Why You Need A Sell Target For Each Stock Held - And How To Set Them

| About: ProShares Short (SVXY)

Did you capture the +11%, 19-day gain - an over 300% annual rate - in the leveraged, inverse VIX index (NYSEARCA:SVXY) that our behavioral analysis of market-makers advocated in our SA article published March 5th? This not just to brag, but to illustrate the portfolio management point of this article. The illustration applies to many active investments, not just apparently exotic ETFs.

Long ago when setting up my first business entity, my smart lawyer taught me an important lesson: After picking a name and stated purpose for the business, the first thing to arrange is how you want to terminate it.

It is just as important for stock investments - maybe more so.

The notion of "long term investing," in today's technological and rapidly evolving, globally competitive world with its fast-moving markets, is an anachronism. Making intelligent specific forecasts, plans and budgets out in time beyond a year or more is simply hoping and wishful thinking. Its other name is speculation.

If a rational milestone of progress for an investment can't be identified, then it probably isn't an investment, but a speculation. And where milestones are acknowledged, when reached, good management requires that the investment be reappraised at that point and compared with other available alternatives so that capital can be intelligently reallocated.

Maybe capital should be put back into the same winning vehicle, but not by accident or indolence if you have any respect for your own competence. Selling it out, at today's trivial transaction costs, forces a realistic decision process.

Now, how best to choose from the alternatives?

Many professional investment organizations in the 20th century went through a decade or more of "Quant" (or was it "quaint"?) portfolio management approaches. Rocket-science complex math formulae were created, usually used on historical data to get overly-precise measures of the "last war" for evaluating at points in time how each investment should be valued. Then, at calendar-quarterly intervals, comparisons were made and the portfolio was "rebalanced" taking capital away from those holdings whose current market prices were calculated to be "overvalued" and allocated to the "undervalued" ones.

Not surprisingly, many of the organizations' clients initially were duly impressed (snowed) by the elaborate procedures. Also not surprisingly, when these backward-in-time-looking and date-driven dealings eventually proved to have unimpressive results over time, clients usually took their capital elsewhere to be managed.

So, trying to get useful investment forecasting value by pounding historical investment data rocks into a fine powder with a computer has been shown in many experiences, by lots of bright people, to be a futile exercise. Unfortunately, that hasn't kept many from continuing to try, especially by those who have made huge, tragic investments of reputation in the effort.

The other thing to be learned from these endeavors is that investment opportunities do not present themselves, either as to entry or exit, with much respect for the calendar. Time, tide, and the competition "wait for no man."

As we explained in another SA article, time is the most muscular factor in the investment return equation. Careless or casual handling of it carries a high price in the rate of wealth accumulation. Explicit, enforced disciplines are called for.

Now the experiences of SVXY return to illustrate the point.

Click to enlarge

(used with permission)

Just in case this picture is a new visual experience, it is not a typical chart of high-low-close past prices actually achieved, but a history of market-maker price range forecasts as seen at end-of-day ("eod") points in the past six months. The difference is that this is a log of forward-looking estimates, not a history of the past.

The current forecast from Friday, 4/19/13, of a potential high of $95+ and a possible low of $83 or so, noted in the picture's lower right corner, is implied from the self-protective hedging actions of the market-makers as they go about their highly lucrative business of helping big-money fund managers adjust their portfolio holdings.

Represented by the most right-hand vertical bar in the picture, that forecast shows a recovery of sorts, both in actual eod price (the heavy dot) and the range of near-future possibilities, over the prior day's forecast immediately to its left.

SVXY, being a financial instrument engineered to produce price actions inverse to what it tracks, and given that the VIX index which is its subject tends to move counter to the S&P500 stock price index from which it is derived, what we have is a double-negative-functioning security that follows, in a highly leveraged way, the actual directions of aggregate market moves.

This provides a very useful measure of the rise and fall of enthusiasms present in the minds of professional institutional money managers as they ply their market-moving trades. We track how well such market-maker forecasts have worked out in actual experience. Our standard test is to set the price at the high end of the forecast range as the sell target, use the eod price of the day following the forecast as the cost (buy) price, and set a holding period time limit of 63 market days (3 months) for stocks, or 126 days (6 months) for ETFs.

The first eod price at or above the sell target closes out the position, and if the target is not reached by the time limit date, the position then closes, regardless of gain or loss. Neither the sell target nor the time deadline gets changed during the period, regardless of subsequent forecasts. If such later forecasts qualify as a buy opportunity, they register their own targets and time clocks.

By taking every forecast as a prospective investment opening, and observing the outcomes, we can and do build actuarial experience histories of market behaviors at every level of upside-to-downside, stock by stock or by ETFs.

Here are the current updates for SVXY: Out of its barely one-year history, there have been 45 days like Friday's where the balance of upside prospect to downside exposure has been at least as attractive. That's almost a once-a-week occurrence, frequent enough to give some statistical encouragement.

During the 3 months following each such forecast, eod prices were higher than the day of the forecast 89% of the time, and lower only 11%. The higher days averaged +28%, while the lower ones showed -6%. The each-day sale of 1/63rd of a position acquired at time of forecast would have gained +24 ½% on its cost. (This is a comparative measuring device, not a recommended strategy.)

Using our test strategy outlined above, the 42 prior experiences all produced profits, averaging 21.8% gains on average in typical 18-market-day holding periods, or 1.10% (110 basis points) per market day. On a 252-market-day year that is an unbelievable annual rate of over 1400%.

But since it is unlikely that equivalent alternatives will present themselves, advantageously timed over the course of a year, a more realistic measure might be just to take the product of each prior SVXY opportunity at today's level that did not overlap in calendar time with other prior equivalent forecasts. There have been six of them, each with 20% or more gains, which compound into a one-year accumulation of +386%, approaching four times the original investment.

And now it appears we may be ready for another try at the brass ring. While IBM's investor-relations folks may be in for some upbraiding by their chain of command, the combined federal, state and Boston law enforcement agencies combined quite effectively to bring the one surviving Marathon bomber into custody, on his way to justice. On balance, that may get the market attitude turned around a bit. This if it does, should set SVXY into another profit orbit. We'll see.

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.