Seeking Alpha
Peter F. Way, Blockdesk (668 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
Profile| Send Message| ()  

Put your money where your mouth is!

Every year-end nearly all investment managers feel they must produce some market outlook writing to reassure (or placate) their clients or their organization's directors. No matter how elaborately defended by assembled data and years of experience, forecast talk is cheap and its credibility lives in an environment illustrated by the most recent U.S. Government report showing major reductions in unemployment at the same time as employment from new jobs shriveled to about one-third of what had been projected or previously achieved.

Such market outlook pieces may get selectively remembered when some fragment in them turns out to come true. But for the most part their guidance value becomes part of the serious, elaborate game of trying to get and stay ahead of the other major players in determining where stock prices are headed. Often it's a matter of misdirection - don't do as I do, do as I say (please!). Smoke? What smoke? (Collectively, it's fog.)

Still, money moves markets, and knowing where it's headed is important.

One way to learn what the big-money-funds are doing (and actually are thinking, not just saying) is to see the influence they bring into the marketplace via the presence in shifting asset allocations of their capital commitments. Those influences are transmitted by the volume market-makers [MMs] who help them effect the necessary transactions.

In turn, the MMs have to briefly expose their own capital to risk in the process. The art form supporting those extensions is the practice of hedging, in which MMs are skilled. We know how to translate the footprints that are left behind in public markets into clear signals of rational price range expectations for major market indexes and the ETFs that make the indexes convenient investment media. We've been at it for over a decade.

Let's look at how the expectations for major market indexes may have shifted (or not) between before the year-end activities, and now, when we have had at least a couple of weeks into behavior in the New Year. Here is how their price range forecasts, in the vertical lines, have trended day by day over the past 6 months for the S&P 500 Index SPDR (SPY):

(click to enlarge)(click to enlarge)

(used with permission)

The rather clear upward trend of price range expectations, while seeing minor pullbacks in August and September, carried the index's price on up even to year-end. But since late November-early December, those expectation ranges have been moving sideways. With prices continuing to rise, the proportions in those vertical-bar price ranges are shifting.

Back in August and September the downside part of the range got shrunk to 1/3rd or less of the whole range. At the start of this year there was an even balance of upside to downside so the downside has risen to 50% from 33%. Our term for this balance is the Range Index, which is a useful comparative measure between otherwise very difficult to compare investments, like ETFs.

SPY's RI has now risen from 33 to 46, a not unusual transit. Here is where it has been from time to time during the past 5 years, daily:

The mid-point RI experience for SPY is about 43-44, so when its price gets up above the 50 RI level it is in its upper elements. More important is what happens to prices next.

When SPY's RI has been 33 (over 100 times of 1261) its price was higher than at forecast time at the end of the next 63 market days (3 months) 76% of the time. The gains in those days had an average annual rate of +34%.

In contrast, at a RI around 55, it sees prices lower than the forecast cost price 40% of the time, at an annual rate of -16%. Perhaps more significantly, at these higher RI levels, maximum SPY price drawdowns run as much as 1 ½ times the average loss rate of the 55 RI. Although they may not be sustained at that level, the ensuing stress on investors may precipitate irreversible actions that prove to be unhelpful.

The moment pictured above in the picture of progressive SPY forecasts is instructive, in that it suggests that a turn in market direction could be arriving. Such a conclusion is premature, until a fair amount more evidence of declining expectations takes place. When we go back to the August-September-October modest cycle, SPY's RI actually changed rather little in the whole time.

What happened of course is that the market rode through it all, although buys of SPY when its RIs were lowest did provide forecast-range tops - that we encourage be used by wealth-building investors as sell targets - at levels which became action points by November.

A longer term look at how expectations have trended may provide more encouragement to the wary investor. Here is how those daily expectations, taken only once a week, have evolved over the past two years:

(click to enlarge)

At this pace, the recent slowdown in expectations advance nearly disappears. But that can be the danger of looking backwards to guess forwards. Driving by the rear-view mirror can be dangerous to your capital's health. Like it was in 3Q 2008. Instead, what would be helpful would be the same kind of look forward that the MMs provide, but on a much further-out horizon.

Our Seeking Alpha articles may make it sound like the MMs are the only smart guys in "the street." That is not our belief, or our intent. It's just that closer up in forecast time, they can be much more helpful to wealth-building investors than the individuals who have already made their pile and whose concerns revolve more out of how to keep it and pass it on to others that matter to them.

The investment professionals who want to enjoy a comfortable life by providing reassurance to such well-fixed clients know they need to have a skilled sense of what may be just over the conventional street "horizon." And, given that, what may be advisable to do about their perceptions.

They are not ignorant of the arts of hedging and arbitrage. What the public has seen, and the newsmedia loves to report on as "hedge funds", for the most part are shoot-the-lights-out risk-taking operators that have dodged the margin rules that apply to the bulk of the public. It has been done by operating under "private investment" (not the public) rules that require participation only by "qualified investors." Such funds are allowed more lax margin rules than the 50% of current value limit permitted the public.

The public standard provides a 2-for-1 degree of leverage. In the hey-day before the failure of Lehman Brothers (and others) leverages of 4, 5, 6 and even more were allowed to favored funds in which the "investment banks" had confidence. Because they were being run by "professionals" who could make it worth the "banks" while. Lucky operators, with that kind of accelerant in their flame-throwers could produce amazing results, compared to staid commercial bank Trust departments. Or other organizations.

Previously "unqualified" but capable of qualification individual investors stampeded into the riotous party, feeding the bonfire fresh capital - for a while. We saw the outcome.

Skilled hedging is a learnable art form, and many investment professionals charged with the fiduciary responsibility of working with the capital of others have developed those talents, to protective ends more than for capital accumulation. When those are the concerns of one's clients, those are the skills that get developed.

The admonition to "be a long-term investor" is far more suited to the established investor than to the capital-building investor developing financial resources. But there are many who have reached that enviable state and benefit from playing the game that way. Often they contract-out their investment concerns in one way or another to skilled investment professionals or organizations well-staffed by such.

One way to deal with equity investments, which need to be a major part of the portfolio of most retiring investors, is through Exchange Traded Funds (ETFs) like SPY which provide the opportunity to grow in value over years, while limiting (through diversification of holdings) interim price fluctuations that could damage desired goals if occurring at inopportune times.

Professional money managers addressing this task recognize the values of arbitrage and hedging to accomplish either and both goals of risk protection and modest capital enhancement or income supplementation. To satisfy those objectives, the creation of long-term options, known in the trade as LEAPS, was established over a decade ago. They are traded daily alongside conventional options with contract expirations weeks to months in the future, but LEAPS have lives measured in years.

Just as we can look at the bets being made through the shorter-term options, sensible and reasoned judgments are also being made with real money (in significant amounts) about the likelihood of more far future events in the lives of SPY.

It appears that the betting is for a gradually expanding uncertainty to the downside in the first half of this year, but no upside until the 3rd quarter, and only modest 5% rise to year end. Those gains are seen as being compounded to year-ends of 2015 and 2016, with little downside market concerns in the next 2+ years.

That's quite a change from the past few years, culminating in 2013. Time for a breather, or is there concern to be discerned from the guarded outlook?

This kind of prospect heightens the value of future specific stock selectivity over the rewarding blind buckshot year we have just had.

Source: Market Outlook Through ETF Hedgers' Eyes