The Stock Market Is Not A Slot Machine, Nor A Vending Machine

| About: Constellation Brands, (STZ)

Summary

How you use it defines, for you, what it is, or can be. For some perhaps a plaything, a form of challenging entertainment, with $ costs and ego payoffs.

For most investors it is a means to build wealth over and above frugality and saving.

But those focused on entertainment may have a better understanding of the game nature of the proposition. Every trade has two sides, every result involves two players; it’s a game.

Stock investing entails risks and opportunities. Deny one and the other is harvested. Just like thermodynamics, nothing is created, only transferred.

Other players changing their minds makes winning in this serious game far more difficult than putting quarters in the slot to get a soda, sushi, or a candy bar.

Play the players, not the game

When you are playing the game (paying attention to what has happened, to try to decide what you might do next) other players are playing you. They are much more interested in what you are likely to do, than why you think what makes you do it.

Constant change keeps the market churning. Change in technology, change in competition, change in consumer attitudes, desires, change in opportunities, change in risk exposures, threats.

What doesn't change? Human nature, behavior.

Financial markets anticipate, as well as react. To deal with both conditions participants must make forecasts. Good forecasts need GOOD information.

GOOD information is not to be found in MIS-information - the deluge of largely irrelevant minutia flooding the print and electronic media that tells you what you already know (or think you know) - and "interesting" tidbits that distract, but are not relevant to what you need to know.

BAD information - DIS-information - is intentionally misleading falsehoods, usually cleverly disguised and presented at times and in ways to get you to do what will help others while hurting you. Value transferred, not created.

Behavioral Analysis

Academics are busy building a school of thought, called "Behavioral Finance", to be taught to students, the public, and (hopefully) to fee-paying business-consulting clients. They attempt to present a need for the subject by creating terminology that helps to illustrate, using long-known errors of perception. Human errors in the form of optical illusions and other common, often trivial, judgmental mistakes frequently made temporarily by humans who, quickly recognize, correct, or adjust for them.

Hopefully this stage of introducing a notion to an "educable" public will evolve from the defense of preventing or minimizing harmful behaviors. It may evolve into a more useful stage of seeking constructive and productive results by identifying and utilizing behaviors of humans that demonstrate desirable developed skills.

Analysis of intelligent behavior

Several years ago we shifted from the conventional focus of gathering (hopefully good) information raw materials for decision-making. We instead put the focus on the behaviors of folks who in-place had the resources for gathering and evaluating that information. Folks who continually demonstrated the value of their behavior by long-term employment for firms rewarding them at enviable 7-8 figure annual compensations.

Fortunately, their behaviors leave unmistakable tracks in accessible public records. And the reasons for their behavior are clear and positive - greed and self-protection.

They have learned how to position themselves at minimal risk between those who want to buy securities, and others who want to sell them. The buyers and sellers have justifiable reasons (in their own minds) for their desires. The middlemen have built supporting resources to aid in the economical transfer of ownership, and have developed the intellectual skills that allow them to capture significant values in the process.

What is the intellectual magic?

It is a combination of continual presence and arbitrage supported by constantly evaluated world-wide 24x7 information gathering systems and staffs.

The middlemen involved here form a community of market-makers [MMs] who provide big-money fund managers the ability to accomplish multi-million-dollar fund-holdings adjustment transactions. These are trades in limited-time-span (minutes to hours) negotiations at transaction costs compatible with the objectives of the transaction.

This is possible because existing broad markets for equity securities are geared to near-instantaneous trades in small dollar amounts with minimal price change. Their "regular way" transactions choke on volume (block) trades, which must be negotiated between volume buyers and sellers. The market-maker community has had a presence in this negotiating role for many decades, so they are well known to the big-money-fund community.

Likewise, the fund-manager community is well-known to the MMs who have direct phone lines to their trading desks, where they communicate on an instantaneous, as needed basis, dozens of times a day. As they have for years.

