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Human Nature & Market Perspectives

We don’t pretend to know where the overall market is going, or why. But we do know what people who regularly enjoy $ million-plus annual take-home pay think is likely to happen in the next 3-6 months to many stocks, ETFs, and market indexes. They tell us, unintentionally, through their risk-aversion hedging actions.

What Can Be Learned From Past Forecasts

The bulk of capital committed to ETFs is in those that track major market indexes. An overall perspective of investor expectations may give clues to what will happen to the market indexes next.

To that end we aggregate the daily forecasts inferred from hedgers’ and market-makers’ self-protective actions as they deal with interests in, and concerns over, some 2,000+ stocks, ETFs, and indexes. The two pictures below draw on 11 million such forecasts collected live since the beginning of the year 2000.

Upside and downside expectations are pictured separately. In each, the broad vertical blue bars measure the proportion of all forecasts indicating potential percentage price changes on the scale at the bottom of the graph.

The colored lines running across the background of those blue bars are the same data as the tops of the blue bars. But instead of being a 10+ year average, they are proportional measures of one day’s set of forecasts. The green line was taken at the market’s most recent low, March 9, 2009, the red line at its high on October 9, 2007, and the yellow is of Monday, March 15, 2010.

Upside distribution through 15-Mar-10

Upside forecasts seem rather rational, relative to one another. While the historical average has a strong optimistic bias, at times of record highs that red distribution is more restrained. After markets have dropped and are about to recover, the green expectations are clearly more enthusiastic than average, yet realistic about the potential for advances.

Downside forecasts have a different character.

They do not span as great a divergence from zero as upside expectations, on average. Optimism again. But in good times they get a bit, well, more human. The prevailing attitude is “let the good times roll, this is the way it ought to be, enjoy it.

Downside distribution through 15-Mar-10

In bad times, “Woe is me” green takes over from “What? Me worry?” red. The recognition of how bad it could hurt gets way beyond normal, with larger projected proportions of severe declines and smaller proportions of the normal, lesser declines.

The span of upside and downside estimates in good times contracts, and expands in bad times. This is what is seen in the CBOE Volatility index (VIX). Don’t get distracted here by those details.

What should be of current interest is whether the “now” yellow line looks more like the red or green lines, or is someplace nicely in between.

For the downside at this point there is no debate; yellow is congruent with “trouble” red. Upside forecasts could see a bit more shift of “now” toward the red “market top.” But there’s not much room for enthusiasm and normal larger expectations are already diminished, accentuating the usual center of gravity.

So, how will the present situation be resolved? It could go into another market drop – we’ve recently seen a -9% airpocket. The year-ago low is -45% below where we are now.

Or, more constructively (?), the world’s economic woes may respond to the combined balm of Madison Avenue and Wall Street, and US consumers, dumbed-down by the educational establishment, egged on by too-big-to-fail banks, will come again to believe they can spend money they haven’t earned, so market optimism will once more return. If it does, then a persistent upside yellow-line shift back to prior averages, or beyond, will save us all.

You may sense my bias, but many things are possible, and it is in the nature of stock markets to surprise.

Copyright © 2010, Peter Way Associates. All Rights Reserved

Disclosure: No current VIX positions