Market Timing Can't Be Done? Well, That's What Market-Makers Do Every Day

Includes: IVV, UDOW, URTY
by: Peter F. Way, CFA

"Everyone" knows that market timing is a futile effort. "No one" can do it, so why bother? The only problem with that notion is that there is a community of folks that regularly demonstrate that they can tell when the market is under-priced and full-priced and act on that skill, to reinforce their annual million-dollar-plus compensations.

We are talking about the market-makers (MMs), who use broad-market-tracking ETFs to hedge the risk positions that their big-money fund clients require them to take in order to be competitive in helping those clients to adjust their portfolio positions.

The MMs, whose cutting-edge, world-wide, instantaneous, 24x7x365¼ information gathering systems try to keep them a step ahead of the clients, are very savvy about using what they know, to earn a buck. Or a billion bucks, or anywhere in between.

What they will pay to convert potential risk into probable profit tells just how far they think prices can travel. The insurance market they use to do it tells us what they think. Here is a picture of how they relate to the iShare ETF that tracks the S&P500 index (NYSEARCA:IVV). Vertical bars are their forecast of coming price range possibilities, and the heavy dot is the market quote of the Index at the date of the forecast.

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(all used with permission)

Each bar is a once-a-week copy of daily forecasts made in "real time" over the past two years. The timing tool is the balance between their prospects for upside price movement (between the current price dot and the range forecast top), and the downside (between the price and the likely bottom of their range). Those proportions are watched closely.

We use a standardized measure of that balance we call the Range Index, which tells what percentage of the forecast range lies below the price at the time of the forecast. A small Range Index means a forecast of lower risk, higher return. A large RI warns of limited reward but lots of draw-down exposure.

To get a longer look at how well the MMs can tell when the S&P500, via the IVV, is pushing toward one extreme or the other, here is a track of its Range Index and price (1/10th of the 500 market index) daily over the past 7 years since 2006. That period includes the 2008-9 market collapse.

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Just in case it might seem like we found the one instance that supports our case (out of 2500 to draw from) here are a couple of other market-index tracking ETFs that show similar tendencies.

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Emphasized by structural leverage, the 3x Dow Jones 30 (NYSEARCA:UDOW) and the small-cap 3x Russell 2,000 (NYSEARCA:URTY) rather vividly portray the market-makers price sensitivity.

The MMs are properly motivated by the fact that these ETFs are engineered in their structural design (rather than by riskier financial leverage) to produce multiples of payoff per dollar of investment. That makes the effect of their timing skills even more apparent than in the 1x IVV.

Of course, leverage from any source cuts both ways. Doesn't that make those ETFs riskier?

Professional handling of risk

A skilled butcher cuts animal carcasses with a large boning knife, constantly sharpened with a steel. The sushi chef adroitly fillets his servings with a diamond-stone-honed slicer. Either tool could cause serious personal harm to the user. But they don't because experience has taught them how to handle the risk potential. When you call the EMT to deal with a loved-one's evident heart attack, you rightly trust that they have been trained to evaluate the situation's risks and they know what will be the proper actions to take.

The short answer about risk is that the trained professional knows how to avoid it and how to handle it when it arises. Arbitrage can be a sharp tool, and market pros know how to use it.

For one thing, when concerned with strategic market risk hedging rather than covering specific ETF exposures, the market pros use price insurance based directly on the index, SPX options. Each contract is calibrated to provide a notional coverage of over $165,000 and deep-in contracts may require the commitment of nearly as much capital. They are not designed for the individual investor. There are over 1500 combinations of strike prices in 15 expiration dates, for both puts and calls.

The notional value of outstanding open interest in these contracts is some $2 trillion, with a current market value in the contracts of $70 billion. Professional margin rules provide for market-makers to offset opposing contracts (a put vs. a call of the same strike and expiration) in their capital "haircut" commitments. So when offsets are considered, there is about $55 billion guarding $1 Trillion, or a protection leverage of some 20-to-one, on average across all SPX contracts.

In everyday practice I have run market-maker positions in excess of 100-to-one, always under daily market exchange surveillance, on the reputation of an established, reliable firm.

An analysis of what real-money [big] bets are being made in SPX options implies the following price range forecasts:

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When the market pro has a good sense of which direction the price is likely to go, and by how much, then the risk is all in the other direction. He can, and usually does, have a plan "B" to mitigate adverse happenings. In fact, his plan "A" hedging operations are illustrations of risk preventions to begin with.

