A half-trillion-dollar market capitalization, like that of Apple, Inc. (NASDAQ:AAPL), trading at an average of $11 billion a day, kicks up a lot of uncertainty dust. That makes it hard to keep perspective on where this item, with a dollar price at some ten times the average stock, may be headed next.
How its prospects are being perceived by the big-money funds - the players most able, and most likely, to move its price - are keenly and carefully watched by folks who help herd this flock, and who make an enviable living at it - the market-makers. Every day they are in constant contact with the trading desks and portfolio managers of the 1,924 institutions and funds holding over two-thirds of the stock.
What is market-making?
Market-making is the trade-by-trade exploration of what increments of capital are required to discover the price, at this moment, at which interested parties are willing to become, remain, or cease to be, an investor in various investments. "Price discovery" is what market-making is all about.
That balance of willingness may vary from one trade to the next, depending upon changing circumstances of the investors, of the thing being invested in, the competitive environment of the investment subject, of influences in the overall investment markets, or of global and political evolutions. But since collections of market data as to price and transaction activity are published daily, for most investors, the day is a relevant time-granule of analysis.
Looking at what causes changes in end-of-day prices, consider the following: A given rise in price, following the day's trading activity reflects the net sequential effect of incremental inflows and outflows of incremental capital onto the market-making scene, measured in value by the volume of trading for the day times the per-share change in the price.
The number of shares outstanding has not changed, only their accepted market value, for the day. What caused the change is the injection or withdrawal into that competitive investment arena of the increment of capital involved. It adds to an "accretion" of similar prior value change perceptions. The bulk of the prior value of those transactions is simply transferred from one former owner to the new one.
During the day, some investors have chosen to reduce their investments for whatever reason, including perhaps a new, higher, liquid price now available. Yet, at end of day suppose the price is now higher than it was at the prior end of day. The sellers were the other side of the trades for investors initiating or increasing investments in the subject. An increase in incremental capital was attracted to the investment, justifying its now higher price.
Decreases in day-to-day price are simply withdrawals of active, incremental capital, for opposite reasons.
What is of interest is not the size of the accretion, per se, but over time, its trend and scope of accumulation and reduction, as a measure of the "hot money" most likely to contribute to future price changes. It also measures newly attracted capital to stock investments currently regarded as "growth stock" situations.
Incremental capital flows in AAPL
AAPL has been through a number of incremental capital traverses, as indicated in our earlier article, and as updated in the following picture.
This is all data that anyone can portray with a computer and an internet connection to Yahoo Finance. Unfortunately, it only tells what has happened in the past, not what is likely to happen next. It is short on insights into the future, keeping it from being of much forecast investment advantage to the viewer.
The major limitation of technical analysis
Looking backward in time can be helpful if there is convincing reason to believe that what has happened in the situation under consideration has a high probability of recurring. High probabilities are rarely supported by the most frequently offered justifications by technical analysts, that of a beautiful single illustration of a satisfying or exciting outcome.
The above picture may be of interest because it tracks an activity in dimensions not commonly explored or published. But it lacks any forward perspective beyond each next day. And please remember that the largest plotted number there for incremental accretion, $12 billion, is only 2.5% of AAPL's current market cap.
None of the preceding analysis can answer, or even addresses, the question of why investors chose to add to or withdraw capital from AAPL's sandbox of interest. The roughest of assumptions might suggest an answer of "because of what they thought might happen next." Yet with no identifiable forecast content, conditions separating favorable from unfavorable subsequent outcomes are hard to find or even speculate about.
Looking forward with behavioral analysis
The concept of incremental capital flows is a rational analytical construct from publicly available data. It is based on the behavior of an investing public, and has continuity of reason through time. What it lacks is the forward look. Suppose, instead of using actual past market prices as the subject of the analysis, investors' expectations for future prices are made the subject.