The MMs know what each fund owns, what their average (and recent) costs are by specific security, thanks to updating services provided by contract-subscription firms. They also know the habits, proclivities, and preferences of the client trading desk personnel. Hockey and basketball game entertainments have been known to play a role.

Key in the MM advantage is their awareness of "order flow". MMs are in a unique position of being part of the communications bridge of buyer~seller negotiations. As a group they know when there is building volume pressure to trade specific stocks, from which direction the pressure comes, and the instant that direction may change.

All this is extremely valuable, so it is closely guarded. The street maxim is: "Those who talk don't know, those who know don't talk".

Buyers and sellers of stocks are in a negotiating war on each trade, and "know your enemy" is just as relevant in this combat field. Because of this the MMs carefully hide their client's identity, although within the MM community the knowledge of what fund organizations have appetites for which securities helps insiders to often have good ideas of who may be involved. They may use those notions, and their "feel" of the market-moment to engineer the cost of the transaction to their own advantage.

That transaction cost typically includes the price of providing "market liquidity". The term refers to the MM's provision of that part of the "other side of the trade" which can't be obtained from other big-money funds or the investing public. The MM fill-in position allows the trade order initiator to get its order "filled". The temporary capital commitment in so doing puts scarce-resource MM firm capital at market risk, and is restricted from further use. Such capital can be liberated for use multiple times in the trading day if the risks it faces are offset by a hedging deal. So greed for the capital re-use, and fear of its damage by being diminished requires hedging.

But there is a cost for the price-change protection provided by the hedge, and it must be part of the trade spread quoted to the fund-manager trade initiator. Too big a cost kills the deal, and then neither the block trade MM negotiator nor the (often) other MM firm proprietary trade desk seller of the protection will get paid. All three parties have their big-boy pants on. Yet hundreds of such deals are done every market day.

How to know the MM price expectations

The result is a revelation of what realistic coming price range possibilities exist in the minds of the arguably best-informed players in this serious game. The protection prices paid, and the structure of the protection deal tell the story. And it is a significant story, since the originators of the trades are the ones with the money muscle that moves market prices.

Not so with the High-Frequency-Traders [HFT], a crowd dealing in nanoseconds, fractions of a cent, and cancelable information-seeking orders. They are liquidity providers for "regular way" trades by the individual investor public.

MM behaviors reflect the open competition between buyers of price-change protection (the block desks serving client funds) and the sellers of that protection (the proprietary trading "prop" desks of other MM firms) evaluating the same price change possibilities from the opposite perspective, equally as well-informed as the block desk buyers. Together their appraisals get reflected in the prices and contract structures of the derivative securities used to provide the hedge.

We have been translating those public records daily since the turn of this 21st century, and weekly for decades in the 20th. Formerly the weekly appraisal forecasts of the MMs were sold only to a limited number of major buy-side institutional investing organizations.

With the advent of more timely daily forecasts its suitability to the needs and objectives of individual investors became apparent. Further, we became concerned that its provision as a feedback into the institutional community might undermine its value by impacting the process. So we allowed the natural people turnover there to let us exit gradually, arousing little notice, from that market.

Now the daily outlooks are only being provided to individual investors on an unscheduled, opportunistic publication basis through Seeking Alpha. Here is an illustration:

What Market-Makers see in Constellation Brands (NYSE:STZ)

They don't see an alcoholic beverage purveyor, they just see a stock that some of their big-money fund portfolio manager clients have run up in price quite determinedly over the past couple of years. For the MMs, it is just another vehicle. They don't hate it or love it, but as long as it continues to warrant block trading activity they're all over it, like white on rice.

The last six months of market traffic has urged them into block trade "facilitations" requiring temporary commitments of firm capital that has to be protected against potentially damaging price changes. Each time, a hedging deal is constructed that (unintentionally) reveals just how far the MM community thinks its price might get pushed in the next few months -- both up and down.

