SDS Is Not The Play

The ProShares UltraShort S&P 500 ETF (NYSEARCA:SDS) is a play against the market. The way the ETF is structured is that it produces the returns each day of the S&P 500 multiplied by a factor of -2x. It’s not exactly like a short, because there isn’t the same scariness around unlimited liability, but naturally it’s an aggressive bet against the market. We think it’s ill-timed with the data pointing positively rather than negatively, in terms of the direction of the US economy.

Points to Consider

While many are coming out of the woodwork talking about the economy being in a recession, even a casual follower of stocks would know that recessionary pressures had started about a year ago, if not earlier for basic materials stocks. Inflation is coming from the fact that corporate profits are stable, accomplished through price hikes and a pretty solid corporate picture, even if it’s without growth.

Inflation is dangerous if it self-perpetuates, and the condition for that is the wage-price spiral. In order for the wage-price spiral to happen, labour needs to demand higher wages because they expect more inflation to come. Inflation expectations have decreased markedly to June 2021 levels. Moreover, real wages are empirically falling. No real wage price spiral here, just an upward adjustment across the board thanks to productivity hits from a tight oil market. This is the basis of the Fed’s rate hikes, and they’ve told us themselves. Without this, there will be no more rate hiking either.

The question then is will the Fed need to reverse course to save a suddenly seizing economy, which would obviously be concomitant with market declines. Here are some of the theories we’ve heard:

• FX risks might be systemic to the economy, with banks having a lot of off balance sheet liabilities in terms of FX hedging instruments. With volatile FX markets, and uncertainty across global economies making differentials harder to predict, banks could run into a problem, and therefore the financial system because of this. We aren’t so worried about this because banks have not had major net income issues with regards to these OBS liabilities yet despite FX volatility already having been substantial with the dollar’s rise. This is a fringe theory, but we thought we might mention it.
• The more obvious one is that there could be an unemployment-contraction spiral. This is the most dangerous form of economic contraction that comes from unemployment brining on contraction in corporate profits. COVID-19 stimulus measures were aimed at avoiding this. We think that besides tech, which represents a disproportionately small part of the labour market compared to its value, employment will not fall. Most labor is very tight and in high demand. In other words, there’s a margin of safety, especially as corporates are proving stability in their performance in the face of pressures already.

Bottom Line

While a severe enough demand crunch could trigger the latter spiral, we think it’s less likely to happen unless there’s another shock to the system which could come from a couple of places. Tail risks include a de-dollarisation of oil as an axis-like coalition around oil forms. Venezuela, Iran, Russia, China and the Middle Eastern states could realise the hand they have with oil resources. America doesn’t produce enough resources to sustain itself, and neither does Europe, so this is a major geopolitical risk that we talk more in depth about on the Value Lab. Nonetheless, it’s a tail risk – unlikely to materialise. As such, a sustained position in SDS seems like a poor way to play the information we have on the current and likely future markets.

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