Worried about a stock market that behaves toppy?
Investor advisory commentary is full of dire observations and shady warnings. But few if any gurus are willing to guess when trouble will hit the fan.
There's lots of advice to build cash defenses, run to gold, seek dividend support. Everything that will spend precious time, perhaps meaningful months of it, with capital committed to tiny returns, or none, or to assured modest losses.
In this game it is a rarity to get paid for no-risk propositions. Falling victim to scams offering such deals is often a far higher probability. Usually on premises that have no real history of payoffs. Periods like this spawn lots of them.
And when the "base-risk" proposition of US Govvies provide 1/3rd % on 2-years, and a giant 2 ½% for a ten-year commitment, income bids for your capital don't have to be very strong.
The best defense is a. . .
That's right, a strong (not wild) offense. One that can demonstrate sound reasoning and evidences of credible payoffs with good odds of infrequent and minimal failures. One based on demonstrated knowledge, experience, and sensible actions, driven by sound motivations. One with the perspective of world-wide information resources and instantaneous communication.
How's this for such an offense? Get the help of folks who have for several years been paid over a million dollars a year to guess where stock (and ETF) prices may get driven to, and how soon. Folks supported by cutting-edge information systems constantly being refreshed by global staffs of 24-hour alert competition-watchers. Folks who every day collectively bet over a billion dollars of their employers' capital, protected by their skills as hedgers and arbitrageurs. Folks determined to keep their prized positions in the universe of investment professionals.
Their help is not voluntary. But they can't avoid it. Nor are they likely to try, since individual investors are unlikely to get in their way. The d-i-y investor community may even make their jobs a bit easier, more profitable.
No, you are not going to be in a contest with them (and you don't want to be).
But big, favorable-odds payoffs in efficient time periods are quite likely to come from the efforts of huge, conventionally-driven investment organizations, the clients of the market-making professional folk described above. The big-money funds operate from misguided reasoning and under the disadvantage of the weight of their own size.
The profits for the market-making [MM] firms employing the well-paid pros come from the skill mismatch between the MMs and their clients, usually kept well-hidden by equally-skilled marketing types at the MM houses.
Of course, those who usually pay the price are the poorly-informed investors in the funds, getting returns on their investment below what might be. Who was it that said "never give a sucker an even break, and never smarten up a hick"?
You know who takes that advice to heart (and wallet)!
Back to your part in the game
The trading-desk MM pros, in order to force the clients' volume block orders through a marketplace with insufficient momentary capacity, have to put firm capital at risk. They skillfully defend those risks and in the process reveal the extent of their realistic, well-informed fears. We know how to extract those bounds from their intelligent behaviors.
That is what is in the first two data columns, (2) and (3) of the table below, along with the end-of-day market quotes (4).
A quick explanation of the less-obvious numbered columns: (5) is the % change between (4) and (2). (12) tells, out of the total number of forecast days available, that sample number of those days with Range Indexes like the present. The Range Index (7) is the percentage of the forecast range (2 to 3) that lies below the forecast day market price (4). Using the prior sample in (12) to follow a standard, simple time-efficient holding discipline, (8) indicates the percentage of them that were profitable, (9) the average net gain on all such holdings, (10) tells how long on average the samples were held, and (11) the rate created by (9) and (10). (13) measures the credibility of (5) given (9), and (14) compares (5) to (6).
Please invest the time and effort it may take to understand the dose that is inflicted by all of those ( )s in the prior paragraph. The data does provide a useful way to compare some not-so-simple, but realistic, investment considerations.
For example, the critical starting point in each is the benefit being offered by each forecast in (5), largest of the top ten for YOKU, smallest for DD. Past experiences of (9) for DD's small +8.1% in (5) is the most credible (13) of the group.
The tradeoff between NEU's +8.6% and its most stressful -1.2% puts it at the top of the reward-to risk rankings (14) of the top ten, a measure continued on down among all 28 potential investment candidates.
Getting paid for taking risk is what investing is most about
Income from dividends or coupon interest is about renting out capital where risk is minimized. In better, more realistic times, a living may be made by renting out capital, but even in better times, it takes a lot of capital to do it.
The trick to being good at wealth-building investing is finding opportunities for good payoffs while the risks involved are proportionally small, so that the inevitable losses are few in number and the costs can be readily offset by the gains. Quicker gains than losses help to make the cumulative results even stronger.
That is why our analysis focuses on evaluating the opportunities being forecast and the net payoffs achieved after realized losses exact their toll. Not all risks need be realized, but it is at their worst price drawdowns where decisions locking in the large losses are most likely to be made.
So we vet all MM forecasts in a discipline that sets specific sell targets for buys at the top of the forecast range, to be achieved within 3 months, or terminated regardless at that point. Knowing that there is an ultimate time limit often helps to get through a temporary price drawdown that may be recoverable and go on to a profitable outcome.
That discipline is what produces the data in (5) through (11), with (12) as a screen for sufficient period of observations and a sample of similar Range Indexes large enough to be statistically reliable. The restriction of the sample to prior cases of forecasts with like upside-to-downside prospects recognizes that risk is not static under all circumstances.
Many misguided confusions of past uncertainty, as in standard deviations of historical price change, with future risk, as in forecasts of coming price change, treat risk as a constant, regardless of the circumstances. Evidence clearly shows that not to be the case.
Let's look at specific cases
The best return-to-risk prospect is Newmarket Corporation (NYSE:NEU), a company that formulates special-purpose petroleum additives and lubricants. We let other fundamental analysts focus on the business and competitive economics. We care about that, but our particular contribution and focus is in the investment payoffs of capital gains achievements in a time-efficient discipline.
