Play the Players

We say yes, and here’s why.

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.

Recent News Market Forecasts

Poor Goldman Sachs, they had two trading days last calendar quarter when they LOST money!

When you learn that in 46 of the other 63 days they made over $100 million each day, it is clear that they aren’t taking unnecessary risks. In fact, very few risks at all.

The art form is called hedging, or arbitrage. During the quarter 78% of their profits came from the proprietary trading desk, where it is actively practiced.

These days hedging is made easier by the availability of highly liquid, easily tradable Exchange Traded Funds (ETFs). On Friday over 1.8 billion shares of them were traded, out of a total of 3.5 billion shares between the NYSE and NASDAQ.

That’s right, over half of the trading volume was in ETFs. I wonder who’s doing it. I didn’t trade any 18 million shares (just 1%) on Friday. Did you?

That ETF volume was at an average of $40 a share, worth $73 billion. And this is in the heart of the summer vacation season, when activity is pretty quiet.

Now, if Goldman Sachs made another $100 million on Friday, their vig on just the trading value in ETFs was only 14 basis points, 1/7^th of one percent. Pretty small.

But they don’t do all the trading in ETFs, they have the company of Morgan Stanley, Mother Merrill, Citi, and others.

Hedging these days is made much easier for us common folk by the availability of ETFs that are engineered so that long positions are the same as being short an index, or whatever the ETF is tracking. No margin account is needed, nor any pledge of capital or impairment of borrowing capacity. Just an ordinary cash account at the broker.

Further, many of the short, or inverse ETFs also have a built-in leverage that magnifies the price moves by either two or three. Again, they’re available without any of the usual broker or bank borrowing encumbrances.

These are popular vehicles for risk management. ProShares, the largest provider of leveraged and inverse ETFs, saw $9 billion of trading in their products, just on Friday. With all that activity, perhaps something can be learned by checking out whether there is more enthusiasm for leveraged short ETFs or for leveraged longs.

Here are the upside and downside forecasts of the prop desks and block desks for both sets of ETFs. Any items above the diagonal dotted line have larger downside prospects than upside.

Uncategorized ETF Investing, Market Forecasts, trading strategy

The Market Thermometers page can be accessed directly from the home page by clicking on the underlined Index Forecasts>> link. Some readers have taken to bookmarking the page on their browser for easy daily access.

It shows what the community of institutional investment strategists must collectively believe could happen to the prices of four major market indexes over the next few months. If their thinking was otherwise, they would be willing to pay different prices to hedge their at-risk exposures in each index.

Covered are the 30 Dow-Jones Industrials (DJIA), the S&P 500 (SPX), the Russell Small-cap 2000 (RUT) and the Nasdaq 100 (NDX). All are institutional benchmarks.

Before ETFs were available it was difficult, but possible, to invest in these indexes. Still, the price insurance markets of listed options in each of them have existed for decades.

We have used some of those evidences of intent since the ‘70s and ‘80s. They come from the investment industry’s best informed and most sophisticated professionals.

What you see in the display is the range of prices for each index that the pros believe are necessary to be protected against; prices that could be encountered under reasonable circumstances. Their high and low limits are arrayed across the top and bottom of the picture.

The red “temperature” column top marks where the index’s current price stands in that range. The higher in the range, the hotter the market action is currently. By implication, then more downside exposure exists.

In the center of the display is a vertical scale of Reward vs. Risk, where Risk refers only to market price risk, or downside threat. The scale is arbitrarily limited to ( 1 : 100 ) and ( 100 : 1 ).

While specific securities from time to time encounter prices that exceed their current forecast limits, this very rarely happens to indexes that are averages of dozens to thousands of stocks.

For the S&P500 the range of experiences across 20+ years is at its cheapest when ten times as much upside as downside is seen ( 10 : 1 ) . It is at its most expensive when three times as much downside as upside is expected, a ratio of ( 1 : 3 ).

The average reward to risk relationship for broad market indexes, as well as for all stocks, is slightly below ( 1 : 1 ), reflecting that investors generally prefer to sacrifice some return opportunity in order to avoid loss. Logically, when downside price prospects are larger than upside ones, the investor is taking on more potential problem than promise.

So when looking at the thermometers it is reasonable to regard markets as getting overheated when the red columns get above the ( 1 : 1 ) level.

That thinking holds true as long as equity investments are being driven by a value mentality. But not all stocks are priced that way. Some are dominated by a momentum notion.

This is particularly true in high growth technology stocks of the type that are prevalent in the Nasdaq 100 (NDX) index. So in that thermometer it is not at all alarming to see the mercury riding in the upper half of its tube.

Conversely, the NDX may see prices low in its forecast range as its constituent stocks decline rapidly in price. Instead of signaling bargains, this often presages continued falling prices.

This difference between value thinking and momentum ideas is why we always consult our actuarial tables of specific stock odds and payoffs when contemplating investment actions. But more on this point another time.

Market Thermometers Market Forecasts, Stock Indexes