In this turbulent market, traders are often looking for the best way to capitalize on each swing.  With the market giving us 200 point ranges on a near daily basis, it seems there is ample opportunity to book some great profits.  And thanks to the ingenuity of Wall Street (only halfway serious there) you can now get even more bang for your buck with leveraged funds.

Leveraged Funds – What Are They and How Do They Work?

Leveraged funds are ETF’s (Exchange Traded Funds) that trade just like stocks.  You can buy or sell at any time during the day, and most of these funds have plenty of liquidity to make trading relatively efficient.  These funds are based on an underlying index and aim to give traders daily returns that are double the returns you would get if you invested directly in the index.

So for instance if you own the Proshares Ultra S&P 500 (SSO), and the S&P were to rise 2%, your position should be up roughly 4%.  There are leveraged funds available for large indices like the Dow, Russell, and S&P as well as for individual sectors such as healthcare, financials, and oil & gas.

An interesting additional resource is the inverse leveraged fund.  An inverse fund actually returns the opposite of the index it represents.  So if you owned the Proshares Ultrashort S&P 500 (SDS), and the S&P were to fall 2%, your position should be up roughly 4%.  These ultrashort positions have become very popular as hedging vehicles, especially in IRA’s where short positions are typically not allowed.

In what may be considered “taking a good thing too far,” we have actually seen a few 300% leveraged funds introduced in the past few months.  In this case, $100 buys you $300 worth of exposure either up or down.  While the tool can certainly be used for good, there are some important issues you must consider when using leveraged funds.

Unexpected Consequences – Drawbacks for Leveraged Funds

Aside from the obvious ability to lose money twice as fast if you are wrong, there are a few other significant problems with leveraged funds.  The issues arise with the mathematics of compounding returns.  Leveraged funds are set up to mimic the returns of an index and double the return (or inverse return) on a daily basis.  But this can make them quite inefficient on a long-term basis.

Consider for instance the index returns for a theoretical week:

• Monday: Down 5%
• Tuesday: Up 3%
• Wednesday: Down 4%
• Thursday: Up 6%
• Friday: Down 2%

Using the returns for the index, you would end up with a 2.42% loss for the week.  So if you were using a leveraged fund you would expect your losses to be 4.84% and an inverse fund might be expected to gain 4.84%.  But as I’ll show you, the math doesn’t quite work that way.  Consider the returns for a $100 invested in a leveraged fund:

• Monday: Down 10% – Now holding $90
• Tuesday: Up 6% – Now holding $95.40 (90 times 1.06)
• Wednesday: Down 8% – Now holding $87.77
• Thursday: Up 12% – Now holding $98.30
• Friday: Down 4% – Now holding $94.37

So you can see that with the compound interest kicking in for both losses and gains, the losses turn out to be 5.63% (significantly larger than simply double the index losses for the week).  When you consider this scenario playing out over the course of a month or a year, you can begin to see how inefficient the fund can be for long-term performance.But lets look at the inverse fund.  Would it actually outperform since its counterpart underperformed during this particular week?  Here is the math on an inverse leveraged fund for the same period:

• Monday: Up 10% – Now holding $110
• Tuesday: Down 6% – Now holding $103.40
• Wednesday: Up 8% – Now holding $111.67
• Thursday: Down 12% – Now holding $98.27
• Friday: Up 4% – Now holding $102.20

You can see that using an inverse double return fund actually returned 2.2% which is significantly less than you would expect.  The index declined 2.42% for the week.  You might expect the leveraged inverse fund to gain 4.84% but instead you only received 2.2%.  Again, the compound math gets in the way when you have large swings back and forth.

The current market has plenty of gyrations back and forth which makes both leveraged and inverse leveraged funds inefficient as long-term strategies.  The funds make for excellent tools in protecting your portfolio on a daily basis.  In fact, the ZachStocks Growth Model has booked solid gains in these positions offsetting losses in growth stock names.  They can also net you some very attractive absolute returns in a short time if you predict the market’s direction correctly.

But the bottom line is to avoid using these funds as long-term positions.  They were not designed to hedge a portfolio through a bear market, and will not be effective in doubling your returns for a long-term uptrend.  As always, know what you are invested in, and study the details carefully.

