There has been an overwhelming increase in historically bearish catalysts facing the stock market over the past few months. This includes not only the record valuations and high debt levels, which have been alarming for years, but more importantly, there has been a buildup in patterns that suggest high immediate downside risk.
In my view, record margin debt combined with low cash levels among investors puts the market in a highly precarious position. This means that investors are aggressively borrowing money to buy stocks and have minimal cash on hand. Historically, this has been know to cause small declines to become large as investors raise to fill margin requirements. As you can see below, low cash allocations and a buildup in margin debt preceded the disastrous dot-com crash in 2000:
In both 2000 and 2008, margin debt was high, and investor cash allocations were below normal. The major difference between those periods and today is that overall margin debt is much higher. Of course, virtually all forms of debt are at record levels today as well.
To make matters worse, the "economic recovery" following the end of COVID restrictions shows considerable signs of weakness now that government stimulus is/has ended. The Citigroup economic surprise index recently dipped back into negative territory, which means most economic data coming out today is worse than expected. This is historically bearish for the stock market.
Understandably, the inflationary impact of supply-chain and labor pressures creates some issues in economic data. Inflation is historically viewed as a sign of a strong economy, but the opposite is true when it occurs due to supply stagflationary pressures. The economy is already in a precarious position. Still, it seems likely that the surging repurchase market activity may force the Federal Reserve to increase rates and end Q.E. to stop the inflationary impact of negative rates. I firmly believe this may soon cause a "taper tantrum" crash in the market.
Now, I know many investors do not wish to hear of "doom and gloom" outlooks. I am not saying a major crash is guaranteed. However, I am saying that historical patterns suggest that significant crashes often occur with the economic and financial data where it is today. More on this in "The Stock Market May Soon Lose Half (Or More) Of Its Value - Prudence Is Key It is true that "market timing" has a negative connotation among retail investors. That said, the "smart/institutional money" investors have been racing to sell stocks today retail investors are the only group still buying. In my opinion, this should be taken as a warning sign that those 'in the know' see that it may be a good time to reduce risk.
I believe very few assets will be safe if this bearish potentiality becomes a reality. Precious metals offer some safety, though I believe physical is best today due to delivery risks in the "paper market." For those who want to stay long equities, utilities may be a decent option, as described in "XLU: Utilities Offer Unique Value In A Rapidly Shifting World." That said, it seems that gold, utilities (and other defensive stocks), and bonds may continue all decline during a sell-off due to liquidity risk factors. As such, it may be a sensible time to consider hedging through a short ETF like ProShares' NASDAQ:SQQQ.
Using SQQQ As A Hedge Or Short Bet
SQQQ is an ETF that delivers -3X the return of the Nasdaq 100. I believe the NASDAQ has the greatest downside risk of the major market indices due to the buildup in retail speculation in technology stocks. As such, strategies that offer inverse correlation to these technology stocks may have the most upside during a crash. SQQQ's performance is similar to a "long volatility" strategy such as the long VIX ETF (VXX). See below:
As you can see, both VXX and SQQQ have negative returns most months. However, during market crashes such as the initial COVID-crash in March 2020, SQQQ surged about 100% while VXX rose around 400%. This was partly because the VIX index was at shallow levels before the crash, so it had a tremendous upside potential. Today, the VIX is still a bit high while the Nasdaq is extremely high, which means SQQQ has a strong chance to outperform VXX during a crash.
Like most levered and inverse ETFs, SQQQ tends to decline over time due to leverage decay and the fact that stocks generally rise in the long run. As such, SQQQ is best suited for a holding period with a maximum of about three months. Historically, SQQQ decays around 7-8% per month, though this would likely be around 4-5% per month during a flat market such as that experienced so far this year.
While the decay rate of SQQQ is high, I believe the fund has a high probability of rising roughly 50% during a correction and much more if the market crashes as severely as I believe possible. As such, buyers of SQQQ today will need the market to experience a correction within around three to six months to break even. Considering there are many immediate bearish catalysts building today, I personally believe we may see at least a correction within the next two months. In my opinion, this means SQQQ may be a decent speculative bet on the market today.
I can imagine many investors may not want to gain from a market decline but instead are looking to hedge long positions. This is one way for investors to protect themselves against downside risk without realizing profits and paying taxes. Ideally, a portfolio's beta (market risk) can be neutralized by placing 25% of assets in SQQQ and maintaining 75% of assets stocks. Such an allocation will still have some drag, though it should be significantly less than a highly speculative 100% SQQQ portfolio. This could also be a decent strategy for investors concerned about downside risk but are not interested in short-term speculation/market timing.
The Bottom Line
Importantly, if SQQQ rises as I expect, I would not plan on holding much past $20-$40. If the stock market crashes much more than around 30%, I believe it could fall much further due to extreme debt and liquidity risks. However, this situation would create counterparty risk such as that which occurred in 2008 wherein some short bets struggled to receive their due payment due to the collapse of many financial institutions. While I am not predicting another wave of banking collapses, many of the issues which led to the 2008 collapse are likely worse today. This includes high leverage and highly aggressive risk exposure.
Overall, I believe that SQQQ may see a breakout as the market faces what I believe to be a high probability of a correction or crash over the summer. This is by no means guaranteed but is based on data that suggests a preponderance of bearish catalyst and high downside risks. Often, investors' bullish emotional fervor can cause stocks to temporarily rise dramatically even when the data suggests they "should" fall. I believe we've already seen this "blow-off top" pattern and that the crash in cryptocurrencies is a canary in the coal mine for a much broader crash. While it is certainly possible that the NASDAQ's momentum returns, I do not believe I have ever seen as many historically bearish signals as I do today.
Harrison Schwartz
HTSchwartzMy books - fiction and non-fictionHarrison is a financial analyst who has been writing on Seeking Alpha since 2018 and has closely followed the market for over a decade. He has professional experience in the private equity, real estate, and economic research industry. Harrison also has an academic background in financial econometrics, economic forecasting, and global monetary economics.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SQQQ over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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