Is the Dumb Money Forecasting a Crash?

Leveraged ETFs have been the downfall for some long-term investors who misunderstood how they worked. But now, one research company thinks that leveraged ETFs may actually provide some helpful information -- and suggests that current signs point toward a possible plunge for stocks.

Following the dumb money
Yesterday, Barron's reported a trend among leveraged ETF trading that TrimTabs Investment Research identified. TrimTabs observed that issuance of new shares of leveraged bearish ETFs, including Direxion Financial Bear 3x (NYS: FAZ) and ProShares UltraShort QQQ (NYS: QID) , was at a very low level of just 0.2% of assets last week.

The interesting conclusion that TrimTabs drew from this, however, was that it might present evidence of a possible return to bearishness for the market. Drawing a parallel between investor sentiment figures and leveraged ETF money flows, TrimTabs noted that 94% of those who own triple-short stock ETFs are retail investors -- so-called "dumb money" in Wall Street parlance.

Serving a purpose
I've been critical of leveraged ETFs in the past, but a lot of that criticism stems from the fact that many investors completely misused them -- and likely continue to do so, despite the best efforts of the ETF companies in question. The confusion that leveraged ETFs generate comes from their daily recalculation of returns.

Here's the thing: By using short-term derivatives, leveraged ETFs do a very good job of achieving their stated purpose -- to double or triple the daily return of a benchmark index. Investors get into trouble, though, when they extrapolate that a leveraged ETF will continue tracking double or triple the return of the index over longer periods.

As an example, take silver prices. Last year, silver went on a roller-coaster ride, as prices climbed as high as $50 in very short order before plunging in equally dramatic fashion shortly thereafter. By the end of 2011, silver had lost about 10% of its market value. As you'd expect, the leveraged bullish ProShares Ultra Silver (NYS: AGQ) dropped significantly -- although its 47% loss was probably a bit bigger than some might have expected.

The problem, though, is that the leverage bearish ProShares UltraShort Silver (NYS: ZSL) didn't give investors corresponding gains. In fact, it dropped even more -- giving shareholders who held the whole year a 60% loss.

Putting leveraged ETFs to better use
So if long-term investors shouldn't buy leveraged ETFs, what should they do? The idea of using leveraged ETF issuance as a contrary indicator is interesting because it focuses on a measurable, concrete number. A sentiment gauge, on the other hand, is necessarily subjective -- saying you're bullish and putting real money down in a bullish way are completely different actions.

Unfortunately, a quick unscientific look provides some contradictory evidence to such a conclusion. For instance, looking once more at financials, volume for Direxion Financial Bull 3x (NYS: FAS) picked up last August -- exactly as financials were bottoming out and beginning a big bull run. Volume has stayed up ever since, only recently starting to drop slightly as the market gets a little less volatile. You can see the same pattern with the bullish ProShares Ultra QQQ -- higher volume during the big bull run, followed by lower volume more recently as the market has hit a short-term top.

On the other hand, volume and issuance aren't necessarily the same. Issuance refers to shares being created by the ETF itself, rather than simply circulating on the open market. From volume figures alone, you can't tell if the smart money is buying, selling, or just trying to tread water.

Stay tuned
The jury may therefore still be out on what lower leveraged ETF volume may mean for the stock market in general. But by keeping your eye on leveraged ETF activity, you can at least keep your finger on the pulse of what fast-money traders are doing to try to profit -- and then draw your own longer-term conclusions from what you learn. As for me, I'm sticking with my CAPScall for the Direxion Financial Bull ETF to underperform the S&P going forward.

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At the time thisarticle was published Fool contributor Dan Caplinger is feeling contrary today. You can follow him on Twitter here. He doesn't own shares of the ETFs mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't leverage your trust.

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