Does The Market Environment Price The ETFs, Or Can The ETFs Next-Price The Market?

Mar.25.13 | About: SPDR S&P (SPY)

This article explores the chicken-and-egg question of "does the market environment price the ETFs, or can the ETFs next-price the market?

Many other analysts and investors spend significant amounts of time and effort attempting to guess what next lies in store for "the market" since the "herd effect" "lifts all boats," despite the frequent presence of many exceptions to those tired similes.

Let's take a look at what market-making pros think about the dozen or more indexes and ETFs that are, or track, or are derived from the S&P 500 index, the "market" most regarded by investment professionals.

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Here are ten ETFs, along with the SPX index itself, all plotted on a common pair of scales, percent upside and percent downside potentials for near-future price changes, as seen likely by the same community of observers, at the same point in time. Why aren't they all tightly clustered about one another?

An easy visual check on the closeness of movement between SPY, the ETF, and SPX, the index, can be made on any number of on-line, price-through-time plots, like on Yahoo Finance. So why are [5] the index, and [3] the ETF, on very different coordinates for both upside and downside?

The first reason, most easily overlooked, is that the forecasts are forward-looking in time, while the test of similar past movements suggested in the paragraph above, is backward-looking, answering a different question. For investors, that's not as relevant a question as it may be for historians.

The second reason, more subtle, is that the forecasts are drawn from the use of options as hedging tools. The options on SPX tend to be used and are driven almost exclusively by an investment professional community, and reflect an outlook directly on the S&P500 index itself.

While the options on SPY are largely dominated by market professionals, a notion that can be confirmed by the volumes of trading and open interest, there is also some influence by the investing public. That public may be more likely to be individuals and less likely to be institutional, given legal and marketing inhibitions about options use, by organizations answering to outside sources of capital or concern over the care and safekeeping of donated capital.

More importantly, the investing public, both institutional and individual, has different forward-looking ideas of what is important to them, than does the market-making community, whose time horizons are usually of minutes, hours and days, rather than months and years. So there is likely to be some slight difference in the aggregate expectations for SPY from the prospects in SPX. And while the past prices track closely, the expectations may be (usually are) slightly different between underlier and derivative.

Well, what causes the big scatter in [6], [2], and [8]? Answer: Leverage.

SPXL [6] and UPRO [2], are both (3x) structurally-leveraged ETF trackers of the SPX. SSO [8] is a (2x) version of the same.

SVXY [10] is a special case, covered rather thoroughly in our last ETF article titled "ETF Leverage Lesson". The leverage there comes about from the hyper-relationship between the VIX index and the SPX, of which the VIX is an inverse price-behavior derivative. SVXY is a derivative of a derivative.

The two other variants, OEX index [7] and OEF [4], an ETF tracker of the index OEX, are heavily cap-weighted shadows of the SPX, being its largest 100 capital-sized members. Some of their differences from the SPX may be due to that minor remainder of capitalizations not common to both.

That leaves VOO [1] and IVE [9], both single-strength ETF trackers of SPX. Neither has any clear reason for having expectations different from the index, or each other. IVE is an iShare, and VOO is a Vanguard offering, with very little institutional or professional following likely.

Why this matters

So, what's the point? The point is that how investors most generally view "the market" as an equity investment environment winds up with several slightly different perceptions for the prospects of the same thing. It all comes back to the notion that when one invests in ETFs, what matters most is what is likely to happen next to the specific instrument, not to some construct of a "market" background.

We have seen, over more than a decade of monitoring the price behavior of hundreds of ETFs, that the most reliable indicators of future ETF prices are the expectations of the professionals making markets in them for their big-money institutional fund clients.

Still, there is a certain "gravity" of investor behavior that tugs on prices of most stocks and ETFs, either directly or inversely, as prices of market-leader issues rise and fall. Why? Investment professionals are typically insecure about their clientèle's perceptions of their abilities, and often are desperate to not appear as being out of touch with market activity. Those with clients fear losing them, those without clients substantiate those fears, by constantly attempting to attract new ones, including the clients of others.

All want to at least appear to have a reasoned market forecast as a defensive shield or a marketing posture. The market forecast often is the basis for modifications in the investment manager's current tactics, and at perceived market extremes, may even shift strategies of emphasis on asset class allocations of capital. So there is a constant appetite for market forecasts, even though a strategy of exploiting market noise-level opportunities may offer a more consistent and satisfying reward-risk tradeoff across time.

Can a better guide to future market direction come from an ETF?

So, to satisfy that appetite, we look to what has produced the best gauge of upcoming moves in major market measures. The former picture of forecast differences in S&P500-based ETFs provides the answer. Look for derivatives with the greatest price volatility relative to the market. In any other such plot, the further the issue is from the lower left of the diagram, the greater is its likely volatility. Here it is SVXY.