Special “hat-tip” to Adam Warner at Daily Options Report who mixes fun and pop culture with a healthy dose of market wisdom.

FD: No positions in stocks or funds mentioned

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President Obama took center stage today as he unveiled the Homeowner Affordability and Stability Plan.  According to the Executive Summary issued by the White House, the plan is expected to “help somewhere between 7 to 9 million families restructure or refinance their mortgages to avoid foreclosure.”

In the first few paragraphs, the summary attempts to assuage taxpayers who are current on their mortgages.  The release explains how foreclosures typically bring down the value of all nearby homes by as much as 9%.  I’m not sure exactly where this statistic is pulled from but it seems little consolation for those who live within their means and are now being asked to bankroll this initiative through tax dollars.

Broken down, the plan has three primary components:

1. Refinancing for Up to 4 to 5 Million Responsible Homeowners to make Their Mortgages More Affordable. This portion is targeted toward homes where a conventional refinance program is unavailable due to the falling value of the home.  Since most mortgages guaranteed by Fannie Mae or Freddie Mac must represent less than 80% of the value of the home, owners are prohibited from refinancing as the value has dropped to make this ratio impossible.  This explains why even though current mortgage rates are historically low, many homeowners are not able to take advantage of these rates.

   It may be a bit unclear exactly how this portion will be implemented, but loosening the requirements on mortgages conforming to FNM and FRE standards may be a good start.

2. A $75 Billion Homeowner Stability Initiative to Reach Up to 3 to 4 Million At-Risk Homeowners This portion is aimed at “helping homeowners who commit to make payments to stay in their home.”  With a hefty pricetag, this program essentially gives incentives to both lenders as well as borrowers to come to terms and keep homeowners in the house and paying their mortgages.  Under the terms of the program, “an incentive payment of $500 will be paid to servicers and an incentive payment of $1,500 will be paid to mortgage holders, if they modify at-risk loans before the borrower falls behind.” Following the initial incentives, an additional $1,000 will be offered to pay down the principal for each year the borrower stays current (up to 5 years).

   This sounds like a win-win situation until you realize that this is YOUR tax money hard at work.  Granted, there is not any easy way to deal with the mess that we are in, but using taxpayer money to reward borrowers for staying current on mortgages seems to carry a significant conflict of interest.  And that doesn’t even touch on how we will define “at-risk” loans and qualify who can participate in this program.

3. Supporting Low Mortgage Rates By Strengthening Confidence in Fannie Mae and Freddie Mac The final piece of the plan is to promote liquidity in the market by expanding and backing financing to FNM and FRE.  The Treasury is doubling its Preferred Stock Purchase Agreement to $200 billion, and will also continue to purchase Mortgage Backed Securities from the two entities.  All of this capital is in addition to the already committed funds under the TARP program.

   It will be interesting to see just how effective these measures are at keeping mortgage rates low.  And then secondly, we will need to figure out whether those low rates are even applicable (depending on how effective part 1 is).  Liquidity can only be significantly impacted if other market participants step in and begin trading these assets.  Otherwise we essentially have a socialist capital structure with very limited free-market efficient dynamics.

The equity markets did not have a pronounced reaction to the news which may be comforting.  We are at a critical juncture and any additional weakness could send indices sharply lower as support levels are broken.  Traders will likely take the evening to mull over the plan and tomorrow’s open could be a bit volatile as the positioning begins.

Precious metals, however seemed to spike a bit higher as the plan was announced.  Gold hit a six month high as the added stimulus continues to erode the confidence in the dollar.  This weak dollar is masked by the fact that many other major currencies are experiencing significant difficulties, but paired against Gold, it is clear that investors are looking for safety and voicing discomfort with paper currency.

One of the biggest criticisms of this homeowner plan will most certainly be that taxpayers are paying for irresponsible actions taken by banks, and homeowners who bought houses they could not afford.  It will take a significant amount of PR from the White House to overcome this resistance and prove that this plan is best for all parties involved.  Obama was careful to point out that this plan is aimed at those who “played by the rules” but fell on hard times.

