Bad News Near-Term: Market-Maker Dow-Jones Index Price Forecast. Protection?

Jun.19.14 | About: ProShares UltraPro (UDOW)


UDOW is now forecast to have price drawdowns six times the size of its possible upside price change in the same next 3 months.

Actual UDOW declines after such forecasts have been over 20 times as large as possible gains achieved.

Rare extreme condition, seen infrequently in past 4 years, but 56 days of similar experiences have been dominantly negative.

UDOW's inverse ETF twin, SDOW, does not produce positive price gain counter-moves; shorting UDOW exposes other risks.

Most levered-long ETFs also in bad reward-risk postures, signaling trouble ahead may not be restricted to big-cap core equities.

It's not our forecast, but from folks who act and profit, rather than talk

We get our principal wealth-building equity investment guidance from the way market-making professionals protect the capital they must put at risk as they perform their essential functions for big-money-fund portfolio managers. Their hedging in key Exchange Traded Funds [ETFs] suggests they now look for an equity markets decline.

The volume of internet stock forecast talk is limitless, coming largely from those who are simply paid to provide content that may attract eyeballs to advertising, many of which have nothing to do with investing. Being right, rational, or realistic has little to do with the writers' assignment, nor do many even care or have the capacity to be credible.

And looking backwards in time at history is a poor excuse for research, either for journalists or investors. What matters in equity investing is what the rest of the investing crowd believes is possible to happen in the future, compared to what all of the observers believe will happen next.

Nearly everyone knows where we are now, which is the essential starting point, the reporter's task. Many investors' actions look little further than what appears likely to happen next, the commenter-analyst's task. Market-makers [MMs] use their experience and resources to forecast (and evaluate) the future, in order to make high-probability-odds bets that are their real payoff for the privileged positions they occupy.

MMs know the past and create the "next", but profit from their understanding of the likely future, created from their own behavioral research into their clients' likely actions further on down the road of time. The rest of the investing community they view as mostly an annoyance that might get in the way of their making obscene amounts of money.

So MMs avoid public contact wherever possible. The last thing they want is for us to know what they are thinking or doing. They operate mostly in their own world, where the public is often ignorant that such worlds exist, and conceal their purposes by complex hedging strategies largely unknown by those outside of their community.

Fortunately for us, their activities leave footprints, when one knows where to look and what to look for. We do, and we're not telling. Those tracks reveal far more useful information than academics, economists, or regulators ever believed was possible. We choose to simply demonstrate with real-time recording of their implied forecasts, followed up by careful, accurate measurements of what subsequently happens in the real life of investment markets.

Some of their forecasts are unbelievably accurate and useful, some not so much. We use the careful measurement of that actuarial history to evaluate which subjects to focus upon so as to heighten our odds of making profits by riding on the MMs' coat-tails.

One particular stand-out in that multi-year ranking perspective is an ETF where the implied forecasts are heightened by increased price-sensitivity. That sensitivity is brought about by its construction using derivative securities for operational leverage, instead of actual equities, and its maintenance by the daily rebalancing of the ETF's holdings. The rebalancing is necessary to maintain a constant relationship between each day's ETF price change and the change in price of whatever underlying index or commodity the ETF is intended to track - in this magnified way.

If our approach of watching the behaviors of MMs is likely to work, based on their understanding of the probable intentions of professional portfolio managers at organizations with the money muscle to move stock prices, then logically, it should be focused on the heavy traffic in stocks in the Dow-Jones 30 index. That price-leveraged ETF is ProShares UltraPro Dow 30 ETF (NYSEARCA:UDOW).

Here is how the MMs have appraised the outlook for UDOW over the past two years, as seen from once-a week looks at their daily forecasts.

(used with permission)

The vertical lines in this picture are the forecast ranges of price made at the time of the contemporary price of the ETF at the dates indicated on the horizontal scale. Those forecast ranges are bifurcated into upside and downside prospects by the then price's heavy dot. Extreme imbalances in those prospects are suggested by yellow "caution" and green "go-for-it" colors.

Sacrificing the perspective of history for the precision of present time, here is what the day-by-day forecasts have looked like in the past 6 months:

Click to enlarge

The prior 2-year picture now is updated to the current date, and is embellished with some of the subject's historical test records. Its current "sell target" top-of-forecast-range price of $121.72 is only 1%+ above its $120.57 price at the time of forecast. Its Range Index [RI], a measure of what percentage proportion of the range lies below the then current price, at 85, is quite high in the historical distribution of RIs pictured in the thumbnail at bottom.

