QID: Interesting On Limited QQQ Upside

The ProShares UltraShort QQQ ETF (NYSEARCA:QID) is a leveraged ETF that takes a bearish bet on the Invesco QQQ Trust (QQQ). While leveraged ETFs are very risky and must be considered carefully, the fact that the QQQ is almost at all time highs despite much higher costs of capital that we think could endure, is unusual even in spite of the AI optimism. We do not think there is any upside to the QQQ, and catalysts are the continuing failure to tackle the last leg of inflation.

Note on Leveraged ETFs

Because they reset daily after mimicking changes in the index that day by a -2x factor in the case of QID, there is the problem of value erosion. While a 1% rebound after a 2% drop isn't so bad, having a 6% drop and a 3% rebound is more than just an additive problem. There is a reason why Warren Buffett's #1 rule is, don't lose money. If you lose money, you have less to recover with, meaning for every drop you need a bigger percentage recovery to bring you back to square 1. If an asset drops 33%, you need an almost 50% recovery to recover. If an asset drops 50%, you need 100% recovery to breakeven. Even if the next day is a bigger rebound than what you lost the previous day, with leveraged ETFs it is still less helpful even if the recovery gets doubled because more money was lost the prior day. You cannot rely in the fundamental situation recovering to prior levels either to recover your investment because of the dynamics of the daily reset. If expectations for the factor underlying the ETF recover to previous levels after going against you, it is unlikely that you will recover your investment fully as well.

If you don't fully understand these risks, do not proceed with a leveraged ETF. They are best used over short durations because of value erosion. They are highly speculative burst instruments.

Links for reference on these risks:

• The Lowdown on Leveraged and Inverse Exchange-Traded Products
• Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors
• Regulatory Notice 09-31 | FINRA.org

The QID Argument

The QID argument can be elaborated as follows:

• Costs of capital are currently high. Due to bloated horizon values that are inherent to high multiple and high expectation stocks, tech companies should have their valuations more sensitive to interest rates than is evident in markets.
• This implies that expectations for AI are massive in the stocks that could benefit from AI in the tech indices. This includes computing power, computing hardware and of course the developers of AI themselves. It is likely, just by virtue of the dynamics of new technologies, that expectations for that growth are also overhyped, especially since a lot of the demand right now could be companies just paying the proverbial 'premium' for the AI option in their businesses, where AI won't be applicable to every one of these businesses.
• With the QQQ being at almost all time highs, it is possible that the cost of capital expectations are that interest rates are going to fall meaningfully more or less back to pre-COVID levels quite soon, before it impacts those deep horizon values with discounting effects. This is absolutely not borne out by the yield curve and the bond markets, where the smart money is. Long-term rates are actually those that are being revised upwards the most. While this is a somewhat decent sign for the economy on the demand side, it is a major problem for technical valuations which are already quite extended even on pre-COVID costs of capital.
• Revisions in long-term rates make a lot of sense considering what could be a lot of difficulty in taking out the last leg of inflation, which if persisting could and already has made its way into expectations. Energy inflation is unhelpful too, and countries with vested interest in the American economy seeing headwinds have a lot of control over the oil price. This last leg has already proven disappointingly stubborn in the last CPI reports.

Bottom Line

QID gets you access quite cheaply to this quirky style of daily-resetting leverage, which is a benefit. Expense ratios are below 1%. The matter of extended QQQ we believe is borne out well by the fundamentals, with equity markets in this case at odds with the bond markets and priced in benchmark rates. We do not believe more upside on the QQQ is very likely, and QID could be interesting.

However, we do not like leveraged ETFs when there are not definite catalysts. We do not know how the market will react to the next CPI report. Holding longer-term and letting interim changes affect a leveraged ETF may subject your holding to value erosion. QID can only be considered very nearly around key economic releases. We wait to consider this till mid-November with the next CPI release or payroll data at the beginning of November which will be the data that may help revise expectations.

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