Don't the pros ever make mistakes? Sure they do, but in only a few out of many adventures. And they keep them small in hurt size.

How can they do that?

First of all, they are better informed than the public. Better means more completely, because they have sources worldwide, industry-wide, and in some cases perhaps even subject-company-wide. Better means knowledge of what's happening right now, and of future plans, soon after they are made.

Better means they know pretty well what the folks with big stock positions, and the folks with big buying power, are likely to do, today, tomorrow, and days after. Because they talk with them several times a day, just as they have been doing with those same people, for years.

They don't just play the game, they play the players.

Besides information, they have extensive resources. Teams of skilled analysts on hand to digest the mountains of real information, misinformation, and dis-information that flow down "the street" daily. They have record-keepers and score-keepers that maintain perspective on the constantly-changing prices and other market dimensions. Ample budgets to staff support roles, meet equipment needs, travel requirements, and emergencies, and to buy outside services.

Perhaps more importantly, they are poised to act, equipped to act, and staffed to act, immediately and constantly. Timeliness often makes a big difference.

Here is another illustration of how perspectives can vary:

One way of making value comparisons is in the histories of how one stock's or one ETF's upside and downside prospects can change across time. That is, one issue against itself at varying times, like in the blue pictures above. The other principal form of value comparison is, at one point in time, to match one subject against several relevant alternatives.

Here is a pair of such comparisons among market index ETFs and indexes, but at two selected points in time when the overall prospects were quite different.

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(used with permission)

In these pictures some two-dozen-plus ETFs tracking various major market indexes are positioned using their upside forecasts on the horizontal scale, and their downside forecasts on the inverted (larger declines at top) vertical scale. For a long position, the more attractive conditions are lower right, and the scariest are at upper left. Equal upside to downside balance is on the diagonal.

The date differences are noted at their lower left corners; then (in mid-November, six months ago) when the index was 1355, before rising some 22%, and now with the S&P500 at 1658.

How well did these forecasts work out?

We have a standard discipline to employ the market-makers' forecasts. We use it to gauge the perspective the MMs have on individual securities. In that discipline the top price of the forecast range is taken as an unchangeable sell target, and the patience limit (on holding a long position taken at the price of the time of the forecast) is set at 3 months from that date. If the target is not reached earlier, the position is closed out then regardless of gain or loss.

Every prior instance of a Range Index at least as favorable as the current-date Range Index is put to the test. For all of them collectively, win-loss odds are calculated, average holding periods are used to determine average daily gains, and annual rates of return from them provide comparative data, subject to common-sense appraisals of the size of the data samples involved.

These histories are employed in preferencing between alternatives. The same strategy can be used to evaluate actual results. The following table provides those results for the forecasts on these ETFs of November 15, 2012.

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There are three types of leverage at work here. The one that is common to all of these market-tracking ETFs is the specific choice of a commitment date, November 15, 2012. That date was apparent from the attractive implied price range forecasts of so many on the list, as seen in the above, first multi-colored R-R picture of that time.

The second , and most powerful leverage in terms of capital effectiveness (as measured by Compound Annual Gain Rate, or CAGR) is the discipline of TIME. It is exercised by the strategy of setting sell targets specific to each ETF (or index) based on the top of their implied price range forecasts at the initiation date, and closing the position out when reached.

The third leverage varies with the issue, based on the structure engineered into certain ETFs, which causes their values (and prices) to move at approximate multiples of the change in the price of the underlying index. When looking at the table's column of Payoff Gains, those leveraged ETFs are mostly the double-digit ones.


The principal point of this article is that there are knowledgeable, experienced folks who have pretty good sense about when markets are near their extremes. The second point is that using their sense of timing in committing capital to equity investments can often add to the resources of most individual investors. The third point is that judicious use of time in the employment of capital resources may be the most powerful tool at the individual's command.

The fourth point, unmentioned up to here, is that equity investing is mankind's second most serious game, after war, where all outcomes are dependent upon the perceptions of other players in the game. That make it impossible to find perfect strategies to employ; everything becomes a matter of the likely odds for success, however success is defined. The fifth point is that long-leveraged ETFs, when appropriately indicated, provide low-risk, high-return capital employment opportunities. The sixth point is that, with a reasonable attitude, caution, discipline, and perseverance, the game of equity investing can and should be the ordinary individual's best path to building personal wealth, far outstripping most other avenues that are legal and morally acceptable.

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.