Will the Market Rally Continue?

Oct.20.09 | About: SPDR S&P (SPY)

We say yes, and here’s why.

We derive forecasts from the hedging actions of the block trading community on over 2,000 widely-held and actively-traded stocks, ADRs, and ETFs. The common denominators of upside and downside price move potentials are present in all of the forecasts. The uncertainty involved in each is indicated by combining the up and down.

Those common denominators let us aggregate expectation descriptors for the equity market as a whole, or for any subset of interest. To put the overall market in a picture many stock investors can relate to, we took the recent price history of the S&P500 index, and expanded it to embrace the daily average upside and downside expectations of our entire population.

SP500 Forecast Ranges

What appears immediately is the way fears and hopes expand the range of expectations when the market is rapidly and substantially declining. Less obvious, but also present is the “What, me worry?” attitude of investors in rising markets. Then the range of uncertainty shrinks.

These effects are more apparent in the following picture:

SP500 Expectations Balance

In the 2008 May-July market decline, downside concerns widened only a bit, while upside hopes stayed high. Those hopes were modestly rewarded by a market rally into September. But as declines began again the downside apprehensions expanded and then mushroomed into a panic, along with plunging prices.

The convictions of optimists are hard to kill off, fortunately, so upside potentials widened appropriately for many stocks, expanding that dimension’s average.

While the market stabilized as year-end approached, the downside fears subsided back to earlier levels. But more bad news lay ahead, and further market declines into early March of this year repeated prior investor responses. Still, they were not as extreme as before.

Nor were they in early July as a month’s worth of declining market index numbers tested investors’ convictions. Then downside expectations did not expand much, and the market rejoined the recovery path.

Now the question turns to can it continue? Is it “what, me worry?” time?

That attitude may have started to appear in early September when downside concerns greatly diminished. They were accompanied by reduced upside convictions, and the level of blue-line uncertainty dropped to a level not seen in over a year.

The following couple of weeks’ pullback shook off the complacency, and once more the raised levels of concern were less severe on the downside than previously. But so were the enthusiasms of the upside. Yet uncertainty remains in a healthy range.

Looking back at the first chart, the S&P500 index price continues to be accompanied by upward trending lows and solid to up-trending highs. Behavior of the lows is most encouraging. Our conclusion is that the overall recovery continues, showing no signs that investors are likely to precipitate a serious downturn, absent the introduction of some new momentous disruptive event.

That appears to be a direct parallel as block traders are hedging their at-risk positions when filling trades in SPY, the S&P 500 SPDR. Their current forecasts are for a range of $104 to $118, +8 ½% on the upside, and – 4 ½% on the downside.

Over the past five years 129 forecasts with similar upside to downside proportions, or better, have seen higher SPY prices in 2/3rds of the days of the following 3 months, averaging +16%, and lower prices in the other 1/3rd, averaging -14%. Buy and 3-month hold gains outweighed losses 1.9 to 1. SPY now ranks better on a reward-to-risk scale than 74% of the 2,000+ issues we follow.

SPY Weekly Expectations

Disclosure: Neither Peter Way Associates nor Institutional Insights has current investments in SPY.