My question is whether those “rules” were really in existence and how we will determine who those fair players actually are.  Hopefully the picture will be much clearer in two weeks when the actual details are released…  But somehow I doubt it.

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NYSE Euronext (NYX) released earnings on Monday and investors were less than pleased.  The company reported pro-forma net income of $0.52 per share which compares unfavorably to the $0.62 earned during the same quarter last year.  The gain was technically offset by a $1.59 billion non-cash charge for impairment of intangible items which are primarily associated with the company’s Euronext merger.  Fortunately, this loss will not affect debt covenants, cash flow, or operations.  However, it is an important reminder of just how ugly the environment has been since NYX made these acquisitions.

Most analyst reports issued since the announcement have been relatively negative.  As Barclays pointed out, there is a good bit of confusion in regards to future expense guidance.  The company continues to make investments in growth initiatives while at the same time cutting back on operational expenses for existing businesses.  The confusion has some doubting the expense synergies that are supposed to be created by the company’s latest two acquisitions.  However, management continues to guide investors to model expense savings of $370 million (250 million from the Euronext merger, and 120 million from the AMEX purchase).

Another issue that may have spooked the markets is the fact that NYX is temporarily suspending their share repurchase program.  But despite this cost savings, management has reiterated their commitment to the $0.30 quarterly dividend.  According to the earnings press-release, this is an attempt at striking a balance between responsible capital management (not spending on share repurchases) and supporting shareholder value (continuing the dividend).  At current prices, the dividend yield is roughly 5.4% which should help to support the stock price.

Investors have an important question to answer when deciding whether to hold this stock.  Would I rather the company invest in its long-term growth, or would I rather the company return capital to me as a shareholder?  This is a classic conundrum and its difficult to determine how successful these growth initiatives will be, and yet investors theoretically own the stock because of expected long-term growth.

I personally believe that a temporary halt in repurchasing shares may be the best move for today.  As NYX attempts to ramp its LiffeClear initiative which will bring futures clearing in-house, the need for a strong balance sheet is paramount.  This measure could certainly increase earnings growth over the coming quarters.  Other growth initiatives will hopefully help the company more adequately diversify its revenue stream.  The company will host an investor day on Wednesday, and any clarity given to the markets could potentially buoy the stock price.

With a single digit multiple, NYX appears to be an attractive investment.  Currently the ZachStocks Growth Model has a position in the stock.  There is certainly plenty of volatility in any financial position, but if the stock is able to defend the $20 price level and rally from this point, it will likely become attractive to both value investors as well as technical traders.  Being paid 5.4% as a dividend certainly makes it easier to wait for the stock to move as well.

FD: Author does not have a position in NYX
NYX Notes
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Additional Reading:
WSJ: NYSE Swings to Loss on Charge

Investors in Visa Inc. (V) as well as MasterCard Incorporated (MA) had reason to cheer this week as stock prices advanced sharply.  Visa reported earnings of $0.78 for the quarter ending December 31.  This beat consensus expectations which were expecting earnings of just $0.66.  After the announcement, the stock rose 11.3% in just two days.

The rebound was good news for investors who had held the stock since the IPO in March of 2008.  These investors had purchased the stock at a price of $44 which has turned out to be an area of support on the chart.  In fact, this level was in danger of being broken in late January until a rebound in the market allowed the stock to re-take its IPO price.

Ironically, the primary reason that Visa beat estimates is not because revenue levels were high.  In fact, US transaction revenue was actually flat with last year’s level.  US credit card transaction volume was down about 6% and US debit card volume was up enough to net those losses out to roughly zero.  The revenue growth came from international transaction volume, and the earnings beat actually came from significantly lower expenses.

Now, I have utmost respect for a company that is able to cut its expenses during a weakening market in order to operate profitably.  However, the bottom line is that Visa is not immune to the global recession which is why management is dealing with expenses so aggressively.  Advertising and marketing remained at $210 million for the quarter which is flat with the end of last year.  This is not the type of action you would expect to see out of an aggressive growth company.

I’m actually a bit surprised that management is not increasing its marketing budget in order to capture market share and  strengthen its competitive position.  The fact that Visa has pulled back spending to this point is a testament to just how difficult this current environment really is.