As explained in several of our prior articles, we are able to systematically derive the future price expectations of knowledgeable investors, from their self-protective hedging actions. We have been doing that daily on over 2,000 stocks, ETFs, and market indexes now for over a decade.
The over 7 million price range forecasts resulting provide a means of comparing them with actual subsequent price behavior. That makes it possible to develop the odds for, and likely size of future price changes, issue by issue, given any level of current forecast imbalance between upside and downside prospects.
Here is the most recent 6 months of daily price range forecasts for AAPL, which contain its recent price peak of 702 in mid-late September 2012.
The notion of using those comparisons to improve on the investment odds and payoff possibilities is attractive, and AAPL's size, investor interest, and unique market position make it an intriguing subject. So here is what the combination of incremental market value analysis and behavioral expectations analysis shows.
Market-maker price range forecast trends for AAPL
We take our forecasts from mid-2006, enough before the 2008 crisis and market panic to give a sense of the market build-up in that period. The whole period to the present, early 2013, provides perspective, which can be examined in further detail.
Apologies for the complexity of this picture, but it may be necessary to have an adequate perspective. Please remember, AAPL is the biggest, most active poker table on the floor. Many very serious players are keeping constant watch over the developments there.
We are looking at the day-by-day changes in the upper ends of those forecast price range vertical lines in the blue-background visual above, plus all the similar forecasts some seven years back to mid-2006. These are the moving sell targets beyond which market-makers see no need to protect themselves when short the stock. After we deal with this dimension, we will do the same for the bottom end of the forecasts.
The red and green vertical bars give incremental monetary dimension to each day's change in the forecast high prices possible, as seen by market makers, times the trading volume for the day. Green bars are days rising in expectations, red ones, falling days. These perceptions are far from constant and are often reversing in direction from day to day.
Their nature reflects investing behaviors based on specific price targets, rather than gradual shifting of asset allocation intentions between alternatives offering more or less favorable prospects, which would be a more sophisticated approach, but is not present-day reality.
That's a fancy (and kind) way of saying what other observers refer to as the "animal spirit instincts" of market participants.
No single day or moving average of a few days is likely to provide a useful gauge of changing opinion or overall market direction. So we run a cumulative track of the accreted day-by-day changes, shown in the black line. For comparison, we include the raw capital flows in the same cumulative period, as a blue line.
Those two lines sometimes diverge, as they did in late 2007 and early 2012. In both cases, they led to further subsequent market price increases (not shown) followed by serious declines. There is a temptation to regard those conditions as overblown upside expectations. The rest of the time the two measures track one another quite closely.
Now let's look at how the forecast downside prospects change, using the same pictorial format.
The day by day low price forecast changes are not as large as the upside impacts, but get more intense over critical time periods. Reductions get repeated day after day, with fewer increases inserted.
The most striking difference in comparison to the upper forecast price changes occurs in the first and third quarters of 2008. When the raw capital flows plunge in each case, the downside expectations are muted by bargain/value investors stepping in to scoop up long-term opportunities.
Their presence causes a divergence between the raw capital flow line and the expectations track. From the 2008 fourth quarter bottom to second quarter 2012, their movements are quite parallel. But now the bargain-hunting long-term investors seem to be again sensing profit opportunity and may be supporting the cumulative downside estimates track.
A re-plot of the two cumulative tracks from the market bottom in March 2009 makes the current activity a bit clearer: (The data prior to 3/9/09 is unchanged and has no relevance to later data in the series.)
The two series track closely until mid-2010 when repeated profit-taking diminishes the incremental capital flow. Then the low forecasts remain resistant to decline as long-term investors anticipate the coming profitability of new products.
All through 2012, the gap grows between profit-taken incremental capital flows and the optimism of big-fund investors as to the possible severity and persistence of lasting price declines. As the market for AAPL declines in Q4 2012 and into 2013 that divergence heightens, with downside market-maker forecasts refusing to follow prices down, on a volume-weighted basis.
What does it all mean for an investor?
