Covering Their Shorts—for Now

03/16/2009 1:00 pm EST

Focus: ETFS

Tobin Smith

Founder and Chief Research Analyst, NBT Equity Group

Tobin Smith and Joshua Levine of ChangeWave Research say they’ve sold their short ETFs, but think the market ultimately is going lower.

Since calling the start of the recession in January 2008, our ChangeWave Research Alliance has [kept] us aggressively invested in our bear market exchange traded funds (ETFs), enabling us to weather what's become the worst storm we've ever experienced.

Now, with the Standard & Poor’s 500 down more than 27% from its January 6th close, our bear market ETFs have rallied back fiercely and given us huge gains since [early September]. (This commentary originally appeared March 6th before the big market selloff on March 9th and last week’s 10%+ rally in the S&P 500—Editor.)

We do expect the S&P 500 to eventually sink into the 500 range after the bad news about first-quarter earnings and second-quarter guidance is priced into stocks. The collapse of our investment banking and "shadow banking" systems (i.e., GSEs, SIVs, private equity, hedge funds, etc.) that account for more than 75% of all lending and financing in the United States up to 2008, pushed the economy and the stock market off the deep end.

This historic, financial system ChangeQuake has unleashed the most powerful deflationary economic tsunami of the past 70 years. And it's this deflationary wave that caused us to lower our fair market valuation for the S&P 500 to the 500 to 550 range—based on 11x 2009 earnings of $48 to $52 per share.

Yet, it would not surprise us to see another bear-market rally occur soon, powered by a bout of frantic short covering.

The bear-market ETFs are short-term trading vehicles and we've been riding them longer than we intended. So, we recommend the following actions:

1.Sell the balance of your UltraShort Financials ProShares (NYSEArca: SKF). We [advised selling] the first half of SKF on February 20th and locked in a nice profit.

2. Sell UltraShort QQQ ProShares (NYSEArca: QID). This is the least volatile ETF of the bunch, but on a market melt-up it would still take a substantial hit.

3. Sell UltraShort Russell2000 ProShares (NYSEArca: TWM). The TWM is more volatile than the QID, and we plan to jump back in for another run in the future, if the opportunity presents itself.

4. Sell 50% of the UltraShort Real Estate ProShares (NYSEArca: SRS). This is the only [short] ETF in which we recommend you continue to hold. It's been acting well lately, and we think it's worth holding through any volatile action.

With investor negativity at the highest levels we've ever seen, the contrarian in us thinks it's the right time to step aside, build up some cash, and prepare to take advantage of the next great opportunities. There will be many of them on both the long and short side!

(Editor’s Note: These volatile, double-short ETFs all sold off sharply in last week’s market rally: All fell by more than 20% and SKF lost more than 40% of its value.)

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