Investment Thrills: Discovering The Little Known? Or Making Huge Profits?

Includes: DRN, SPY
by: Peter F. Way, CFA

If, for you, investing is an entertaining hobby, there can be great satisfaction in finding some usually ignored, obscure but uniquely promising enterprise, priced at a single-digit P/E that is about to be thrust into public recognition.

Additionally, if you write a blog or if your ideas have other public exposure, there is also the ego-pump of having been among those early to draw the attention of your peers to its attractions.

But when it comes to that single-digit P/E, many times the undiscovered are tenacious in retaining that valuation. Your discovery may be deserving of attention, but somehow the payoff remains a distant future prospect even after it is revisited further out in time.

For many investors, such an approach is an unaffordable luxury. They (we) are in it, most of all, for the payoff. Times are tough, and incremental income may be scarce.

So how to find the present-day value that is likely to have rewarding tomorrow-day recognition? We think it's better to have a sharp focus on probable price change prospects among large numbers of alternative investments than to spend time intensively searching for an ignored treasure here and there.

We come to that conclusion because stock prices are inherently "noisy" over "manageable" time periods of a month to a year, offering abundant opportunities to profit from skillful identification of the odds for prospective payoffs.

For some that isn't investing, it's just "trading" or "opportunism."

When the profit potential is examined under a disciplined approach with rigorous value objectives and risk exposure limits, shorter-term investing is simply shopping for good gain potentials on a less forgiving basis, with clear-cut return potentials and an intolerance for wasted capital investment time.

Here is what it takes to exploit that approach:

* First, identify a competent source of stock price change expectations.

* Next, get them to regularly tell you what they expect, and record their projections.

* Then test their prior forecasts to find the stocks in which they have consistently scored.

To offer a current example of what that can provide, first, let's establish a sense of what is typically seen by competent price forecasters by looking at two ETFs.

SPDR S&P 500 (NYSEARCA:SPY) is one of the largest Exchange Traded Funds, tracking the broad large-cap market index most widely used by professional investors to gauge price changes by the stock market. The $118 billion of capital committed to it sees 120 million shares traded daily, such that its total a.u.m. (assets under management) is fully turned over every 8-9 market days. It has been around over a decade.

The Direxion Daily Real Estate Bull 3x Shares (NYSEARCA:DRN) is a smallish, actively traded (12 day full turnover of its $100 million a.u.m.), highly leveraged Exchange Traded Fund with a transaction history of over 3 years.

The volume market-makers are essential players in providing the liquidity which assures that prices truly reflect what buyers and sellers can agree on without big jumps in price from trade to trade, regardless of how lumpy in size the orders are confronting the market. Regularly they are needed to put at risk their own firm's capital to make that value continuity happen.

Their jobs require that they have a sense of what may be coming next, since there is an ever-present hazard that some buyer or seller has possession of information that is certain to move the stock's price when known by others. If the market-maker doesn't know it first, in the parlance of the business, he "gets bagged" and loses money.

To minimize such losses, market-makers do two things. 1) They maintain world-wide information-gathering systems with instantaneous 24x7x365 communications abilities that have been expanding their reach (and grasp) for decades, and 2) they buy price change insurance as protection against developments that they may not yet be aware of.

Few certainties exist in the stock market. One is that the market makers are going to know more about any actively-traded stock or ETF than you do. You might be able to ride on their coat-tails, but rarely will you be able to get ahead of them.

Let's go back to the ETF examples offered. In each one, the market-makers are the dominant players in the price-change insurance market. That market is the one in listed options. They typically make up 2/3rds to 3/4ths of the transactions there, and they are continually present. Their presence sets the prices in that market. Your 5-lot trade is less than a sneeze in an open interest of hundreds of thousands of contracts, all of which are interrelated.

What they will pay to protect themselves from being bagged by their big-money fund clients, and the way they seek that protection, tells rather precisely just how far they think those clients are counting on the prices to run; where the clients are likely to step in to add to existing holdings, or to bail out. After all, the market-makers are in phone conversations with these clients dozens of times a day, working to get their orders filled. Having such conversations over periods of years develops insights into how people think and act.

Few certainties exist in the stock market. One is that everyone makes mistakes, no matter how extensive their resources, experience, or incentives. Including market-makers. But they may well be the best price forecasters in the game, and so we choose to rely on what they tell us, remembering that every forecast has odds of success and failure attached.

Market-maker protective actions define price ranges that are often invaluable guides to investment action. Much of the time they are far less so. Sorting out which is which depends on the extent of the imbalances between the stock's upside and downside price change prospects and upon the expected behavior of the players in the game toward that stock's past price actions. Each stock has its own special character.

So we look first at the array of forecasts implied by the market-maker protective actions, and the upside-to-downside imbalances they present. To make those imbalances less unwieldy, we describe each forecast with a term of Range Index that places the stock's current price as a percentage in a span where the low forecast = zero, and the high forecast =100. The lower the RI, the more upside price change prospect it has, the higher the RI, the greater the drawdown exposure may be in its picture.

Here is how SPY's Range Indexes have been arrayed over the past 4-5 years since mid-2007, including the 2008-9 crash. This distribution is from an actual count of implied forecast RIs; it is not the product of some statistical formula.

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The average here of 43 may strike you as an optimistic bias, somewhat more upside than down, as the usual outlook. A 50 RI indicates a forecast of as much likely upside as downside.