The implication seems to be that institutional commitment to AAPL is continuing strong, and that much of the profit-taking incremental capital withdrawal is flowing to shorter-term investors and speculators, while big-money funds may be adding to positions at lower costs.
While the opportunity for long-term investors is apparent, more time-sensitive investors have less current encouragement. Looking at the blue-background visual of the past six months of daily forecast ranges for AAPL, it seems clear that there is not yet any lasting indication that expectations are firming up. The head-fake of recovery in October-November could easily be repeated.
To attempt some clearer indication as to market-maker insight into possible upturn in AAPL's price, we have disaggregated their overall AAPL hedging actions into time tranches dictated by the price insurance markets. Here is what that shows:
Here's how to interpret this information. In a perfectly neutral current situation, a stock should have forecasts with equal downside (low forecast from current price, aka drawdown) to upside (high forecast from current price, aka sell targets) at each time tranche.
As the insurance periods extend in time, the uncertainty will grow and the size of the upside and downside moves should increase, reflecting the increased potential for needed protection by the market-maker whose capital has been exposed by providing liquidity to the market in order to get his fund client(s) volume order(s) filled.
In a perfectly normal situation, the flare of that uncertainty should be symmetrical as to upside and downside possibilities, like the bell of a trumpet. Here we see that there is far more upside than downside, a bullish condition. Further, as time of protection increases, the disparity of upside to downside (simple percentage changes) increases.
What is indicated here is that the likelihood of further substantial downside exposure does not increase much going out five months in time. But the potential for increased gains improves markedly in the 4-6 month time periods.
Testing the market-makers' effectiveness
We have multiple cross-checks on how well the market-makers have in the past made forecasts that have come to pass. The simplest of these simply looks at actual day by day price changes from the forecast day, noting both the proportions of up days vs. down days in the subsequent 3 months, and the average size of changes in each. Also noted is the maximum worst down-day's price change.
A more sophisticated and more realistic test sets each day's high price forecast as a sell target, and looks at subsequent market closing prices each day for the first day to reach the sell target. The history of forecasts on a stock can be stratified by the upside-to-downside proportions of the forecast, as identified by our Range Index Measure, defined in our other articles.
When we test a stock's current forecast we look at all prior Range Index instances at least as attractive as its present one, to exclude all less attractive forecasts. Those forecasts reaching the sell target within a specified holding period are compiled as to gains and the time taken to reach their objectives.
All the rest are considered closed out at the end of the holding period and their gains and losses and holding periods are included with the outright successes. Average raw net gains, annual rates of gain, sample size, proportion of loss experiences, and maximum drawdown experiences in each experience are collected.
This gives us a standard means of comparing the effectiveness of the market-making community in making forecasts, not only between stocks, but within each stock at various levels of upside-to-downside (Range Index) forecast proportions.
Since our software allows a choice of holding period length, we can use this test on a given stock to see how much impact patience time limits have had, by repeating the test at various periods.
In the case of AAPL, the circumstances prevent any significant conclusions, due to the small number of instances of very small Range Index experiences. A look back at the blue background picture of the most recent 6 months daily forecasts shows how extremely low the current price dot is in the range at present.
Interestingly, AAPL's history has been much more promising when buys were initiated at higher Range Indexes, where upside prospects were on the order of only 2-to-1, instead of the present 16-to-1. This is common when growth stocks become "cheap" as the result of a phase of declining prices, and the condition persists a while. It is after a bottom is reached and the turn starts to produce a price recovery, that the expectations, while still optimistic, tend to acquire a more balanced nature, which shows up in attractive returns results in the tests.
That being the case, time-efficient investors are well advised to monitor the stock's daily forecasts until a couple of weeks or more of increasing price range forecasts are present, with more ordinary Range Indexes, say in the 30-40 area.
In sum, now looks like a better-than-average buy time in AAPL for the patient, long-term investor. Market-sensitive, time-efficient investors will get their chance after the stock's recovery has begun and fair-weather followers clamber to get back on board.