Stock Market Weather Forecasts By ETFs

 |  About: ProShares UltraPro Dow 30 ETF (UDOW)
by: Peter F. Way, CFA

Climatologists have seen their technologies advance markedly in the last 50 years. So have market forecasters, and the stock seers have more than a hundred years of practice at it.

The weather guys have one thing on their side in this comparison contest, which is that the rules in their game are set by nature. That makes scientific observation of previous events a more reliable forecasting tool. While more at the fringes of "hard science" than chemistry or physics, there are lots of well-known norms of weather experience for them to draw upon, more than reliable ones in the investment scene.

That is because the game of investing, particularly stock investing, is driven by competitive-strategy-fueled humans whose social reactions make its study one of the "soft sciences" - inherently harder to forecast. What works one time, may not the next. What you get told, you maybe shouldn't believe too much.

But there are some basic human action rules that rarely are ignored. Perhaps #1 is: Take care of #1 first, with greatest possible certainty. Even when you can't be absolutely certain.

When competitors sit at the trading desks of volume market-making firms, knowing that if they perform as expected, their compensations in 3-5 years can allow them to retire for life before they get to age 30, and screwing it up so their boss has to take a 50% pay cut means they're certain to face a clawback, termination, and possible further employment blacklisting, then rule #1 is mightily self-enforced.

So they learn how to assess risks and how to build cost-effective hedges against them, so that the firm will gladly continue, even increase, the boss' compensation.

The risk-involving volume transactions they conduct, each hundreds of times a day, logically tend to be in the most widely-owned, largest-capitalization companies. Among the first to come to mind are the 30 Dow Jones Industrials. Those 30 stocks currently have market-caps totaling $4.6 trillion, well over ¼ of the market cap of the S&P500 index of over 15 times as many stocks.

It should make sense that the potential price problems anticipated by hedges in those stocks may be better thought out than in many other issues. An ETF based on the 30 stocks ought to have the same quality of anticipations behind its pricing. Now suppose the ETF is so constructed that its price moves are likely, day by day, to be three times the volatility of the index.

Hedgers in that ETF (NYSEARCA:UDOW) do it like porcupines make love - very carefully.

Now, here's the point. Hedgers can't avoid leaving footprints behind in the hedging markets. We know how to translate those footprints into the price limits of their concerns about protecting #1. We do it every day for UDOW and some 2500+ other equities.

Those revealed concerns have both upward-reaching potentials above the current market quote, and downward-risking exposures below the market price. The balance between the up and down has very logical implications for an ETF like UDOW. Here we have pictured what those up-vs.-down balances have been looking like in UDOW each market day of the past 6 months.

(used with permission)

Those market-makers have been issuing warnings of impending market price problems for weeks now, suggested by the yellow caution lines, where far more downside is in prospect than upside.

If those warnings were not part of your investment inputs, the best next question to ask is "is it time now to scoop up bargain-priced stocks, or is it too early?" Or is this just a lucky run of time when these guys happened to hit it just right?

A look at their forecasts, using daily expectations taken once a week, over the last 2 years may put the "lucky guesses" question to rest.

This provides some more perspective than just the 6 months daily detailed look. We urge folks to come to their own conclusions about the data. But it has been rare that there were only one or two days of opportunity to pick up bargains. And often the forecasts left little downside room in those green lines.

The market weather forecasters may not see sunny days near at hand yet.

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.