Market Outlook By Market-Making Professionals, Part 2

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.

In part 1 of our Market Outlook article, we explained how Market-Maker [MM] expectations are derived and then converted into explicit price range forecasts. From those, Range Indexes can be measured and compiled each day to picture the current bell-shape distribution of forecasts for over 2500 equity investment instruments, stocks, ETFs, and market Indexes.

Interesting perhaps, something new to contemplate, but not a presentation with which many investors are comfortable. Most are used to seeing time series of one or a few factors pictured so as to observe interrelationships of change across time.

With daily data for the various forecast components, perhaps we can provide a better perspective if we look back daily at the past 5+ years, including the "Great Recession." Let's see what was actually happening to equity forecasts during and after that period of stress.

The trying year, 2008-2009

We took all the 2,000+ forecasts each day and calculated the average upside and average downside change implied to be possible. Here is how those averages trended over the five years from the beginning of 2008 to the present of mid-2014:

As the trauma of 2008 unfolded and equity prices plunged, forecast reductions could not keep up, and apparent upside prospects (green line), which had drawn back a bit from July, expanded widely above +20%. They were illusory.

Likewise, downside forecasts (chart red line) lagged behind falling prices making the risk concerns appear not as real as the market behavior. They got taken down in earnest by October and November, although the trauma actually hit in August. December 2008 was the most pessimistic period, with average downside forecasts reaching -14% (0.86 - 1.00). As 2009 grew into early March, the downside norm regained to -10%. It had started 2008 at -7% or -8%.

Since the beginning of 2010 the average downside price forecast has remained fairly calm, gradually reducing from -7% to -5 ½%. Most of the recovery enthusiasm has been shown in larger upside prospects. Occasionally, like 3rd quarter 2011, they exceeded +20%. Now they have pulled back to a +12% as market prices climbed.

Having data of the upside to downside forecast balance allows us to picture that in Range Index terms, and also to calculate the degree of uncertainty involved from the bottom of the average forecasts to their tops. Here is how those compared to S&P500 market index progress:

In 2008, as Range Indexes (blue line) plunged from mid-40s to below 20, uncertainty between high and low prospects (red line) widened, almost doubling from near 20% to almost 40%. It did not return to the 20% level until the beginning of 2010. Now it is just under 20% as market indexes have climbed into new territory.

Other measures, like the volatility index, [VIX] confirm that uncertainty is at very low levels. Those who wish it were a forecasting device, rather than the after-the-fact measuring tool that it is, take the presence of such low volatility reassurance as an ominous icon. In fact, the time to use the VIX is after it has risen, because then its subsequent path then can be timely anticipated.

Instead, the better market perspective measure relates the equity asset class' Range Index to the scope of its uncertainty. Let's look at that in deeper detail to see what it really offers.

The cost of uncertainty

A simple scatter diagram of Range Index values (that portion of the forecast range below current price) plotted against uncertainty (the size of the forecast range in percent change from its lowest price to its highest) daily during the whole past 5+ years produces what would be a plate of spaghetti if it were a line diagram:

Perhaps there is something there, but the visual confusion is not encouraging because there is so much noise around the least-squares best-fit line. Within the scatter there seem to be sub-plot groups easy to imagine with tendencies counter to the aggregate best-fit.

Let's try to logically partition the time period into subsets. We offer

  • A build-up and collapse period, from start of 2008 through collapse, up to the point of the market recovery's start 3/9/09
  • A definable recovery period of 6-7 months to 10/22/09 when uncertainties leave the mid-20%s and RIs leave the mid-40s
  • A post-recovery period ever since where average forecast uncertainty sizes and Range Index downside potentials have played nicely with one another

Putting pictures of these three periods on exactly the same scales as the scatter above, with zero - zero in the lower left corner and the same upper and right-hand extremes should help all to keep perspective of the different period properties.

First, the period of build-up and collapse:

Its best fit line tends to separate the upper high-uncertainty panic and following days from the more orderly period leading up to the frights. Higher Range indexes are the market pros' inclusion of more downside potentials, and often accompany the comfort of lessened uncertainty. With a shift in recognized stress, that whole pattern here jumps up in uncertainty and moves left toward smaller forecast downsides, partly as forecasts lag price changes.

When the market senses there will be a tomorrow that includes them, and it can't get any worse than it is "now" then the sentiment changes rather dramatically, and the bargain-hunting begins. Recovery is underway.

It is not a time of change, but one of stability. The change is a failure to keep getting worse. Now things seem to be able to be counted on not to get worse. Improvements catch hold, do not erode. Eventually, things seem to be getting back to normal.

Finally, the bad times are recognized as being over and the size of uncertainty declines as prices rise while downside possibilities get even smaller, not larger. Things once again are behaving "normally."

But as Range Indexes rise (less room for prices to climb) and uncertainty declines (smaller gains to be had along with smaller risks) finding worthwhile equity capital gains targets gets harder and harder.


Our "answer," if there is one, is to avoid the market averages, however compiled, and look for stand-out opportunities that are least-impacted by the market's tidal flows. There seem to always be a few stocks or ETFs that will buck the mainstream.

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.

Active shorter-term investors need a different path.

The answer for them: Don't invest in stocks with only average prospects. Find ones with stronger than average prospects that have in the past produced good near-term gains far more often than they have produced disappointments.

We find them by looking at all the stocks and ETFs in our population, as pictured at the left of that first (7/25/14) Market Profile illustration in Part 1 of these Outlooks. Since each equity issue is most reliably its own norm when it comes to future behaviors, we analyze each one's own history of how it has behaved in the past, following prior RIs like that seen today. They are typically found at the top of our irregular but periodic Seeking Alpha article lists of most promising Market-Maker forecasts.

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.