. We limit that to three to six months for ETFs, and back up the inferred forecasts of the pros with actuarial records of subsequent price behavior.

This allows us to get a sense of the overall equity market sentiment at the market-maker level. The sentiment is expressed in the balance between upside price prospects sought and downside prospects being avoided.

The recent mix of upside forecasts looks a lot like the shape seen at the 2007 market top. Both are much more concentrated in low upside expectations than the average experience. It's a fairly reserved outlook.

Downside forecasts, in contrast, are much more optimistic relative to past experience. They are heavily concentrated in small decline expectations, in far greater proportion than the historical average.

What is being suggested by present expectations is a wait-and-see attitude, one that often leads to a herd
instinct to not get left behind if markets surge ahead. That backdrop may be just what it takes for some
unforeseen event to subsequently start a panic.

The BRICs Are Back
Our standard for investment recommendation is a 5% risk-balanced price gain within the next three months, multiplied for leveraged ETFs by their leverage factor. Among international ETFs, one exceeds that threshold with a projected price gain of more than 6%. The Guggenheim BRIC (NYSEArca: EEB) tracks an index of US-traded shares of companies from Brazil, Russia, India and China.

The largest potential among leveraged ETFs is in the Direxion Small Cap Bull 3X Shares (NYSEArca: TNA), which tracks the small-cap stocks of the Russell 2000 index. Its upside forecast of more than 15% is supported by a history of average gains of 24% three months later in 77% of the instances similar to this one. Netted against those gains are the losses realized 23% of the time in similar situations, averaging 12%.  

The ProShares Ultra Basic Materials (NYSEArca: UYM) with two times leverage, also makes the grade. So do the similarly leveraged ProShares Ultra Industrials (NYSEArca: UXI) and ProShares Ultra Technology (NYSEArca: ROM).

[Lawrence Roulston recently argues the case for further gains by the metals, while longtime technology enthusiast James Stack has pulled in his horns a bit as the bull market ages—Editor.]

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