TNA - Buy Rating On TNA For The Coming Small Cap Breakout

2023-12-19 06:15:50 ET

Summary

• Small caps have been the best-performing group among major indices recently, signaling a potential end to years of underperformance.
• The Direxion Daily Small Cap Bull 3X Shares ETF offers leveraged exposure to small caps but comes with elevated risk.
• Small caps are on the verge of breaking out of a multi-year consolidation pattern, presenting significant upside potential if a breakout occurs.

Tech stocks have been getting a lot of the headlines from the massive bull run we've seen in the past two months or so, but it's actually the small caps that have been the best performing group among the major indices. Small caps have been awful on a relative basis for years at this point, as just about any other index has performed better, and in most cases, by enormous margins. Those days, however, may just be nearing an end.

One way to take advantage of this - if trading small caps is your kind of thing - is through leveraged exposure. There are lots of ways to create leverage, but certainly the easiest way is to own a leveraged exchange-traded product, such as the subject of this article: Direxion Daily Small Cap Bull 3X Shares ETF (TNA).

The TNA is an ETF that seeks to return 3X the daily return of the Russell 2000 index, which is a collection of approximately 2000 small cap equities that's extremely diversified, both in terms of number of holdings, but also industries represented. What TNA does is seek to produce the daily return times three, so an already volatile asset class is magnified in terms of volatility. Let me say right up front that TNA is a trading vehicle, not something you buy and forget about for years. It's a product that allows targeted exposure for relatively short periods of time in order to maximize return on invested capital. Returns go both ways, however, and there's a lot of risk involved.

Leveraged products are riskier than their non-leveraged counterparts, so keep that in mind as we go through the setup here. If you're looking for further reading on how these products work - and the risks involved - there are terrific resources available. Both FINRA and the SEC have resources for investors to arm themselves with knowledge to trade these products. I'm not going to go through what's in the linked posts but I just want to make it clear there are enhanced risks anytime leverage is employed.

TNA's ratings from Seeking Alpha include a big fat 'F' rating on risk.

Annualized volatility is ~60% , which is about 5X that of the S&P 500. Small caps are inherently more volatile than the S&P 500, and the fund is 3X leveraged, so the moves are big.

The other thing to point out that fits very neatly into the point made above about not trying to buy and hold this product is the three rows at the bottom about tracking error. These are somewhat comical values given how large they are, but basically it just means this fund really doesn't track the underlying index over time. That's fine because we know that's the case with leveraged funds; it's something to be aware of and to not try and hold this thing for long periods of time.

With all the disclaimers and reasons not to own this out of the way, why would you want to buy it? In short, there's tremendously significant upside potential into 2024 if all goes well.

A raging bull, but extremely overbought

As I mentioned, small caps have been horrible. While much of the rest of the developed world has been producing new highs, the small caps have been languishing in a trading range. The key here is that - as of the close on the 18th - small caps are just a sniff away from breaking out of the trading range that's persisted for the past 18 months. It's not a done deal by any means, but it's looking increasingly likely that this trading range will finally find a break to the upside.

Below is a chart of the TNA for the past 4 years, and we can see the trading range at the right, but I want to highlight here just how overbought TNA is right now. I've drawn in red vertical lines at the other three occurrences of the PPO being as overbought as it is today.

The first was in June of 2020, which preceded an immediate 35% decline in TNA. The second was in November of 2020, which was completely ignored by investors and saw TNA rise a further 120%+ from the overbought signal. The last occurrence was in August of 2022, preceding an immediate decline of 47% in the TNA. Overbought conditions are generally a sign of a bull market, and even with the 2020 decline, it was reclaimed in reasonably short order and gave birth to a renewed rally that saw the TNA return hundreds of percent to shareholders. These conditions, however, are a warning sign when investors are this bullish. Things can get frothy and when they do, there can be sharp selling.

Despite this, I think the odds favor a breakout before any significant selling, a basing/consolidation, and then further upside. This is more or less what the bigger indices did, and I see no reason the small caps cannot follow suit. There's a lot of catching up to do here, and money is flowing in extremely quickly into small caps, so I think this may actually be the end of the consolidation pattern that has formed for the past 18 months.

We can now take a look at the IWM, which is a pure Russell 2000 index fund, to get a clearer look at the setup, ignoring the choppiness inherent to the leveraged fund.

The IWM is testing extremely critical resistance at about $197/$198. It crested that level a couple of days ago, but fell back. It's tremendously overbought, but unless we see significant selling this week, I don't see enough bears out there to drive this thing meaningfully lower. In other words, I think a small cap breakout is a matter of when, not if.

I mentioned chronic underperformance of small caps in recent years, and here's a snapshot of just 2023. The IWM underperformed the QQQ by 30% from March to November, and 19% on the SPY.

However, since the bottom on a relative basis in November, small caps have beaten the Nas' by almost 8%, and have beaten the S&P 500 by a little more than that. Does this mean small caps have to continue outperforming? No, of course not. However, if the breakout above the massive triple top at $197/$198 occurs, look out above on both an absolute and relative basis.

Wrapping up

I'm not here to argue, or to prove that I'm 'right' on any of this. I'm not bothered with any of that as I'm just trying to follow price action. Right now, price action is telling me the time to own small caps is now, as they're on the verge of breaking out of a massive, multi-year consolidation/basing pattern. I will say again the breakout has not occurred yet, but if it does, the bull run is likely to be huge and prolonged. If I'm wrong and they get rejected at resistance again, so be it. But right now, the risk/reward of owning small caps is far too good for me to pass up, and I'm long.

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