TECS - TECS: There Are Reasons To Be Bearish

2023-10-06 13:25:34 ET

Summary

• TECS is a leveraged ETF that takes a bear position against technology stocks which drive US indices.
• Leveraged ETFs like TECS can experience value erosion and are best used over short durations.
• There are reasons to consider a bear bet against tech indices, including inflation concerns and the outperformance of the stock market compared to the bond market.
• The issue though is time horizons. While TECS provides cheap leverage, its conditions make it difficult to tackle a bear thesis outside of catalysts from upcoming macro data.

The Direxion Daily Technology Bear 3X Shares ( TECS ) is a leveraged ETF that takes a bear position against technology stocks that lead the market indices. These stocks have continued to rise and outperform despite the fact that in many cases they are seeing tougher business environments and definitive increases in cost of capital. Taking historical precedents, the market crash in the 80s was preceded by similar conditions of higher rates and outperforming equities. We would be careful.

Note on Leveraged ETFs

Because they reset daily after mimicking changes in the index that day by a 3x factor in the case of TECS, there is the problem of value erosion. While a 1% rebound after a 3% drop isn't so bad for the underlying index, having a 9% drop and a 3% rebound is more of a 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.

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

TECS Breakdown and Comments

TECS is exposed to the large cap tech stocks that drive the indices. As always, Direxion ETFs have some major benefits of scale, which is that their engineering of these types of leveraged ETFs gives investors access to leverage at quite a cheap expense ratio of less than 1%. For intraday trading this is ideal, however, the resetting nature of the leverage makes the return profile different from a typical short as explained above. A recovery in the underlying index to starting levels doesn't necessarily restore the resetting leveraged position due to the value erosion dynamics.

There are reasons why speculators might consider a bear bet against tech indices, which drive overall US market indices, at this point in time. One of the reasons is the continuing evidence that the last leg of inflation is not being broken. Job openings risi ng means a tight labor market and genuine risks for a wage-price spiral, likely an unacceptable risk for the Fed to keep monetary policy at all accommodating.

Related to that, higher rates to fight inflation means higher cost of capital, to which tech shares are more pronouncedly exposed compared to lower multiple stocks.

Finally, there is the general issue that the stock market is outperforming compared to the bond market despite both being negatively exposed to higher rates. There is also the fact that we have passed some absolute thresholds. We are completely out of the TINA environment, which changes everything even though the markets haven't responded accordingly. The bond market declining of course makes sense, but in this case there should be more correlation with equity markets. The lack of this correlation now means it could catch up later, like it did in 1987 . There are quite a few similarities, and while this time is a little different since it corresponds to the breakout of AI and other trends that maybe compensate for value destruction from higher cost of capital, the AI revolution is still in its infancy and disillusionment could be the next point of order.

Bottom Line

A serious correction in equity values would not be that difficult to see, also as long-term rate revisions prove to be consistently underestimating the trend of both tackling the persistent elements of today's inflation, but also the general inflationary pressure caused by deglobalization and the probability of further supply flare-ups in the future.

The issue with TECS is the features of leveraged ETFs by Direxion. The timing of a crash is totally unpredictable, and in that regard we cannot use historical precedents. While incoming data for September could be a catalyst to the downside, especially with the knowledge that the oil rise is going to make inflation look worse lately, holding TECS for any period longer than necessary could be counterproductive, even if the material elements of a bear thesis are right.

We certainly don't believe there is any upside to current markets. A lot could go wrong with AI, including regulation and other blowback, and the tight labor market could rear its head both in inflation persistence as well as union action and strikes. Things aren't great in the world right now, it's important to remember that fundamental fact.

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