Figure 1

(used with permission)

The vertical lines in this picture span the range of price possibilities worth protecting against, with a heavy dot of the market quote at the date of the forecast. That quote separates the range into upside and downside price change prospects. A metric called the Range Index [RI] tells what percentage proportion of the whole range lies below the then current price, the perceived risk. Low RI = a stock cheap relative to expectations.

Today STZ's RI is 26, which means the MM community sees three times as much upside price gain possible as there may be price drawdown exposure. That sounds kind of good, but how has it worked out in the past?

The small blue thumbnail in Figure 1 places a 26 RI in the array of RIs over the past 5 years as pretty low in the distribution. That's good, but doesn't tell how big a payoff is in prospect, or what the odds are that a buy today might not be profitable.

Figure 2 is a scatterplot relating each forecast available in STZ's market history (since the beginning of 2007) with the profit or loss outcome of being subjected to a standard-measurement portfolio management discipline, TERMD. A hindsight-proof metric, TERMD is the acronym for Time-Effecient Risk Management Discipline. In it a buy position established -- at a cost of the closing market price the day after the subject stock's forecast is made -- is closed out at the first instance of a subsequent closing price equal to or greater than the top of the forecast's price range. If that hasn't happened in 3 months (63 market days) then the position is closed out regardless of gain or loss. All closeouts make the liquidated capital available immediately for an alternative commitment.

Figure 2

Click to enlarge

(source: blockdesk.com)

The payoff extremes in this scatter diagram are the result of the 2008-9 market episode. Otherwise, the relationship between RI and payoffs is reasonably expressed by the solid line of best fit. Better and more frequent profits result from lower Range Index forecasts. Figure 3 shows this more clearly.

Figure 3

Click to enlarge

(source: blockdesk.com)

STZ's odds for profit under TERMD discipline generally range from 70 out of 100 to 90/100. The size of the payoff typically declines as RI levels increase.

This Odds and Payoffs relationship is made specific to today's STZ forecast in Figure 1. The row of data between the two blue-background pictures shows the Win Odds at 95/100 and the net payoffs at +12.2%, drawn from the experience of 75 prior forecasts with RIs of 26, out of the last 5 years' daily forecasts.

The achieved 12.2% payoffs compare with the current upside forecast of +8.6% to provide a strong credibility ratio of 1.4. The associated risk element is an average worst-case price drawdown experience in those 75 prior positions of only -2.9%. The ratio of forecast reward (+8.6%) to this risk is nearly 3 to 1, quite attractive in comparison to other alternatives available at present, as seen in figure 4.

Figure 4 Click to enlarge

(source: blockdesk.com)

This is a summary of our daily ranking of the top 20 stocks and ETFs in a population (today) of 2,650 equity issues (out of some 3,800) with sufficient market information to derive forecasts passing our quality controls. STZ is among the top 20, and its comparable data to Figure 4 is the data row in Figure 1. STZ appears to be an attractive candidate at this point for investors seeking wealth-building vehicles for actively managed portfolios of the type suggested by TERMD or the like.

Conclusion

This is a tough game. Big-money fund managers are doing well if 55-60% of their trades turn out to be profitable. Price range expectations of the MM community are reached in many cases 75% to 85% of the time to the upside, and more frequently to the downside. Which often makes them worth knowing.

If your investing objective is wealth-building rather than income or entertainment, you should focus attention on price change potentials and the expected time periods their investment may require.

That is because in today's rapidly developing technological world change brings uncertainty. And uncertainty results in price decreases as well as increases. Each year most stocks range in price, from low to high, multiples of their percent change in earnings.

So it is important to take care in when investments are made, and when it may be time to move from one highly productive investment to another, while the gain is still yours. You won't do it perfectly, but with frequent attention and good comparisons between alternative choices, far more productive rates of wealth-building can be achieved than by simply buying and holding things while they go down.

Disclosure: I/we 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.