Last letter (4/19/10):  “The GS fraud case probably is not going to be a single-purpose or single-event action.  We may hear more from the Feds at Justice, and certainly from the “plaintiff’s bar,” now notified that suits against one of the “deepest pockets” imaginable will provide an ongoing legal fee lottery for some time to come.”

As predicted, the legal piranhas are swarming to the class-action attack.  Additionally, stories of criminal investigations circulate.  In recognition, GS stock has been reclassified by S&P to Sell.

There are clear indications that Goldman Sachs knew as much as a week earlier that the suit was coming.

This provides an opportunity to illustrate just how well a transparent risk-evaluating market (like listed stock options) functions.  The following picture is drawn from our related website, blockdesk.com, where we display how protection-derived price range forecasts for stocks evolve through time.

GS Daily Price Forecast History on April 30, 2010

In the week before announcement of the SEC’s initial fraud complaint against Goldman Sachs, the public market in GS stock stood in denial, with prices even rising a bit further. (They are partly obscured awkwardly, by the data table in the upper right corner of the picture.)

But the better-informed options market anticipated what was to come, adjusting its prices to forecast (in red) a drop to at least the $160 area from $180, and perhaps to as little as $140.

At the complaint, GS prices closed in the upper $150’s after seeing intraday lows there each day.  This Friday’s close took GS down to $145, with once-again lowered price projections.

Ironically, the GS options prices are dominated by the entire block trading and proprietary trading community, of which Goldman Sachs is the most influential member.  But it is a market driven by risk-neutral arbitrage, where no one party in the community can control outcomes, as this makes evident.

Live by the sword, die by the sword.

Goldman Sachs, although seriously wounded, will not perish.

The principal issue in the financial reforms discussion remains the enforced legal separation of trading roles between agents and principals.  Unless they are kept separate, conflicts of interest cannot be avoided.

This is what Glass-Steagall of yesteryear, and currently, “Volker rules” involve.  The legal structures of former securities brokerage firms, now federally-insured “banks,” throws additional political conflicts of too-big-to-fail and risk-taking-with-insured-public-deposits into the mix.  Common sense demands it all be unwound into separate firms that operate either as agents or principals, but not both.

The outcome ought to see a return to partnerships undertaking the proprietary trading role and the underwriting-dealer functions as principals, with corporations (possibly “banks” ?) acting as agents to facilitate trades.  But both functions are essential and must be provided.

The firms that need to be so dismembered are putting up a defense that such action would drive those markets offshore, to the detriment of US employment and economic recovery.  With so many countries abroad suffering from the world-wide market’s collapse, it is hard to conclude that there are many, if any, eager to be hosts for the possible future repeat of such atrocities.  This is a pure red-herring defense.

A multi-trillion-dollar market functioning from Guernsey or the Caymans is not credible.

The complete lack of any clearing and performance-guaranteeing entity in the mortgage securities market induced the immoral and unrestrained behavior leading to that market’s collapse.  Even Goldman Sachs admits that a clearing operation in mortgage-backed securities is essential, and offers its participation.

What is lacking further is a risk-insurance market that has standardization, transparency, and enforcement to provide liquidity in the MBS market.  Needed is the function that is so well performed in equity markets by the Options Clearing Corporation.

The risk-mitigating vehicles attempted were Credit Default Swaps (CDS), but rather than being related directly to the CDO securities, they were between institutions on a private-deal basis, with no standardization, transparency, or evidence of enforceability.

From someone with little knowledge of the bond markets for MBS, it seems like what needs to occur is the evolution of well-defined standards and genuine ratings for the CDOs (with some legal recourse to the raters), and an options-like market based upon CDO market evaluations.  Then this more specific put-your-money-where-your-concerns-are mechanism would act as the means of inducing liquidity into the market for MBS bonds, as well as ensuring ultimate responsibility of actions.

Copyright © 2010, Peter Way Associates.  All Rights Reserved

Fifty-plus years ago at the beginning of our involvement with investment markets, the cop on the beat was the New York Stock Exchange.  They were the ones monitoring trading activity, setting the rules of engagement, and controlling access to the market that really counted.  If you wanted to be a part of the game, you had to play by the rules and behave.  Otherwise, you got thrown out, permanently.