Looking to the quarters ahead, management has reiterated their commitment to growing earnings by roughly 20%.  At this point, it looks like that growth will be from cuts in expenses instead of due to actual revenue growth.  This game can only be played for so long.  Once excess expenses have been cut, management must make the decision to cut necessary projects which end up affecting long-term revenue growth, or else abandoning the 20% earnings growth target.  Neither of these choices will likely have a positive effect on the stock.

On a macro level, Fitch recently commented on credit card issuers stating that late payments on US cards topped record levels.  Last month default levels rose sharply and Fitch expects the credit card Asset Backed Securities to worsen because of the delinquency rates.  Investors in Visa and MasterCard will argue that this doesn’t matter because these companies simply process the transactions and do not have credit risk.

But credit risk eventually affects Visa because as banks deal with increasing credit risks, they will begin to issue fewer cards which means slower growth or even a decline in the transaction revenue.  International markets are facing similar problems and while they may not be saturated to the point that the US markets are, the anticipated growth in international market is likely too optimistic.

I read an interesting article in the New York times this weekend about increases in bartering as a method of payment in Russia.  This is due to the sharp decline in the ruble.  It may sound a bit dramatic, but I wonder if a decline in the purchasing power of the dollar could eventually lead to increases in bartering as a means of payment instead of cash transactions.  Russia saw this type of exchange account for as much as 50% of revenue for many mid-sized business during times of extreme stress.

It is difficult to suggest shorting Visa in the face of the strength we saw last week.  But one method of playing this situation would be to buy puts on the stock.  That way there is a finite amount of capital invested, but once the stock loses its momentum, put buyers could profit handsomely.  The timing is difficult to call, but I anticipate Visa shareholders experiencing frustration in the coming months.

FD: Author does not have a position in V
V Notes
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Additional Reading:
Big Picture: Will Big Banks Ever Again be Allowed to Fail?
WSJ: Visa’s Results Defy Economic Slump

Quality Systems Inc. (QSII) reported earnings late last week.  Revenues came in well above consensus expectations as physicians continued to spend on technology.  This spending is in spite of economic weakness and is certainly a good sign for this growing company.

The healthcare records management sector has gotten plenty of press over the last few months.  At this point it looks like $16 billion of the new stimulus bill will be earmarked to help pay for updated electronic health records.  There is some speculation that physicians who are reimbursed by medicare will have to file forms electronically which could further increase the growth in this area.

While the earnings figures were relatively strong for QSII, the stock closed the day sharply lower as traders seem to be following the “buy the rumor, sell the news” mantra.  Traders had bought the stock hand over fist in December as it became clear that stimulus measures would include a medical records program.  But short-term traders can sometimes get impatient, and it looks like they are searching for alternatives as it will take some time for the stimulus dollars to reach QSII.

During the conference call, management noted that the company expects a strong benefit from the stimulus package.  It may be that revenues are not impacted until late 2009 or even early 2010, but the additional business should come.  Until that point, it still appears the company is able to grow at a steady clip regardless of economic conditions.Third quarter revenues (the company operates on a March fiscal year end) were aided by two acquisitions and investors should probably expect additional purchases in coming months.  With a health cash balance, and virtually no short-term debt, the company is in an excellent position to acquire struggling competitors.

QSII trades at a published PE ratio of 26.  The multiple is certainly higher than the market average, but is likely to accurately reflect the potential for strong growth in this industry.  The stock pays a quarterly dividend of 30 cents which equates to a 3.2% dividend yield.  When compared to Athenahealth (which was featured here in late December), the stock trades at a much more attractive multiple.  Now obviously ATHN has a stronger growth trajectory, but its stock price has much more risk than QSII.

With the most recent decline in the share price, QSII appears to be a solid long-term investment candidate.  Macro forces should benefit the sector in coming quarters, and the added exposure will likely lead to multiple expansion.  The company has a solid track record of growth and a management team that is talented at running and growing the business.  I would be interested in picking this name up anywhere below $40.

FD: Author does not have a position in QSII
QSII Notes
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Additional Reading:
Trader Mark Unpacks QSII Earnings
AthenaHealth – Impressive Company, Dangerous Stock