Can Reactions To Tragedy Make The Market Stronger?

by: Peter F. Way, CFA

Investor "sentiment" insight has long been pursued in trying to gauge the "tide that lifts all boats." Most of these efforts tend to be anecdotal and involve a large component of judgment about macro influences on the part of the observer/promoter, so they often have poor credibility, particularly by investors who don't "buy" the premise being proffered. We take a much more disciplined approach that aggregates micro outlooks, stock by stock.

Our central focus continues to be the use of investments to help people build personal wealth, rather than as a form of education, employment, entertainment, or as a retirement hobby. While those other dimensions have their appeal and are often desirable pluses in the process, monetary rewards are in our view, of the highest priority.

Capital put to work efficiently to this end requires timely reassignments, which means selling prior purchases when alternatives provide higher probabilities of better rewards. That usually puts the decision focus primarily on the market prices presently carried by assets now owned or those available to be owned, and likely future prices for those same assets.

Current prices are continually changing, along with prospects for their future, as consumer attitudes, competition, technology, and market psychology develop. It is the dynamics of investor impressions and attitudes that is perhaps the most difficult, and most telling, part of the puzzle to appraise.

We have a unique way to approach and monitor that piece of the puzzle on an issue-by-issue basis. One that deals commonly with each investment vehicle, so that future price prospects can be directly compared between investment choices. In the process, what develops is an overall aggregation of investment prospects among over 2,500 of the most important, widely-held, and actively evaluated equity investment alternatives, a "sense-of-market" outlook.

But our approach is not isolated from circumstances that impact investor impressions and attitudes broadly, influences that may urge the pursuit of differing portfolio management strategies or tactics.

Examples of such circumstances include: Significant direction-changing national elections; threatened collapse of essential social functions (like potential bank failures from mortgage-backed security frauds); multi-national economic advantage efforts (OPEC oil price cartel, Euro common currency controls); widespread social upheavals (Arab spring, revolution in Syria); natural disasters (tsunami impact on Japan's nuclear power); or terrorist actions (Homeland Defense reaction to 9/11 attack, and a "Boston Strong" reaction to the marathon bombings.)

How can comparable forecasts for many stocks be obtained?

Our form of investment analysis is a subset of what has for several years been referred to as "Behavioral Economics." Amos Tversky and Daniel Kahnemann, professors at Stanford, got it all started by usefully examining real investors' balance of concerns between fear and greed. At the time (1960s), those concerns did not have the means of measuring that we now have, but their work was insightful and thought-provoking.

Because of that, the field largely evolved as a misguided plaything of the academic community, focusing on the errors that people make, rather than the things they do right. When examined by the professional investment community, it has repeatedly shown trivial, if any, accomplishment in the pursuit of above-average risk-adjusted investment returns.

Instead of focusing on human errors, our analysis utilizes the deliberate, intentional, self-protecting actions of well-informed, experienced investment professionals. These are sophisticated actions, taken as they go about their very highly rewarding practice of risk-taking (and avoiding), in order to "make" markets for big-money fund managers who regularly deal in investment volumes that tend to move markets. Generically, this approach is of a class called the "rational actor model." We prefer to separately identify our work as "Intelligent Behavior Analysis."

Coupled with time-efficient disciplines, it has repeatedly been shown to be productive in identifying timely, lower-risk, higher-return investment selections of stocks and ETFs. Our Block Traders' ETF Monitor publication on Forbes.com is now in its 11th year. It compares some 250 ETFs and is perhaps the oldest one dealing with ETFs exclusively. A companion publication monitors market-maker forecasts on as many Energy-source and Precious Metals securities.

So what does this approach show now?

The end product of Intelligent Investment Behavior analysis on each subject is an explicit forecast of a "likely" future price range. Likely-enough to justify a meaningful expenditure of what could be part of a trade profit, to protect against harm should such prices occur. The model from which the forecasts derive is uniform for all subjects, and has not changed in over a decade.