That role continued up until the last few years, when it became undermined as major brokerage houses shed their partnership structures in favor of public-ownership corporation status.  Then when the exchange itself became a for-profit corporation with its own IPO, pretenses at discipline from that quarter disappeared.

During all this time the SEC was a paper pussy-cat, kept understaffed and emasculated politically, to the benefit of the investment community.  Only trivial matters of form, rather than substance, were dealt with.

Finally, when the Madoff affair appeared, publicly and politically obvious, postures at the SEC became intolerable.  Separately, the subsequent CDO/CDS whitewash and taxpayer-paid bailout of the perpetrators was the final straw.  Now national outrage is widespread, and we hear of tea-parties.

Nothing happens in the beltway until the involved bureaucrats are sure their backs are covered, regardless of which political party is nominally in power.  For the SEC to frontally challenge the king-pin of political influence from the investment community appears to mean that the oval office has been kept fully apprised and endorses the action.

That suggests major difficulties for congressional “financial reform” movements that simply tut-tut the status quo.  The GS fraud case probably is not going to be a single-purpose or single-event action.

There may be a parallel here to the recent 7.2 Richter earthquake in our neighborhood just south of the border.  In the following week there were over 2800 aftershocks agitating the immediate topology.  We may hear more from the Feds at Justice, and certainly from the “plaintiff’s bar” that have now been notified that suits against one of the “deepest pockets” imaginable will provide an ongoing legal fee lottery for some time to come.

While much will be made in the media of how terrible all this is, in fact the true nature of the events are beneficial in the longer term if the public can see that regulation of securities markets is being taken seriously.  Fair and honest markets are essential to the way society must operate in our style of democracy.

Because of the SEC charges of deception and fraudulent actions in the GS case, it is important that our subscribers know that all of our information comes from publicly available sources that are highly transparent and cannot be fudged.

The whole issue of derivative securities is poorly understood by the bulk of the public at large, including politicians, and unfortunately, even economists.

When there is a central clearing facility for all transactions in a given type of security, then for each trade a buyer can be matched up with a seller, and proper balances can be maintained to assure each one’s responsibility to act under the terms of the deal.  When those terms are standardized, as in listed stock options via the Options Clearing Corporation, the job gets much easier.  Major problems don’t happen.

That did not exist in the CDO/CDS world, and is becoming clearer in the SEC charges.  It is also explained somewhat in Michael Lewis’s book “The Big Short.”

To allow a return to a “dealer market” in these securities invites a repeat of the catastrophe already encountered.  When banks – either “investment” or “commercial” – are allowed to traffic as “dealers” without any disciplined track kept of who owes and who owns what, then pirates are again abroad on the mortgage seas and the buck will stop only at the least able buccaneer.

When the NYSE was in control, a broker that behaved like a “proprietary trading organization” was regarded as a “bucket shop” and was excluded from dealing with the investment public as a transaction agent.  Its role as a counter-party principal adversary was quite clear.  A return to that distinction is now badly needed.

What Can Be Learned From Past Forecasts

The bulk of capital committed to ETFs is in those that track major market indexes. An overall perspective of investor expectations may give clues to what will happen to the market indexes next.

To that end we aggregate the daily forecasts inferred from hedgers’ and market-makers’ self-protective actions as they deal with interests in, and concerns over, some 2,000+ stocks, ETFs, and indexes. The two pictures below draw on 11 million such forecasts collected live since the beginning of the year 2000.

Upside and downside expectations are pictured separately. In each, the broad vertical blue bars measure the proportion of all forecasts indicating potential percentage price changes on the scale at the bottom of the graph.

The colored lines running across the background of those blue bars are the same data as the tops of the blue bars. But instead of being a 10+ year average, they are proportional measures of one day’s set of forecasts. The green line was taken at the market’s most recent low, March 9, 2009, the red line at its high on October 9, 2007, and the yellow is of Monday, March 15, 2010.

Upside distribution through 15-Mar-10

Upside forecasts seem rather rational, relative to one another. While the historical average has a strong optimistic bias, at times of record highs that red distribution is more restrained. After markets have dropped and are about to recover, the green expectations are clearly more enthusiastic than average, yet realistic about the potential for advances.