Please keep in mind that few serious investors are likely to put their capital at risk in coin-flipping activities. The imbalance suggested by a RI of 43 may be what it takes for realistic, well-informed and well-adjusted (emotionally) investors to consider a "fair" starting point for any proposition.

Now let's see what has been the actual next-3-month behavior of SPY prices following each date of forecast. The proportion of higher vs. lower end-of-day (e.o.d.) comparisons with the forecast day's price gives a rough sense of the ODDS of what might be the result of a "blind" exit from a buy at a RI at some given level.

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The actual price changes subsequent to the array of forecast RIs suggest that market-makers active in SPY have a fair sense of the probable coming bias of market price changes, at least as they are reflected in the S&P 500 index. In an interesting, perhaps coincidental, result, the higher/lower odds cross over right at the 50~51 RI level.

Now we need to consider how large those average price change PAYOFFS have been to see if this is a game worth playing. For some it may be. Probably for many individual investors, it might not. The next picture tells that story:

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Volume-trade transaction costs, professional trade spreads, and advantageous margin rules make 1% or less advantages very worthwhile for the pros, especially when captured thousands of times a day. But for the individual investor, these pictures mainly just reinforce our assertion that there is a very logical, reasoned process going on here. That notion is furthered when these rather similar, opposite costs and opportunities are coupled with their related odds of occurrence.

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This picture confirms that when market-makers see more upside than downside in the SPY, the odds-weighted payoffs are likely to produce gains in the next 3 months. More so, as the upside-to-downside imbalance approaches (but does not yet reach) a 3 to 1 ratio (a RI of 25).

Conversely, at the point where the other half of forecasts favors more downside than upside (RI=43~44), the odds-weighted result turns negative, in increasing severity to about 5 out of 8 losers (a RI of 62), but remaining in negative territory throughout.

So this provides what a reasonable proxy for what the overall market looks like, behind the trading curtain. Let's see what might be offered in profitable but not-average situations. That's the role of the DRN.

We can parallel the presentation used for SPY to best highlight the advantageous differences offered by DRN. They start with half of its forecasts presenting equal amounts of upside to downside, not the 43-to-57 proportions of SPY. How that will play out will become apparent as we proceed.

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The ODDS of actual price change direction heavily favor RIs that show any balance in the direction indicated. This suggests that these market-makers are sensitively attuned to the inclinations of their clients.

While what I am describing as a selection/evaluation process is far from the conventional thematic approach to ETF selection, there may well be buried in it a sense of big-money-fund portfolio manager attention to the real estate focus of DRN.

Real estate was the principal cause of the 2008-9 market crisis, and it is not unrealistic to reason that the funds' management pros would be alert to and expect an ultimate real estate recovery. The subsequent price changes in DRN as telegraphed by the m-m's forecasts may indicate a keen sense of how those prospects appear and disappear.

Now let's see if those PAYOFFS make our attention worthwhile. Remember, the deck is stacked in our favor, with a 3-to-1 structural leverage in the holdings of the ETF.

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Oh boy! Gains averaging between +20% and +30% all across the array of bullish Range Indexes, while the losses incurred at just about any time hover around the -10% level. We have to know what is coming when the gains and losses are weighted and netted against one another across this whole array of RIs.

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Odds-weighted returns netted against one another produce risk-balanced returns approaching +15% nearly everywhere a DRN Range Index is below the mid-40s. That potential reaches up towards +20% as the RI declines to 25, the level where forecast upsides are 3 times the downside.

The orange vertical bar signifies the current DRN Range Index. If markets of the next 3 months behave exactly as they have over the past 3+ years, there should be a +14.2% gain in our future. But don't get carried away with precision, because while markets may approximate what they have in the past, this game is an art form, not a science.

Remember, it all depends on what somebody else thinks still another person might pay for DRN out there in the future.

The above pictures show price and direction averages over periods of time. That's not the way most folks make investments. We make a decision to commit, and once the trigger is pulled, we look to find some reason to change our mind. Hopefully that will be of the "take the (more) money and run" family, rather than the "Uh-oh!" variety.

We have a more realistic, standardized test of investment performance that fits this kind of information. It consists of deciding on some level of Range Index (like today's), or any more favorable, that should prompt a buy action. Then, going back in time as far as is relevant or we have forecasts available, we take as a sell target for that buy the top of the price range forecast for the stock in question.

Then we look to see how soon that target is achieved by an e.o.d. subsequent price, and close out the position and measure its gain. If the target is not achieved by the end of 3 months, it gets closed out regardless of how much it may have gained or lost.

Here is what is obtained for DRN, at a Range Index trigger of 42, the recent RI.

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These 201 buy decisions were about one-quarter of the 808 forecasts we had available. Of those buys 25 wound up losing money, but 7 out of 8 were profitable at an average of +15.7% including the losers.

By properly chain-linking each position's 1+gain amount times the cumulative product and determining the average daily change achieved in the time the holdings committed capital, an annual rate can be calculated.

Those positions were held an average of 34 and a half days, which yields an annual rate of gain of +91%.

That's a nice result to contemplate. But then, when we commented on DRN in our earlier article Comparing Incomparable Investments: ETFs, its 11% upside target was achieved in only 10 market days. You just never know.

But in fact, every day we review and test out over 2,000 stocks this way, and come up with at least a half dozen or more that, at their present Range Index, have come up with many instances of gains and losses that in combination are at triple-digit annual rates.

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.