Comparison of the extreme prices, higher and lower, of each forecast, with its current market price provides upside and downside potential price change expectations by the Market-Maker ["MM"] community for each subject. In turn, each of those dimensions is highly comparable from one subject to another. Their aggregation can provide a measure of "market" strength and weakness that has relevance from any one point in time to any other.

Here is a picture of what changes in that aggregation has looked like since the S&P500 Index's last peak in October 2007.

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While this may provide interesting perspective for the whole period, certain points of interest (the 4th quarter of 2008, for example) beg for more clarity. Plus, a better insight as to what the present offers would be helpful.

Fortunately, the comparability of the data, along with its daily granularity, allows decomposition of the aggregates into more revealing detail. When we look to see the makeup of the expectations by the proportion of issues at various forecast change sizes, a more interesting picture is exposed.

Here is how the upside prospects looked, on average since 2000 (the blue vertical bars) and what the proportions were in October 2007 and at various points to early in the September 2008 plunge, finally winding up as the market bottomed in March, 2009.

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The red October 2007 market peak (at 1565) line clearly emphasizes issues then having smaller upside-prospects, at the expense of those normally enjoying upside prospects in the mid-teens and higher. The market's interim decline to 1276 in March of 2008 is shown by the light blue line to swing in the opposite direction, favoring the frequency of higher-upside items, at the expense of the smaller ones.

By the end of May 2008, at an S&P500 of 1400, the pendulum swings back in the purple line to a more normal stance. Then in September of 2008 with the market clearly in a serious plunge at 1224, the orange line reverts more to (but not yet) the light blue line's shape. It takes the market's final exhaustion (green line) at an S&P500 index of 676 in March of 2009 to start the turn-around.

The current upside picture

So, where are we now, with the S&P500 returning to the high neighborhood of October 2007, with an even higher market index of 1582? The yellow line below tells the current outlook.

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I think we've seen that shape before. Yep, in July of 2011, just before the SPX dropped -17%. Still, it recovered in six months to be back at a price level where this orange-line alarm had just been sounded.

But now there ought to be enough concern to take a look at the other side of the coin -- the downside expectations.

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Here we see a whole different set of indications from the MMs. Their appraisal of clients' intentions at the (red line) market top were not any different than the overall average. And at the pit of despair in March 2009, the outlook was far grimmer than ordinary.

It was the strength of the upside prospects that started the upward trend. That can be seen in this article's first picture, of the balance between the upside and downside aggregates across time. There, the blue line nets the downside against the up.

The present downside proportions as shown by the yellow line in the picture immediately above are less threatening as to size and extent than what has normally been seen during more than a decade.

So, what is likely for the market now?

An easy guess might be that most stocks are due for some decline, but it might be more gentle than usual. What is "usual"? How about the past three interruptions in the S&P500 in its climb from March 2009?

The April-July 2010 correction spanned -16%, while the April-August 2011 dip gave up -17%. Then in May of 2012 we saw a -10% correction, followed by a recovery and from a higher level, a -7% retreat, which is now more than made up.

We find general market move estimates of little value, when there are professional real-money bets being made and taken on specific market indexes. Here is what they show as of 4/29/2013.

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It may be tempting to look at the "Low" and "High" forecasts for the market indexes, implied by MM hedging, as being "strengthened" by the uncommon occurrence of our Federal Government getting something (resolution of the Boston Marathon bombing) accomplished effectively and in a timely manner.

We wish it were so, a harbinger of national triumphs to come. But the realities of the marketplace suggest more restrained optimism, both in the proportion of stocks and ETFs with limited upsides, and the specific rather negative on-balance bets being made in the leveraged ETFs that track multiples of the indexes.

Besides, there are usually specific stock and ETF situations that are only minimally (or not at all) affected by the market environment. To the extent that these can be identified by market-maker actions, we prefer to direct our attention and capital commitments there.

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.