Play the Players

Recent responses to our first post to Seeking Alpha questioned whether Block Trader forecasts had useful predictive value. We wouldn’t have been maintaining them on a daily basis for the past decade if they didn’t.

Our principal interest is in identifying specific investment opportunities, not having market environment discussions. Still, with a backdrop of over 5 million price range forecasts, the potential for useful information exists.

But that overall equity market is subject to such a diversity of influences and changing circumstances, getting any useful handle on it is a task beyond nearly everyone, including us and our sources – who may be the best informed players in the business.

Instead, we prefer to find time-disciplined, defined-size, price swing situations in specific investments that have evidence of fairly reliable prior forecasts. We limit ourselves to time horizons that have reasonable chance to be foreseen, usually 3-6 months.

We get our forecasts from the way that market professionals protect themselves as they compete by taking necessary at-risk positions in stocks and ETFs. Their hedging activities are committed, forward-looking forecasts of what they believe can happen.

Here is a picture of how they saw prospects for XBI, the S&P Biotech SPDR, during the past two years:

In this chart the vertical lines are forecasts of prices to come, not records of prices past. The colors suggest investment traffic signals available at the time.

A simple, but useful guide is to consider the range top of a forecast as a sell target for a buy made at that date. The target should be kept specific to the buy, and not changed, despite subsequent events.

You say that’s not the way it’s done? Not what you’ve been taught?

Suppose you chose to buy the XBI in early April, 2008 at $50 because the biotech industry’s future then looked very bright. Damn! Were you smart – for a while.

Doing what you were taught, you held it for the “long term.” Maybe not so smart. Because here you are a year and a half later at $52 with only a 3% annual rate of gain.

Using the traffic signals instead, and reading rough estimates from the chart, you could have had (April’08)Buy@50-Sell@60, (October’08)Buy@50-Sell@57, (March’09)Buy@43-Sell@51 for gains of $10, $7, and $8; $25 instead of $2. And have had your capital available for other use perhaps 1/3^rd of the time.

With no sickening lose-a-third-of-your-money drops from $69 to $43.

This is shorter time horizon active investing, not day trading. You would have made three transactions in a year and a half, not an hour and a half. Holding periods averaged four months, not four hours — or four years.

The market-makers don’t want or intend to hold any position four months. But they can probably anticipate most of the price-moving conditions in the next 3 or 4 months. They just don’t know for sure when any of them might occur. So their uncertainty has to include them all, even if their positions are eliminated in 4 days.

Just try and anticipate what any company is likely to really earn in 4 years, let alone what their capital structure (number of shares) may be and what their auditors will allow them to report. And correctly guess what the market conditions will be like out there in time, and you might know what your return on investment will be.

Duplicate that effort for all of the candidates you might speculate in so that comparisons can be made, and, voila, you’re a long-term investor (?).

There’s a reason that America’s Cup sailboat skippers sail all those short tacks. That way the competition doesn’t get away from them if the wind shifts temporarily in their favor.

Our Approach ETF Investing, investment strategy

Long-term, stock prices as a group tend to rise at 9 – 10% a year. The industry likes to reinforce that idea by keeping the public’s attention on market indexes of many stocks – at least 30 in the Dow Jones Industrials, 100 in the Nasdaq, and 500 in the S&P500.

By combining the diverse price actions of many stocks in these indexes and reporting on their small combined price moves day by day, it appears that only modest changes may be going on. Maybe it’s just another year when market prices rise their usual +9%, or maybe a bad year when they decline -5%.

But let’s look at what is happening to specific stocks’ prices. After all, they are what you may be investing in and risking your capital through.

I systematically follow about 2,500 stocks, ETFs, ADRs, and indexes on a daily basis. In 2007, there were only 74 that had price ranges during the year, low to high, of less than 20%. There were also 221 that had price ranges of 100% or more.

These are all stocks the academics and economists tell you that go up some 9-10% a year on average. You’re aware, of course, of the statistician that drowned while wading across a pond that was only 2 feet deep, on average?

That 9-10% is what physicists call signal. The 100%+ is what they call noise.

Both offer opportunity. But where is the greatest, most frequent opportunity?

The average price swing during the year was about 68%, several times that 9-10% trend. And 2007 was not an unusual year in the market. Not like 2008.

As important, how long did it take a typical stock to make its traverse? About 7 months. So the value of perfect information (i.e. hindsight) was an annual rate of change equal to 222%. That’s the gain you might have had with a perfectly timed buy and perfectly timed sell, on stocks representative of the average, that could employ your capital fully over the year.

Not likely, so what are the odds that good timing could do better than the 9-10% trend? We can get a sense of the answer by finding out how many stocks out of the total produce a price upswing gain greater than that. The answer, in 2007, was 65% of them – even when we recognize that many of the stocks’ price swings were downward.

Big potentials exist in the noise. And they are magnified by the time component. More about that another time. Till then, make some money for yourself in the market.

Peter Way, CFA

Our Approach ETF Investing, peter way, stock market theory, trading strategy

Join me in thinking differently about making investments. This second article for Play the Players is intended to set the tone of what you will find in continuing articles.

I want to address people who know that they do not always have the facts or perspective needed to make odds-on, profitable decisions. While we hope to provide that in a mildly entertaining way, an informative focus is likely to be more important to us than amusement.

Hopefully, more important to you, too.

Our principal topic will be equity (stock) investments, of the publicly traded kind. But since their prices are impacted by an enormous range of influences, we will be drawn into many areas.

Please note the immediate aim on prices. They are what produce the only two things that matter in stock investments, or any investment for that matter, Risk and Reward.

Yes, there are sometimes dividends that enter into the reward side of the proposition. But it is hard to find any stock that, in the course of a year, does not have its price change by several multiples of its dividend. In our world, dividends are trivial, even inconsequential.

Isn’t knowing how likely the stock you might buy will see its price go down more important than how likely the dividend is to be cut? Of course, a dividend cut is part of the price change odds calculation, so we’re not ignoring that. But many other things can cause a price decline.

Why not find a way to condense all of those details and conjectures into something that can be managed? Why not find a way to “contract-out” that hard investigative analysis? There are folks out there who make a serious living out of doing just that work. You shouldn’t need to.

I am a CFA, a Chartered Financial Analyst, with a 3-digit charter (#953) issued in 1966, the first year charters were awarded to professionals who took all 3 required annual exams. Now nearly 100,000 CFA charters have been earned, worldwide.

The CFA Institute sets the standards for professional behavior, ethics, and minimum analytical capabilities. Influencing the investment decisions on Trillions of dollars (yen, pounds, pesos, etc.) makes it a very serious undertaking. And an essential one. Someone has to know what is really going on behind the accounting numbers.

I am old enough to remember when the principal entities of the accounting “profession” were called “the big 8.” Now there remains only 1, or perhaps 2, depending on how you want to count.

“How you want to count” is why so few of the originals remain. “Counting” is the artistry that has been practiced under the (dis)guise of Generally Accepted Accounting Principles, or GAAP. So much can fall into that gaap, often what you see isn’t what you get. Accounting enterprises, when joined with consulting ones, resulted in horrible conflicts of interest. Which is why many of them disappeared.

But CFAs love GAAP, because it importantly becomes a reason for their being. They get to solve the mysteries. Still, while analysts provide important inputs to the pricing process, they don’t set prices.

And prices are what create your reward – or risk.

So in our next session we’ll take a look, in a way the investment industry would rather we did not, at how stock prices behave, and who really sets them.

PFW, CFA

Our Approach etf investment, investment theory, peter way, stock market theory