Downside forecasts have a different character.

They do not span as great a divergence from zero as upside expectations, on average. Optimism again. But in good times they get a bit, well, more human. The prevailing attitude is “let the good times roll, this is the way it ought to be, enjoy it.”

Downside distribution through 15-Mar-10

In bad times, “Woe is me” green takes over from “What? Me worry?” red. The recognition of how bad it could hurt gets way beyond normal, with larger projected proportions of severe declines and smaller proportions of the normal, lesser declines.

The span of upside and downside estimates in good times contracts, and expands in bad times. This is what is seen in the CBOE Volatility index (VIX). Don’t get distracted here by those details.

What should be of current interest is whether the “now” yellow line looks more like the red or green lines, or is someplace nicely in between.

For the downside at this point there is no debate; yellow is congruent with “trouble” red. Upside forecasts could see a bit more shift of “now” toward the red “market top.” But there’s not much room for enthusiasm and normal larger expectations are already diminished, accentuating the usual center of gravity.

So, how will the present situation be resolved? It could go into another market drop – we’ve recently seen a -9% airpocket. The year-ago low is -45% below where we are now.

Or, more constructively (?), the world’s economic woes may respond to the combined balm of Madison Avenue and Wall Street, and US consumers, dumbed-down by the educational establishment, egged on by too-big-to-fail banks, will come again to believe they can spend money they haven’t earned, so market optimism will once more return. If it does, then a persistent upside yellow-line shift back to prior averages, or beyond, will save us all.

You may sense my bias, but many things are possible, and it is in the nature of stock markets to surprise.

Copyright © 2010, Peter Way Associates. All Rights Reserved

Here is an update.

At the time of the prior post, the forecast was for an upside potential price of  $54.47 (+4.1%) and a downside of $49.39 (-5.6%).  Its history, following 394 prior forecasts of like proportions, was that closing prices higher than the forecast day’s closing price (then $52.32 ) happened 46% of the time, with average gains of +5.4%, and lower prices were seen the other 54% of days in the next 3 months, falling an average -6.8%, with largest losses typically running -9.6%.

Not a particularly exciting moment in the life of XBI, but we simply wanted to brag about a good past history of identifying price extremes.

During the past month XBI has in fact declined, in sympathy with the market, to $46.61, off by -11%, on October 28.  The forecast at that point was a high of $51.52 (+10.5%) and a downside of $46.48 (-0.3%).  The odds for higher vs. lower prices then were 3 : 1, with 75% of the days in the next 3 months following 53 similar prior forecasts averaging gains of +8.3%.  Loss days averaged -4.5%.

In our book, these are attractive proportions, indicating XBI should be bought at that time.

It has turned out well.  By November 16 XBI rose to $51.31, and today, the 17th, passed the $51.52 upside target on an intraday basis.  Our practice is to close out such a position and look for ways to re-employ the capital, including the +10.5% gain.  It took 13 days, better than the usual 40 or so.

Unless you are skilled in options trading, the VIX may only be a curiosity.

Now there are both VIX futures (CBOE/FCE) and a VIX-related ETN (VXX) available to play with. Don Fishback has just written a very good Graham&Dodd analysis of the VXX at Seeking Alpha that should discourage anyone from exploring that ETN with real money.

Especially those who learned that, no matter how smart you think you are, investing in things you don’t really understand can be detrimental to everyone’s economy, including yours.

What is not often recognized by casual observers is that the VIX itself has options that can be traded. Skilled options traders usually employ them to get big leverage advantages when they are convinced a directional play in the market is at hand.

The VIX tends to be a contra indicator, being low when markets have built up strong advances and everything looks too good to go wrong … go wrong … go wrong, and then jumps up high when it does and no one seems to know where the bottom will be.

For a long time the VIX seemed to range over a span of 10 at the low end to 40 at its tops, with 20 or so sort of a central tendency. But then came last year’s September Crisis and the VIX rocketed to 80.

As things struggled to get back to normal the VIX hovered between 40 and 60 until the notion became accepted that perhaps a bottom had been reached in March. Since then the VIX has gradually been working its way down to between 20 and 40.

