Seeking Alpha
Peter F. Way, Blockdesk (747 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
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Into a narrow industry focus ETF.

But aren't ETFs just funds of stocks? Won't they get hit just as bad as the market-tracking averages like SPY, DIA, QQQ, or RUT?

Oh, now I get it - pick an ETF that is defensive in nature. One focusing on an industry that has not been caught up in stock euphoria. That's what makes the smart money smart?

So if we look at an array of these ETFs that are being constantly reappraised daily by the guys making markets in them, helping the smart-money, big-money hedge funds, endowments, and mutual funds, jockey their portfolio emphasis around, maybe we can learn where they're headed?

Even if we can't jump in ahead of them, we small investors can probably ride along on their buying pressure. And more easily get out when this game looks like it is getting tired. So what does it look like are the better bets at this point?

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(used with permission)

This picture checks out the guys handling the trade orders of the big funds, and the market-making outfits that help them get the orders filled. It plots how they see the future price prospects of a couple dozen ETFs aimed at very specific industries. They have to work both sides of the trades during each market day, so they see both price gain and drawdown exposure as developing prospects.

The map plots downside risks along the vertical scale on the left, and upside opportunity along the horizontal scale at bottom, so good buys ought to be toward lower right and good shorts toward upper left. That diagonal line ought to be the neutral. So what's this [4]?

It's the PowerShares DB Agriculture (DBA) ETF. It makes sense. If stocks and the economy are going to hell, folks gotta eat. So what does DBA hold? John Deere (DE)? International Harvester? Potash (POT)?

Surprise! It has 96% of its assets in ag futures: Sugar (CANE), live cattle (COW), corn (CORN), coffee (CAFE), soybeans (SOYB), cocoa (CHOC), lean hogs, wheat (WEAT). Really a diverse play on the products being consumed, not on the equipment manufacturers. And as an ETF, it can be traded like a stock. We know how to do that, and won't get caught up in futures "maintenance margin" adjustment requirements we may not understand, ones that deservedly create apprehension.

So let's learn more. Do these guys, the block traders and market-makers really know anything about the futures markets? What has been happening to the price of DBA? Should it really be an offset to a lousy market environment?

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Well, maybe not always, but most of the past two years it has behaved as expected. It does look like a contra-mover to the market. Have the market pros anticipated this? What do they think can happen now? Here is a look at their forecasts, weekly over the past two years:

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(used with permission)

Hold on a moment. This is not an ordinary high-low-close chart of past price ranges. It is a history of the price range forecasts seen by the pros as recorded once a week, live, over the past two years. Those heavy dots in the vertical forecast lines are contemporary market quotes at the time of the forecasts.

Their expectations ranges have been coming down pretty steadily during this period, until just recently. Now DBA's forecast range is rising and its price is pretty low in that forecast range. That's why on the risk-reward tradeoff map DBA is located where it is at [4].

Hmm. Not much downside, and an expanding upside. Has that been a good sign in the past? If we look to see how its price has behaved in the 3-4 months following every time the pros have seen what they are describing now, what will that look like? How does that compare with their outlooks for DBA at other times, or on average?

Here is a table that looks at the forecasts for DBA every day for the past 4-5 years. It sorts the forecasts by their upside-to-downside balance, cumulatively from the most extremes at top and bottom, to an overall average of all forecasts in the blue line at the center. The balances are shown in the red and green labels, and their count is in the first column to the right. Clearly, DBA rarely has a forecast where its downside is twice as large as its upside. DBA's present balance is indicated by the magenta count number.

The remaining columns to the right show the annual rate of price change for the count of forecasts in each row, between the time of the forecast and the number of days later in the yellow footers for each column.

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Reading across in the 10:1 row, there are 85 market days of the last 4-5 years (1130 days) where the forecast balance between upside and downside was at least ten to one, and the average price gain in all of them some 2 months (40-45 market days) after forecast was at an annual rate above 70%. At that length of holding period better than 9 out of every 10 (of the 85 days) DBA's price was higher than at the time of the forecast, as shown in this parallel table.

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The extent of the historical record from live forecasts made across several years offers strong persuasion to the notion that DBA is a viable buy candidate at this point in time.

Disclosure: The author has an investment interest in the website blockdesk.com which, while not yet open to the public, is in conversion from being a delivery medium of information to institutional investors to a new life of providing similar help to do-it-yourself investors.

Source: Where The Smart Money Goes When It's Worried About Stock Prices