The essence of valuation lies in comparing like things. While that is difficult even with specific companies, like Ford (F) or General Motors (GM), when it comes to choosing between ETFs of Nasdaq big caps (QQQ) and strictly financial stocks (XLF) or emerging markets shares (EEM), how can it be done?
We think we have an (but not yet the) answer. To get to it, let's look at a comparable approach to values in another investment area, real estate.
There, value suggestions are usually based on comparable properties, and their relevant features. Now while there may be hundreds, perhaps even thousands, of places in Dubuque of the same square footage, number of bathrooms and bedrooms as a hypothetical Malibu pad being considered, the most important dimension in real estate takes over. Location, location . . .
All of the comparables offered up will be in the neighborhood. Similarly, investment comparables need to be regarded in terms of their most important dimension. Price. Not just today's price, but where it may go in the foreseeable future, and what may happen to it on the way.
Since every equity investment is worth just what some other investor is willing to pay for it today, based on what he or she thinks some other investor is likely to be willing to pay at some point in the future, it makes sense to find appraisers who have demonstrated skill in their vocation. The equity markets and the market for equity appraisers make that job easy.
Folks putting their firm's capital at risk in hundred-thousand to million-dollar-plus lumps, hundreds of times a day get paid multiple-million-dollar yearly compensations because, being good at it, their pay and bonus is only a small fraction of what they make for the firm in a year. And there is a line-up of young tigers eager to take their jobs if they get tired or falter.
The firms have the best instantaneous world-wide information gathering systems to make as sure as possible that they don't let their big fund clients blindside them as large chunks of portfolios get adjusted. The information gathered includes all the fundamental and technical analysis available, perhaps even some intelligence not supposed to be circulated. Some firms in dealing with their clients and the muppet public may have a P.T.Barnum, vampire squid philosophy approach, while others take a longer-term view of golden geese. But all are competitive, and must be to survive.
An important part of this appraiser community's skill set is knowing how to, and when to, lay off risks that must be taken. If the cost of risk insurance still leaves a profit in the transaction's trade spread for the trade facilitator, the deal gets done. Otherwise . . . next? It happens thousands of times a day.
If you think trading big blocks of stock can get vicious, think again about the price insurance market. There, the sellers are typically other houses also doing the block trade facilitations, equally well informed and active, but their prop trade desks are charged with the mission of getting the last possible buck out of the concern in every trade over what might happen to that stock's price next.
Part of that process is a negotiation between the trade facilitating house and its client as to what it takes to get the proposed order filled within the acceptable time contemplated. Will they pay up to get this deal done, or is it going to be . . . next?
This essential protection game can't get accomplished without leaving footprints in the markets. Those can be translated into what must be the concerns of the participants about likely price possibilities at the time. We know how to make the translations.
As important, we have over a decade of daily score-keeping on how well the market-making community has foreseen the subsequent price actions of over 2,000 widely-held and actively-traded stocks and ETFs. We trust, but verify, in the weeks and months after forecasts for each issue, at various levels of trade-offs between their then upside and downside prospects.
So, our way to compare the otherwise incomparable is both quantitative and qualitative. First, find what skilled appraisers think is the reward-to-risk balance in price prospects, and then consider what the odds of success may be for a likely payoff.
These common denominators can bring Dubuque and Malibu a lot closer. We don't promise a rose garden, but experience shows it to be better than the typical cabbage patch, and far better than the ungraded toxic hearsay dump.
Regular readers of our Forbes.com investment letter Block Traders' ETF Monitor are familiar with our usual pictures of the odds-weighted net payoffs for the specific ETFs in each of our ten arbitrary groupings. At present, most of the few long-position opportunities are in the set that is architected to produce augmented returns from the fund's structural leverage.
In contrast, those ETFs so structured in the opposite direction, to produce gains or leveraged gains when a long position in the fund's holdings are going down, show a strikingly different picture. Here is the difference, shorts first:
(click to enlarge)
From an overall market outlook, the message seems clear. Downside bets may be dangerous to your financial health. But just how soon might the upsides be realized? That is concealed in the calculations, which have a patience limit of the next 3 months. So recovery could occur before the November elections. Politically that could be read either way.
Biggest bang for the buy buck now comes from DRN, a (3x) leveraged long fund of real estate stocks. Its upside target of a +10% gain has a 7 out of 8 chance of being reached, based on over 300 prior such forecasts. Average time taken to get there has been less than 5 weeks, magnifying the target prospect to an annual rate of return of 175%. Possible drawdowns on the way to target from similar prior forecasts have been as bad as -13%, and have averaged -10%.
So you can decide. Now, or . . . next?
Disclaimer: The foregoing forecasts and underlying analyses are the results of observations made by Investment Professionals other than ourselves and their opinions are subject to change without notice. Any forward-looking opinion is necessarily constrained to the available data in hand at the point in time of such opinions; further, there can be no guarantee that such opinion is accurate or complete. No warranty, express or implied is made that any such opinions can or will be profitable. All liability for damages or loss, direct or consequential, including but not limited to the use, misuse, unavailability of service or from other causes rests solely with the user. Reproduction of charts and graphs is allowed for the exclusive use of the subscriber only. Distribution in whole or in part by any means without prior written consent is not authorized.