But SVXY is a relatively recent creation, offering inadequate experience to draw from. A far better guide is the (3x) leveraged ETF tracking the Russell 2000 small-cap index, URTY. Here is its past two years' activity, in comparison with SPY, both with market-maker expectation ranges shown at weekly intervals.

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These are not conventional high-low-close charts looking backwards in time at past price activity, but are a history of forward-looking forecasts, with end-of-day prices (the heavy dot in each vertical range bar) contemporaneous to the time the forecast was made.

It seems apparent that market-maker expectations for URTY are a more sensitive and productive indicator of what is likely to be coming next than what is indicated for the SPX index, via the SPY ETF.

Does it look like a market correction coming?

But at present both URTY and SPY indicate potential trouble for the market. Their current Range Indexes are 74 and 76. Translated, it tells that, of their present price range forecast, that numeric percentage lies below the current price. Which means market pros see three times as much downside price exposure as upside possible price gain ahead for each of the S&P500 and for the Russell 2000, the small-cap standard.

Our graphic program above colors the forecasts when an ETF's market quote approaches either forecast extreme. So URTY's volatility is visually emphasized with standard driving signals. But to help comprehension of the comparisons further, here are the daily tracks of the Range Indexes for each ETF.

The price volatility of URTY is about four times that of SPY, as it is evidenced in their Range Indexes. Trying to get much future price guidance for the S&P500 from the SPY Range Index is futile. But for URTY, the sensitivity of small-cap stocks to market pressures by big-money investment organizations, and the structural leverage built into the ETF helps a lot. The next 3 months' average closing prices of the SPX following each day's forecast are shown in the broad orange line, concurrent with the date of the forecast. Its scale is on the right of the picture.

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When the URTY Range Index is below zero the S&P500 (tracked here by the SPY's next-3-month price average) usually soon rises. When that R.I. gets above 80, or into the 70's, where it is now, better not look for market strength, and defensive tactical moves may make good sense.

How broadly-based is the market concern?

There are other compelling indications for market caution at this point beside a single market-average concern. They relate to outlooks for specific ETFs, in comparison to other periods followed by weakness in equity and ETF prices. For example, consider this lineup of global and international ETFs. Nothing here looks cheap (in or near the green area). Few offer double-digit percentage gain prospects, and many are over close to the the cautioning yellow zone.

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Most of the issues are seen by market pros to be relatively risky (above the diagonal dotted line, the point where upside prospects equal downside). It's not hard to understand why, with Syria in chaos, Egypt threatening to go there, Iran continuing its agitation, Israel widening its settlements in disputed territory, South Korea making further outlandish threatening noises, Latin America celebrating the demise of one strong-man and its country's hand-off to another, who may be eager to show his style is at least as "good." And of Cypriots raising the notion that Brussels may not appreciate how close the EU is to public revolt over its centralized attempted high-handedness.

ETFs with a narrow industry focus show a similar clustering toward the high-risk neighborhood and an aversion to prospects formerly offering investing enthusiasm. Only two precious metal miner ETFs are seen as having double-digit upside chances.

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The contagion can also be seen in the broader fields of economic Sector ETFs and other ETFs tracking broad market indexes beside the SPX and RUT.

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We don't see any specific cause for such widespread apprehension, and it may pass without incident. But a Pollyanna approach rarely seems like good risk management.

Here is what has transpired in just three weeks to the other sensitive ETFs of the leveraged long group, first as we discussed them in our last letter to subscribers. In the lower picture, the only issues now with any considerable upside are both precious metals ETFs, and the two up there with the worst upside to downside now are a (x3) leverage of the S&P500 (NYSEARCA:UPRO) and our illustration ETF, the (3x) Russell 2000 (NYSEARCA:URTY).


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All in all, this just looks like a poor time to be committing capital to risk in ETFs.

Unless your portfolio may need some defensive precious metals strengthening.


The foregoing forecasts and underlying analyses are the results of observations made by Investment Professionals other than ourselves and their opinions are subject to change without notice. Any forward-looking opinion is necessarily constrained to the available data in hand at the point in time of such opinions; further, there can be no guarantee that such opinion is accurate or complete. No warranty, express or implied is made that any such opinions can or will be profitable. All liability for damages or loss, direct or consequential, including but not limited to the use, misuse, unavailability of service or from other causes rests solely with the user. Reproduction of charts and graphs is allowed for the exclusive use of the subscriber only. Distribution in whole or in part by any means without prior written consent is not authorized.

Copyright © 2013, Peter Way Associates. All Rights Reserved

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.