November 21st, 2008

A New Scapegoat for the Market Collapse

You haven’t heard this anywhere else – yet; at least I haven’t. Have you ever wondered, speculated, about the coincidental connection between the spread of short and ultrashort ETFs and the rate at which the market has imploded since the market peaked last October? I know this sounds a bit like conspiracy theory talk but ….. ?

There’s no question that the subprime mortgage crises would have happened eventually as home prices stopped escalating. And there’s no question that defaults in securitized mortgages and other debt instruments would have led to a financial crises among their investors. There’s no question that a deep economic recession if not a downright depression would result from a crises in banking and other financial institutions – it always has in history.

But what we didn’t expect and we still can’t fathom is the depth and precipitousness of the stock market’s decline. I’m no financial markets expert but it seems to me that the creation of such an easily accessible synthetic instrument as a short or double short EDF might have a deleterious impact on stock market stability. Is there much difference between a host of short and ultrashort ETF holders rooting for a 5% down day and short sellers, intentionally or not, contributing to a run on a financial institution and ultimately its inability to survive?

Proshare Short and Ultrashort S&P and QQQ ETFs came on the market July 13, 2006. They saw little volume until a year later, just as the sub-prime mortgage crises first surfaced. Today, according to my count, there are 47 short and double-short ETFs covering indexes, commodities, industry sectors and foreign markets. And how do these ETFs, which are constructed around options, impacted the VIX making its meaninfulness and less useful and relevant (as I understand it, the VIX measures market volitility through option pricing and the pricing of options must be impacted by their use by Proshares in short and double-short ETFs).

Granted, any investor could have achieved the same end by selling the long etf’s short or purchased put options. But could introducing another financially-engineered instrument, the short and ultrashort ETFs, with all their holders profiting from massive sell-offs, have aggrevated what would have been sever but not calamitous? When these ETFs were introduced, sufficient thought may not have been applied to the interrelatedness between the ETFs, options, the indexes and the underlying stocks themselves. Just thinking out loud.

If you’re interested in learning more, I recommend the 66 page pdf Proshares Funds Statement of Additional Information which can be found on the Proshares Funds website (and who is Proshares Funds anyway?). If you can understand better how these instruments work, leave a comment and help us all learn more.

This may sound like trying to find a scapegoat for the market crash. First it was the management of Freddie and Fannie, then the CEO’s of Lehman and Merrill and now its the CEO’s of the Detroit Three. Perhaps, all along, the finger for the market collapse should have been pointed at Proshares Funds and their short and double-short creations. But what do I know, I’m just a stock chartist.

full disclosure: I currently own SDS and have previously also owned TWM and QID and may do so again in the future.

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