Doubling Down on the Dow (and the S&P)

09/05/2007 12:00 am EST

Focus:

Richard Band

Editor, Profitable Investing

Richard Band, editor of Profitable Investing, thinks the market is going to go a lot higher and he says two leveraged funds could juice up returns of gutsy investors.

By my reckoning, the major stock indexes probably won’t reach their final highs for the current cycle until at least until the fourth quarter of 2008. Reason: The price/earnings ratio for the overall market didn’t hit bottom until June 2006, and it normally takes about two and a half years from that point before the market cycle crests.

So we’re heading into what ought to be a period of rich rewards for investors who simply hitch their wagon to the market indexes. But you can do even better than the indexes, without sacrificing the diversification (safety) of an index fund.

How? By purchasing a leveraged vehicle whose price movements amplify those of an index. For starters, consider the ProShares exchange traded “double bull” funds, [which] track familiar indexes such as the Standard & Poor’s 500 or the NASDAQ 100, but with an important difference:  The “double bull” funds own enough futures and options to drive the fund’s share price up (or down) twice as much, on a daily percentage basis, as the index being tracked.

Thus, if the S&P 500 rises 1% in a single trading session, the ProShares Ultra S&P 500 Fund (AMEX: SSO) will climb approximately 2%. Of course, the fund’s leverage will also double any loss.

Over longer periods than a day, the 2:1 correlation begins to fade. Financing costs, built into the price of futures and options, tend to erode your gains over time. Furthermore, the fund itself incurs operating expenses.

Thus, while shares of the SSO fund chalked up a delightful 24.9% return, at market value, in the 12 months ended July 31, that performance fell short of doubling the S&P 500 itself (up 16.1%).

Realistically, I think we can count on SSO to outdistance the index by about half over the remaining life of the bull market.

If you’re looking for a little more punch, I suggest the ProShares Ultra QQQ Fund (AMEX: QLD), which mimics the NASDAQ 100. Until about two months ago, it seemed as if the technology-freighted NASDAQ might stumble along aimlessly for the rest of 2007.

But then, in one of the pleasant surprises Mr. Market occasionally serves up, NASDAQ found its footing and began to hold its ground better than the S&P during the recent “correction.” Earnings estimates for many key technology stocks have picked up in the past 90 days—likely a harbinger of buoyant share prices ahead.

Technology stocks are volatile. In this case, though, volatility should work in your favor, perhaps with a bang. 

Buy SSO on a dip to $84.50 or less and QLD at $92.40 or less. (Both closed about 10% higher Tuesday—Editor.)  Set a stop 12% below your entry point to guard against the risk of a runaway loss. Ideally, to avoid a tax hit, you should hold these funds inside a tax-sheltered retirement account.

(These funds are suitable only for investors comfortable with risk and able to withstand big losses—Editor.)

Subscribe to Profitable Investing here…

Related Articles on