But as that has been going on, and particularly of late, the market has been undergoing short spasms of decline and recovery. One currently is in progress. The last 4 days has seen the VIX jump from 20 to 28, a 40% advance. Some VIX options are up +100% or more. The S&P500, or SPX, has declined by -4 1/2%.

Wouldn’t it be great to know when to get aboard that kind of a ride?

This is speculation, not investing. But because there seems always to be an appetite for such gambles, I’ll let you in on what we find in looking at how the options pro traders are behaving.

The analysis is the same as what we use to identify the expectations of the big volume market makers in stocks. Here the players are a different bunch, with very different tempraments and behavior limits. But they are driven to operate from the same set of logical rules while seeking low-risk, high-probability profits.

The accompanying chart shows what the options pros must believe could (not will) happen to the VIX’s price in the near future — two weeks to two months. The green days are where the expectations range is virtually all higher than the heavy dots that mark the end-of-day values for the VIX.

On a short-term basis the VIX typically moves contrary to the SPX. Under the right extreme circumstances expectations for changes in the VIX can point to changes in the S&P500. Here is a picture of how nearby SPX moves relate to where VIX expectations are in terms of its present price. (The VIX metric is like a stochastic, but uses our derived forecasts rather than backward-looking price history.)

Draw your own conclusions.

Despite the fact that it doesn’t seem to be getting either more Swine Flue vaccine on the scene or more mortgage or small business credit available, the trillion-dollar pace of deficit persists.

Perish the idea that it be called inflation, but prices of many things keep going up, including ETFs denominated in dollars.

Expectations of market-makers for ETFs holding either precious metals or stocks of companies that mine the stuff are on the rise, too. That makes several ETFs attractive, odds-on buys at this point.

Most appealing is IAU, the COMEX Gold Trust i-Shares, where volume market-makers see the potential for upside gain of over +10% in the next 3 months, compared to a downside exposure of less than one-quarter of that. Their batting average has been very good, with higher prices following forecasts like the present 78% of the time.

Silver may have an even bigger kick, with SLV, the Silver Trust i-Shares priced to provide an upside of almost +15% in that same time, at an exposure of some -6%. The scorecard here is not as overwhelming, but higher prices 71% of the time after such forecasts is not bad.

Even better odds and bigger price move potentials are present in AGQ, the Proshares Ultra Silver ETF that has (2x) leverage engineered into its holdings structure. There prices have been higher 75% of the time, given current day forecasts, and by 27%, on average. The forecast is only for 23% gains. But leverage has its downside, where the encounter could run to -10%, instead of only half as much at SLV.

The parallel ETF play to the dollar’s continuing debasement lies in TBT, whose (2x) internal leverage magnifies the short position it provides in 20-year US Treasury bonds. At a price of $47.89 its forecast of $54.37 indicates a possible gain of +13% with an exposure of only -5.5%

All of these ETFs have better Reward-to-Risk scores than 94% of the 2,000 other equity securities we cover. But don’t take too long to decide, their prices are constantly in motion.

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.

We derive forecasts from the hedging actions of the block trading community on over 2,000 widely-held and actively-traded stocks, ADRs, and ETFs. The common denominators of upside and downside price move potentials are present in all of the forecasts. The uncertainty involved in each is indicated by combining the up and down.

Those common denominators let us aggregate expectation descriptors for the equity market as a whole, or for any subset of interest. To put the overall market in a picture many stock investors can relate to, we took the recent price history of the S&P500 index, and expanded it to embrace the daily average upside and downside expectations of our entire population.

What appears immediately is the way fears and hopes expand the range of expectations when the market is rapidly and substantially declining. Less obvious, but also present is the “What, me worry?” attitude of investors in rising markets. Then the range of uncertainty shrinks.

These effects are more apparent in the following picture:

In the 2008 May-July market decline downside concerns widened only a bit, while upside hopes stayed high. Those hopes were modestly rewarded by a market rally into September. But as declines began again the downside apprehensions expanded and then mushroomed into a panic, along with plunging prices.

The convictions of optimists are hard to kill off, fortunately, so upside potentials widened appropriately for many stocks, expanding that dimension’s average.

While the market stabilized as year-end approached, the downside fears subsided back to earlier levels. But more bad news lay ahead, and further market declines into early March of this year repeated prior investor responses. Still, they were not as extreme as before.