Other data in the mini-table between the picture and the thumbnail relates to UDOW's full 4+ year life history of 1075 market days. Only 34 of those days have been on the order of today's RI.

Using those 34 days' forecasts as a sample, 85% of them (29) in a standardized test strategy produced a profit in subsequent market days. The strategy buys the subject at a cost of the next day's closing price and takes a profit at the first next day's close at or above the forecast's top-of-range price. If that goal is not reached in 63 market days (3 months), then the "position" is closed out at the resulting gain or loss that day.

The average net gain from all 34 such positions was only 0.3%+, realized in an average holding period of 21 market days. Those experiences produced net gains at an annual rate of 4%+. During their "holding periods", the worst-case price drawdowns from cost were averaged, with a result of -6.7%. At an 85% win odds rate, obviously all but 5 of the sample recovered from their maximum drawdowns.

Still, it usually is at the point of maximum emotional stress where bad choices of locking in a loss occur. So we view the max-drawdown figure as a realistic measure of risk.

What is important in this discussion is direction, rather than scale. Clearly, the proportions being presented by MM forecasts for UDOW are reinforced as to direction by a 1-to-20 reward-to-risk ratio of 0.3%+ to -6.7%. The RI's 85% of forecast range to the downside is a first, and very important clue.

A very helpful perspective is provided by an examination of what has happened to UDOW's price following every one of its 1073 forecasts. That is shown in this table, which makes calculations of price change in cumulative 5-day increments up to 16 weeks following the date of the forecast.

Click to enlarge

The rows of the table are cumulated from top and bottom extremes, to meet at the blue 1:1 row in the middle. A count of the number of forecasts included in each row is indicated in the #Buys column. The magenta 56 indicates the RI of 6/18/14, and includes the few worse-proportioned (for a long investor) instances.

The most stressful experiences for a long UDOW investor entering a position at prior times like what is now being seen by MMs happened some five weeks (25 days) after entry, and persisted in lesser amounts up to 16 weeks later.

Obviously, long UDOW investors were far happier at such holding period lengths when initiating positions at negative RIs (100:1 reward-to-risk forecast proportions) or RIs of up to 2 or 3, where as many as 104 opportunities existed. The average annual rate of this 3x-leveraged ETF during its life has been 35%+ or more (see the blue row), some 3 times the rate of rise in the DJIA index in the past 4 years.

It's pretty clear that the MMs have a good handle on when UDOW is an attractive long investment and when it is not.

Investment choices for the other side of the coin both have limitations that many investors would rather not entertain. Simply shorting UDOW at times like this requires borrowing shares of the ETF to deliver to the buyer of such a short sale, and the lender of such borrowed shares typically has the right to demand them be returned to him/her at any time.

Be assured that the lender will pick a time most favorable to him/her, which usually will be the point in time most uncomfortable for you. In any short, you are also selling your control over your investment.

The evil-twin long-position alternative to UDOW, ProShares UltraPro Short Dow 30 ETF (NYSEARCA:SDOW) is of the tribe known as inverse ETFs. They suffer from an asymmetric price bias that arises in the daily rebalancing of the ETF's holdings proportions. It effectively prevents all but the most precisely-timed positions from benefiting from actual declines in the holdings of the ETF, as is originally engineered. The best simple advice for most inverse ETFs is: "Don't try this at home - your home or anyone else's."

Best at this point to be out of any UDOW position.

Now, perhaps more importantly, the message that the MMs are sending about UDOW has further ramifications. The 30 component stocks in the Dow Jones Index make up way more than half of the cap-weights of the S&P 500, and are about a quarter of the value of most actively-traded stocks worldwide. If they are headed for trouble, it's not likely they will be alone. Fear, particularly, is contagious.

To get a sense of how the MMs see the broader picture, we look at the many other long-leveraged ETFs where we have the benefit of their outlook for gain, in contrast to what their similar prior forecasts have involved as worst-case price drawdowns. Here is a picture of what that shows currently:


Everything above that dotted diagonal line has prior price drawdown experiences (left vertical scale) worse than current upside price forecasts (lower horizontal scale). It's not a happy picture.

These ETFs cover a wide array of market indexes, both here in the U.S. and abroad, and of various commodities and industries. Sell in May and... ?

June might work, too, and there have been recent inducements to stick around. There may be more, but watch your step. Snoozing on the beach might mean more than just a little losing.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.