The means of our analysis is behavioral analysis, but not in the usual manner of looking for errors that investors make, but instead the things that investment professionals do well, so that we can ride their coattails. Our differentiation is referred to as Intelligent Behavioral Analysis.
While some of our presentation productively uses pictures of the evolution of past MM forecasts for specific investment subjects in ways that resemble the "charts" of technical analysis, the resemblance stops at appearance. Our pictures are of forward-in-time price estimations, not backward-in time histories. The price projections are already pictured by the forecasts, they do not need to be conjured up from past shapes or trends.
Instead, the pictures do give a clear idea of how price expectations are evolving, both at lower and upper bounds. Perhaps more importantly, each vertical price range span shows the balance between upside and downside prospects as the current market quote itself is changing. When that balance becomes extreme, color changes in the price range line may call attention to the situation.
Here is how NEU presents itself daily over the past 6 months:
(used with permission)
The tops of the December and January forecasts all were exceeded by market prices by mid-February. As were the low Range Index (green) forecasts of February by mid-late March. Cautionary (yellow) forecasts of March were ultimately fulfilled (both to the upside and the downside) in April.
Now in mid-May the low Range Index of 3 can be seen in the small blue thumbnail picture as being of one of but a few, with many of more balanced forecasts present most of the time.
The odds of a profitable outcome over the coming 3 months are encouraging, it having happened in all 3 other instances of the past 5 years. That is signified in the Win Odds column at 100 of 100. The average holding period of 33 days makes it likely that all 3 reached their sell targets before a 63 market-day 3 month time limit arrived. The short time involvement liberates the capital involved to be reinvested quickly enough so that its gains at the same 7.9% level could be compounded to a 79% total over the course of a year. Not too bad for a likely risk exposure of less than -2%.
Now for a horse of a different color.
Youku.com (NYSE:YOKU) is a Chinese television broadcaster over the internet. Lots of competitive issues apparently surround this situation, which we have no way to evaluate.
But our MM guides have the assessors and translators on the scene to put the stock into a hedgeable perspective. Their continuing appraisals over 6 months look like this:
The recent 6 months history has been one of decline. Is it a falling knife? In fact, the past 3 ½ years of forecasts have had 20 instances of Range Indexes at this level, and 19 of them have come up as profitable. And not trivially so, with a 23+% average of gains net of the one loser.
To suffer through lots of gains at such handsome payoffs (in 27 market days - only a week more than one month) the investor had to tolerate worst-case price drawdowns averaging -3.7%. That's not exactly an "ouch" in most investors' playbook. Taking one gain that size would be a year's quota for many investors. To be able to compound it into a year's experiences puts the gains up over 600%. Even only once is a nice lump to average in with the rest of the portfolio's results.
This case fits in very well with adequate net payoffs at fairly trivial risk. How about others?
Next on the list is Polaris Industries Inc. (NYSE:PII). Here is a US producer of recreational and utility vehicles well set to benefit from the continuing well-being of those consumers who have ridden through the recent recession with steady employment incomes. How the other 99% are fairing may not impact their purchasing decisions much.
Or, it may. But that's not what comes through the MMs' appraisal of this stock currently, with a +15% upside and only 1/8th as much downside (about -2%). In fact, the nearly two dozen prior experiences like today's forecast in the past 5 years have seen every one come up profitable, after seeing worst-case price drawdowns of only 1/6th of the prospective gain.
There's no guarantee that the next 3 months will be the same as previous comparable circumstances. Could be worse; could be better. Here's how its past 6 months has evolved and how its Range Indexes have been distributed over the past 5 years.
And for a solid wealth-building reassurance
Here is a DJIA war-horse, in business since the US Revolution, and likely to survive the next one, if there is such a calamity. E. I. duPont de Nemours and Company (NYSE:DD) sports a dividend yield better than a 10-year US Government bond in addition to a prospective 8+% price gain in the next 3 months.
What makes it special is that at a Range Index of 22, its forecast is as cheap as it has been at any other time in recent history. Almost two dozen prior forecasts like today's have worked out all profitably at greater payoffs than are being currently expected. It's hard to imagine a higher-quality bet to make in questionable times than this one.
Check out its price and forecast history weekly over the past 2 years:
Let's close with an always controversial candidate
Netflix Inc. (NASDAQ:NFLX) has just had its biggest pull-back in stock price in two years and is now poised, by MM appraisal, for a +16.6% bounce-back to recoup about half of what it has recently lost.
At a Range Index of 24 a downside forecast of -5.5% is seen as possible. Out of over 60 prior forecasts at this level the average worst-case price drawdowns was -5.2%, so that may be on target for realism.
But that doesn't mean that such losses have to be taken. In fact only in 4 out of 61 previous comparable forecasts were losses actually taken, leaving net payoff profits at the level of +15.3%. That's a 93% odds of winning. Investors get paid for encountering risks; they must suffer through the emotional strain, but capital doesn't necessarily have to get damaged. Here is a case where over 4 years a series of modest risk exposures allowed the capture of net profits at an annual rate of +168%. That makes the strain quite worthwhile for many investors.
Just because many investors see negative signs for the market as a whole, out of over 2500 widely-held and actively-traded stocks and ETFs there are nearly always a few candidates that can provide attractive reward-to-risk tradeoffs. Instead of running scared to the sidelines, or into trivial-yielding income situations that discourage a timely re-entrance into recovering stocks, there is a better way to react.
It is to use careful judgment to find those opportunities to keep capital active and productive, even when markets may get into turmoil. The Market-making community can help identify the best opportunities because of their information-gathering systems and the need to be constantly active in the markets. Past evidences are available of the subjects where they have excelled in their foresight.
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.