Nor were they in early July as a month’s worth of declining market index numbers tested investors’ convictions. Then downside expectations did not expand much, and the market rejoined the recovery path.

Now the question turns to can it continue? Is it “what, me worry?” time?

That attitude may have started to appear in early September when downside concerns greatly diminished. They were accompanied by reduced upside convictions, and the level of blue-line uncertainty dropped to a level not seen in over a year.

The following couple of weeks’ pullback shook off the complacency, and once more the raised levels of concern were less severe on the downside than previously. But so were the enthusiasms of the upside. Yet uncertainty remains in a healthy range.

Looking back at the first chart, the S&P500 index price continues to be accompanied by upward trending lows and solid to up-trending highs. Behavior of the lows is most encouraging. Our conclusion is that the overall recovery continues, showing no signs that investors are likely to precipitate a serious downturn, absent the introduction of some new momentous disruptive event.

That appears to be a direct parallel as block traders are hedging their at-risk positions when filling trades in SPY, the S&P 500 SPDR. Their current forecasts are for a range of $104 to $118, +8 ½% on the upside, and – 4 ½% on the downside.

Over the past five years 129 forecasts with similar upside to downside proportions, or better, have seen higher SPY prices in 2/3rds of the days of the following 3 months, averaging +16%, and lower prices in the other 1/3^rd, averaging -14%. Buy and 3-month hold gains outweighed losses 1.9 to 1. SPY now ranks better on a reward-to-risk scale than 74% of the 2,000+ issues we follow.

Peter Way Associates has no present investments in SPY.

Where there is volume, SKF the leveraged (2x) inverse (short) of financial stocks is their best odds-on play, but it’s a modest chance (65-35 odds) on a big gain (21%) that might include a -12% drawdown from cost along the way.

Not what you’re looking for?  Next best bet of the moment (with market liquidity) is SLV, i-Shares in silver.  They offer about the same odds with less volatility (+10%, -6%) and about half the odds-on payoff experience of SKF.  It falls just under our minimum return hurdle of 5% in 3 months.

Now if you’re willing to work in something that typically only trades 200,000 shares a day, then IAU, the COMEX gold iShares may appeal.  They present a very high odds for a +10% 3-month gain with only a -1% downside history.  Here history is the rub.  These ETFs have only 9 months of trading for us to track, and only a dozen days with forecasts as good as today’s.  Evolving experience may not be as favorable.

An alternative in the less-liquid-trading camp at this date is PIN, the Powershares India ETF.  More history for us to work from (year and a half) but it is back to the mediocre gain-loss odds (63-37) for big potential price swings (+23%, -12%), like SKF.

Sorry, but right now there are no stamp-your-foot, pound-on-the-table screaming buy opportunities.  Better to keep your powder dry.  Check in tomorrow or later in the week, and we’ll see if something better appears.

The bears are on the prowl during this mid-vacation-season.

While the second team is in charge, trading volume of all stocks typically declines a bit. Yesterday it ran about 4.4 billion shares on the NYSE, AMEX, NASDAQ, and regional exchanges. ETF volume, on some days over 50% of the total, was down to 30%, at 1.3 billion shares.

The lower volume encourages some players to stick around during a time when their activity can have a more pronounced market effect. Trading of leveraged and short ETFs gives us a look at what they may be up to.

At yesterday’s prices, all ETFs traded over $58 billion, down from a prior 3-month daily average of $68 billion, a decline of -15%. Over 9/10^ths of the usual $68 billion is in 76 ETFs that normally trade over $100 million a day. Over 3/4^ths of the action is in two dozen ETFs that each trade over $ ½ billion daily.

Over $9 billion of trades were in inverse, or short-positioned ETFs, with less than $6 billion in leveraged long ETFs.

High rollers like the 3x action of the FAS (leveraged long) and the FAZ (levered short).

While trading in the FAS edged off less than ¼ of 1%, volume in the FAZ doubled.

FAS is trading near the middle of its past 52-week range, while FAZ is near its low.

A quick check of all the inverse, or short-position ETFs among the most actives shows that they too are trading near or at their lows.

They may not stay there when the first team returns.