Post-Election Market Potentials

Includes: FXE, SPY, UDN, UUP
by: Peter F. Way, CFA

Lots of folks have lots of guesses.

Unfortunately, at this stage of the political process, many of them are tainted by what doom is about to befall all of us if "the other guy" gets elected. And the rationales for consumption leading to those intended conclusions often are built on shaky, incomplete, and hugely biased data. From both sides.

This is not an election result forecast. It is a despite-the-election-result exploration.

To conduct an intelligent exploration, it is usually a good idea to know where one is starting out from. Otherwise, it's easy to get lost in the adventure.

Well, how can we tell where we (the market) are, without getting tripped up in all the politico-rhetoric?

A wise person many years ago advised me that "people spend their money on things that are important to them." For me, that's significant, because prices in the market (which, importantly, define where "we" are) are entirely a product of what players in the (very serious) game think today that other players will pay later on for each investment in question.

So I seek knowledgeable players that are highly motivated to spend "their" money protecting their million-dollar-a-year-plus salaries and bonuses by protecting the at-risk capital of their employers -- capital necessary to be put at risk to earn multiples of those compensations. Those players are to be found on the block-trade and prop-trade desks of the market-making firms that serve big investment funds and institutions.

What those blockdesk pros will pay to protect the capital required to fill the stub ends of million-dollar fund orders, and what other firms' propdesk pros will charge them for the hedging insurance, tells just how far both sides think prices may run, up and down.

Their current notions of those likely price extremes are reinforced and updated by the employers' worldwide, 24/7/365 information-gathering systems that have been accumulating technical strength and capacity for decades.

We have been monitoring their self-protecting actions daily for over a decade on over 2,000 of the more active and widely held stocks and ETFs. Our behavioral analysis model has had no significant change in all that time (none needed) and applies to each issue in the same way, producing end results that are highly comparable across equity investments of all types and interests.

Currently we have a turn-of-the century database of over 7 million separate forecasts, on over 2100 stocks and ETFs, showing each one's upside and downside price change potentials as appraised during each of more than 3200 market days. When those expectations are aggregated daily during the past five years, here is what they show:

(click images to enlarge)

The ability to separate future uncertainties of investments into upside and downside components is of considerable value, since the only time upside uncertainty can reasonably be considered risk is when the investor is in a "short" position. For most individual investors, that is not the usual posture.

But the complement to risk in uncertainty is opportunity. And when uncertainty rises, as it did in 4Q 2008, opportunity often rises. Still, the artistry to good investment risk management lies in the productive balancing of these dimensions. That scorecard should be dictated by the investor, since his/her anxiety is an often hidden, but an always controlling, individually-set factor

The quick appraisal of this broad-sweep picture is that, of late as we work through elections to the end of the 2012 year, the rising market has reduced rational upside return expectations overall, but has not raised downside concerns. This appears to be neither a fear-gripped, nor an exhausted market.

From such a broad measure of expectations, it is dangerous to generalize. The "other guy" (whoever he is in the mind of the market) might win. U.S. politicians might continue to believe the rest of the world (China, Brazil, India, etc.) will forever put up with endless U.S. dollar value destruction, and get fooled. Europe might continue to believe in national sovereignty, end the euro, and put itself back to war (internally in the form of populace revolutions). Economic viability threatened, Iran might go end-game and start a nuclear war. Or even more disturbing, some other "monster in the closet" we aren't even contemplating might make itself known. Threat potentials are endless -- some say pointless -- since they likely are already "in the sauce."

It might help to look at how the market-pro expectations look in finer detail at this point in time, compared to other times of very different circumstances.

Because we have an array of price-change potentials, both upside and downside, across this population, we can examine their intensity at present levels, on average over the decade-plus, and at recent market extremes. Here is how the proportions of the population were represented at various upside price change prospects:

The blue columns provide a background norm of upside prospects across a spectrum of varied market circumstances. The red line shows the proportions of the population with market-maker outlooks at the market's top in October 2007. The pros then had a below-average apprehension. At the market's pit in March 2009, the green-line upside potentials became sufficient to overcome fears, and the recovery began.

Now, in yellow, we crowd the red line's full-priced posture, but are still close to the multi-year average distribution.

Downside concerns appear to be more complex. In the same format on a negative horizontal scale, again the blue columns provide the long-time average.

But apprehensions at the market's top were accompanied only by normal downside concerns. And it took the presence of pretty extreme fears to create the accentuated opportunities seen in the green line on the upside picture.

Now about the present. The abnormal concentration of limited downside prospects has been going on during most of this year. To me, it says that Mr. Market has been waiting for things (election, fiscal cliff, Europe) to become resolved, with the conviction that they will, and as they are, corporate cash hoards will get put back to work, marketers will figure out how to get consumers to spend some of their new savings because it's not the end of the world, folks will gradually find re-employment, and the market will march forward and upward in a reasonably disciplined way.

Or not. We rarely find future price appraisal odds at 100 to one, and never (that we believe) at 100 to zero.

Disclosure: I 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.