SSO: Despite Recent Rally, I’d Still Urge Caution (NYSEARCA:SSO)

Main Thesis & Background

The purpose of this article is to discuss the ProShares Ultra S&P500 (NYSEARCA:NYSEARCA:SSO) as an investment option at its current market price. This is a leveraged ETF that can be highly volatile. Specifically, it is designed to offer a “return that is 2x the return of its underlying benchmark for a single day, as measured from one NAV calculation to the next”. This benchmark is the S&P 500, so SSO is the right move when one expects large-cap equities to rise.

I covered this fund roughly three months ago, when I suggested readers would be better off avoiding such an aggressive equity play. In hindsight – this was good advice. Despite SSO rising steadily this past week, it is still down by double-digits over that three month period:

While I certainly welcome the renewed sense of bullishness permeating through equity markets, I would urge readers not to get carried away here. There are a few broad concerns I have for U.S. equities that suggest to me getting into a leveraged S&P 500 play is not the most prudent thing after this recent rally. I definitely recommend staying invested, but doing so in a way that manages downside risk. In that mindset, I would wait to see if markets drop further before placing a “buy” rating on SSO again.

Aren’t Stocks Looking Cheap? It Depends

To begin, let us focus on large-cap valuations. This is always a key metric for me and one I focus on when deciding to buy SSO. As my followers know, I am always invested in the equity market, but I use this ETF as a way to get overly bullish during sell-offs or when the market seems cheap. In my view, that is not the environment we are in.

But, wait, you might say – aren’t stocks cheap now? Simply, it depends how you look at it. In one light it may seem so. For example, the forward P/E for the S&P 500 has dropped to what seems like a very reasonable value. It rests near the level hit during Q1 2020, which ended up being a good time to position oneself for the long term:

I could see how an investor could use this as a takeaway for getting aggressive. The market often trades at higher valuations, especially over the past two years, so why not get bullish now?

To answer that we have to consider what the next few quarters are going to bring. Yes, stocks seem much more reasonable based on a forward P/E – but that only translates to market gains if investors begin to bid stocks back up again. Even if they are, the P/E ratio is also influenced by the “E” (earnings), not just the multiple investors are willing to pay for the index.

When looking at earnings there are reasons to be concerned. Chief among them is that net earnings revisions are negative. What this means is that more earnings (actual and estimated) are being revised down, not up:

What this means is that the P/E could rise from here even if stocks stay constant or decline. That is a worrying thought, and one to factor in before deciding stocks are reasonably priced or “cheap”. If one was to buy now because the P/E looks reasonable, but then earnings come up short and push the P/E up despite constant share prices, then it turns out these were not value positions after all.

This is not to be overly alarmist. Buying the S&P 500 (and SSO by extension) when valuations look reasonable is a long-term winning strategy. That is why I have held SSO in the past and always keep it on my radar. But negative net earnings revisions suggest stocks may not be as value-priced as they appear on the surface. This makes me think a better opportunity will present itself.

Volatility Is Elevated, But Not At Panic Levels

Another reason why I am hesitant to be too bullish here is investor sentiment. Simply, investors aren’t nervous or scared “enough”. What I mean by that is that while volatility is up, it is not at “panic” levels we have seen in the past:

This is similar to the valuation piece I touched on above. Volatility being elevated above historic norms typically translates to positive buy-in targets.

But we have to consider the headwinds facing the market. These include continued Fed rate hiking, stubborn inflation, China lockdowns, and war in Europe. With a potential energy/gas shortage coming to Europe this winter, I think it is reasonable to expect investors will have another round of panic. If we see that come to fruition and volatility spikes to those panic levels we have seen in years past, then I will be advocating buying SSO with complete confidence.

Interest Rate Risk May Not Be Getting Priced In

The theme for 2022 has been mostly negative. This has been driven primarily by sticky inflation and the Fed’s desire to combat it through interest rate hikes. The impact of those hikes has not been wildly successful, but the bad news is (from an investor perspective) the Fed is staying the course. Fortunately, markets have begun to live with this reality and we have gotten a bit of a reprieve from the selling we have witnessed over the course of the calendar year. However, my concern is that rates are going to continue to rise in the next few quarters and markets are beginning to ignore that headline risk.

To understand why, let us look at the path for rates here in America. While we are at levels not seen in a decade, the Fed’s expectation is that rates are still going to rise at hit the 5% range before beginning to fall in 2024:

This tells me that we are going to continue to see ups and downs in the S&P 500 over the next 6-12 months as the Tech/Growth-heavy index faces this macro-headwind.

Yet, investors do not seem phased by the prospect at the moment. Consider that in the options market, the relative cost of contracts that pay off if the S&P 500 drops by 10% has declined markedly. It sits currently at the lowest level since 2017:

The takeaway here is that appetite for bearish wagers has been on the decline. So the direction of investor sentiment is moving overwhelmingly towards “bullish” by this indicator. To me, that means it is time to get cautious, not optimistic, and supports my hold rating on SSO.

There Is Good News To Be Had

Through this review I have struck a modest tone. But I want to emphasize I am not predicting a massive drawdown in stocks from here. Do I think patient investors will be able to pick up the S&P 500 / SSO at a better price in the coming months? Yes. But I also don’t think we are in for another 15-20% drop like the one we have suffered so far year-to-date.

To understand this rationale we have to look at the positive factors influencing the market as well. One is the wages and employment figures have been reasonable, despite inflation pressuring both. In addition, GDP growth turned positive in Q3 after falling for two consecutive months:

This is good news and sets the economy up nicely pushing into the new year.

Beyond that I see other factors that could support higher equity prices domestically. One in particular is the ongoing difficulties facing China. While this might not seem relevant, my thesis is that investors who are pulling out of China now may be looking for a safe haven. And that safe haven may very well by the U.S. – or U.S. stocks to be precise.

To see why I am thinking this way let us reflect on the investment environment in China at the moment. After years of bringing in billions in foreign cash, sentiment has sourced international. Foreign nationals have actually pulled more money than they put to work in China this calendar year, a major shift:

The conclusion I draw is foreign investors are fleeing China. While the impact of this is not fully known (and the trend could reverse at any time), my thought is this will be a windfall for U.S. stocks on a relative basis. Investors are taking their money out of China and it has to go somewhere. In this climate, the safe haven status of the U.S. may work well to its advantage and the advantage of those already holding funds like SSO.

Bottom line

This is a tricky market. One that is moving fast and stringing together days of gains only to often see those gains evaporate a week or two later. In this climate, I suggest approaching leveraged equity plays like SSO carefully. With the rally this past week, I wouldn’t recommend jumping into the fund here with multiple headwinds on the horizon. Plus, stocks are not cheap and investors are not panicking – two attributes I want to see before really getting bullish on the market.

As a result, I continue to believe a “hold” rating is appropriate for SSO. For those who are more risk-taking there could be some value here, but for more patient investors like myself, I am going to wait for a better buy-in price.