Market Outlook By Market-Making Pros, Aggregating 2500+ Stocks And ETFs

by: Peter F. Way, CFA


Market-Makers [MMs] enable volume transactions for their big-money fund clients by filling out the assembled available “other side” of each trade with their own firm capital.

They protect that capital against price-change risk by hedging transactions in markets of related, alternative-investment securities.

What they will pay, and what sellers (typically other MM prop-trade desks) will charge for that insurance tells just how far all parties concerned think prices could go.

Upside and downside price prospects, often unbalanced, reflect each issue, but on a highly-comparable standard basis, allowing an overall look at thousands of equity issues.

Those aggregates and their details, not available anywhere else, can be helpful in portfolio asset allocation considerations and planning.

What does the array of upside to downside prospects look like now?

There are 2,553 equity issues here in late July that have sufficient hedging activity to provide price-range forecasts, implied from the hedgers' commitments to current transactions. We measure them in terms of each one's whole range of likely prices, highest to lowest, what percentage of that range lies below its current market quote. Our term for the measure is the Range Index [RI] and it can be above 100 if the quote is above the highest forecast, or even negative, below zero if its market price is below where the hedgers think it ought to be.

The horizontal scale at the bottom of this picture displays the span of Range Indexes.

(used with permission)

On July 25, 2014 there were Range Indexes averaging 33.9 for 2553 equities. The 33.9 indicated that on average there was about twice as much upside price prospect (100-34=66) as there was downside (33.88). The bulk of the stocks and ETFs clustered around the RI 34 average, but many lay below zero (cheaply priced) and some approached or exceeded 100 (expensively priced).

To put some recognizable dimensions to the upside and downside prospects, we took the geometric mean of all 2553, each between their market quote and the upper end of their hedging-implied forecast. Today it averaged +11.8%. Doing a similar calculation to the downside produced a risk forecast of -5.6%. Again, the dimensions are about twice as much upside as downside.

While there are considerable variances between the size of individual forecast price ranges, over time the average size of them all has also varied under different market conditions. So has the average range index, and the upside and downside averages. Now the average bottom to top range is 18½%.

What have market extremes looked like?

Here are parallel pictures to the one above, first as of May, 2008 as market optimism took on full bloom, and then in October, 2008 at the height of the financial panic as investment firms were failing and about to be (but not yet) rescued.

First you have how MMs perceived stock prospects in the next 3 months after mid-May 2008, when SPY traded at $142. The RI average then was 46+, with almost as much downside as upside, but very few "cheap" stocks or ETFs with RIs at 20 or less.

Next, in October 2008, SPY's price was plummeting below $90 and fear was rampant. Forecast cuts could not keep up with price cuts and now the average RI was less than 20, at 17. Very few issues saw upsides as large as their downsides at RI = 50.

Everywhere frightened investors looked, capital was being flushed down the scuppers. Note the towering number of implied (from hedging actions) forecasts well below -20, where market prices are far below forecasts.

Neither of these extremes (intentionally selected) is present today. While the euphoria of mid-2008 still offered trivially greater upsides on average, the message of its RI distribution lies in the extremes.

The expected upside payoffs for many stocks, despite their relatively high prices, had nowhere near the balance of downside risk perceptions by the public that were being protected against by the market-makers. The uncertainty span of maximum downside-to-maximum upside price outlooks for the average issue was only 20%.

In contrast, the panic of October reversed the extremes. Very few names offered MM forecasts of specific equity upside prices with the muscle to support RIs where upsides even matched downside, let alone outweighed it. The fear level pushed the span between average upside and average downside to 35%.

It is in those comparisons of extremes where the forecast judgments of the MMs come alive. In May 2008, their upside price change forecast average was +10% and downside was -9%; only a +1 net difference. But in October while investors (?) were running around with their hair on fire, the MM upside forecast average was +24%, while the downside average was only -7%, a net opportunity of +17% instead of the May 2008 near-push of but +1%.

How does their present picture compare to earlier ones?

Let's take a look again at today's Range Index distribution, with particular attention to the outliers.

In contrast to the "they can only go up" euphoria of the investing public, market professionals in mid-2008 were saying "nothing is either cheap here, or even good value" since nearly all Range Indexes started appearing in their distributions where at least 20% of the range was below the current market quotes. And about half of all stocks had about as much downside as upside.

Now the RI average, instead of 46 is 33, with twice as much upside as down. But the uncertainty range is even more limited than it was in good times 2008, 18% instead of 20%. While there is downside recognition, the upside is more tightly bounded.

And so far there is no sign of the opportunities presentable in a fear-driven situation.


We take this to suggest better odds for profit in near-term (3-6 months) investments, but smaller payoffs in the process. The building presence of very low (negative) Range Indexes indicates a gathering concern on the part of MMs, but not yet to a degree that even begins to suggest public investor concerns. When such concern will develop, GOK.

But long-term investors, particularly of the buy-&-hold type, need to be building warchests for possible advantageous opportunities to add to favored holdings at more reasonable prices than those seen in recent times.

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.