Buy Apple, Amazon, Or Google? A Behavioral Analysis Update Of Market-Maker Hedging Actions

Includes: AAPL, AMZN, GOOG
by: Peter F. Way, CFA

What market-makers will pay to protect their at-risk capital commitments, required by competition for trade orders from big-money-fund clients, tells just how far they think prices of these stocks may go.

How well their prior forecasts, with an upside-to-downside balance like today's, have fared in the past, tells how strongly we should believe whether these forecast price ranges may come to pass. That also provides the typical odds and payoff experiences to compare buy choices between Apple Inc. (NASDAQ:AAPL), Inc. (NASDAQ:AMZN), and Google Inc.(NASDAQ:GOOG).

These forecasts are not simple assertions of opinion by observers of questionable qualifications, merely based on past history, but are sound, logically-derived, forward-looking beliefs, backed with major real-money commitments, made by highly experienced folks in positions to be among the best informed in the business, on both sides of each million-dollar-plus trade.

As always, there are no guarantees in this business. But at least we have hard evidence of the odds for success from their similar bets placed in the recent past. Ones which give a sense of the drawdown risk present, as well as the potential payoff rewards. No hand-waving, "fuzzy logic," obfuscation-by-generalization here, just solid, comparable metrics.

The three companies are all vital, highly competitive, technology giants. Economic disaster is not likely for any of them. Corporate profits are assured by their product markets and consumer appetites.

But that is not sufficient for our investment success.

Intelligent Behavior Analysis

What matters in the market are player perceptions of future value.

This is a very serious game in which every investor's every outcome depends on an action taken by someone else. That is what makes it a game.

And the most advanced stage of any game is where players, in addition to skillfully playing the game, win by playing the players. As is done in chess, poker, and bridge.

The same information technology that makes AAPL, AMZN, and GOOG intriguing to investors is what is increasingly making the investment playing field, once a more-level terrain like Kansas or Florida, now more like the Andes, Alps, Himalayas, and Rockies.

But knowing what the most skillful players in this game know (and act upon) becomes a vital resource. We can't beat them at their game, but because of our differences in size, we can piggy-back on their unintentional guidance.

Let's look at how they think the prospects of risk and reward compare among our three principal subjects, and some other relevant alternatives. Here is a layout of the prospective upside and downside percentage price changes they thought were possible in the coming 3-6 months as of last Friday.

(used with permission)

In this opportunity map long-position investments appear undervalued in the lower-right green area and may be subject to drawdown risk as they approach the upper-left yellow and red sections. Equal up-to-down price change prospects are along the dotted diagonal.

Our subjects of interest are numbered 1, 2, and 3, with key market indexes at 4, 8, and 9. Other more marginal industry competitors at 5, 6, and 7 add a sense of perspective.

How Market-makers Hedge

First, a word about the index forecasts. Their source, as with all our forward-looking data, comes from the hedging done by market pros in the listed options markets. While stocks and ETFs have investable option underliers, no such direct instruments are available with these indexes. But the intensity and volume of their options activity makes it clear that their principal use is by market professionals to protect against general equity price change in various broad sectors. So they provide an environment forecast for general comparison.

Their position in the map makes clear a more subtle dimension. Forecast uncertainty, as reflected in the size of the prospective price range, increases with each plot's distance from the lower left corner. Index forecasts, due to their diversification, tend to be more restrained.

Our three focus companies, AAPL, AMZN, and GOOG, all suggest higher uncertainty than is seen for the market, but the balance of that uncertainty between reward and risk is seen to be at least as favorable as the market for a prospective buyer or holder of a long position. The three other industry comparisons, Yahoo (YHOO), Hewlett-Packard (NYSE:HPQ), and BlackBerry (BBRY), all offer less encouraging, but still positive, balances.

Well, is the answer to the buy question clear? Does AAPL dominate all others because of its +18% upside forecast and near-zero downside exposure?

Not so fast. Market-makers are not God-given visionaries of the future, they're human like the rest of us. Despite their extensive information and other resources, nobody in this business, besides B. Madoff, bats 1.000. (If you don't know what he did, Google the name.)

How to Handle Uncertainty

What we do to recognize that reality is to look at all the daily forecasts they have made on these stocks in the past 4-5 years and see what has subsequently happened to prices. We look at all forecasts that were at least as attractive as those of the present. The table below shows how AAPL appeared then:

AAPL's price range forecast indicates a potential price rise of +17.5%, and a possible drawdown exposure of -1.2%. Unfortunately, the past 25 experiences (out of 1261 days in the last 4½ years) have encountered maximum drawdowns in the 3 months following each forecast averaging -14.8%.

So the market pros were way too optimistic in their downside judgments in many of these cases. That had the effect of reducing the win-odds ratio at this level of upside-to-downside forecast to only one out of five, shown in the table above as 20/100.

That result is the product of applying our standard procedure of testing forecasts. In it we close out hypothetical buys from the end-of-day price of the day after the forecast as soon as the high forecast price is reached at the end of a subsequent day, or 3 months (63 market days) later, whichever comes first. Here, in 20 of the 25 signaled buys, the 3 month closeouts were at prices below cost.

Growth vs. Value Stocks

This kind of effect is common stocks that are regarded as "trend-following," "growth," or "momentum" issues. If their basic economic circumstances do not change materially, the over-emphasis on price, good and bad, eventually reverses and longer term, they follow a cyclical path, often with an underlying trend. While their owners may get growth, it comes at a high price of periodic emotional distress, and considerable cost in terms of time squandered.

Here is how AAPL's forecasts look in that longer-term (2-year) context. When the turn will come is not yet evident.

Now, only a few days later, is a fresher look at the earlier comparisons, after markets have recovered a bit.

(used with permission)

The index forecasts are at 1, 4, 9, and 10. AAPL is at 5. HPQ and BBRY are 3 and 8, with equal or greater upsides, but at a cost of much higher downside risk exposure. AMZN at 2 has slightly less upside potential than AAPL, but less risk exposure. GOOG and YHOO at 6 and 7 suffer both higher perceived risk and lower returns than either two members of the "A" team.

Apple vs. Amazon

So let's take a look at the odds and payoffs comparisons between AAPL and AMZN. Here is what AMZN now looks like:

To be fair, the past few days have significantly changed AAPL's appearance, for reasons that are to be the subject of a subsequent discussion. The current comparison for AAPL is:

The two stocks appear to be almost an even contest, as the market-makers see their big-money clients prepared to act upon them, and as history of prior forecasts for each have performed.

Both have experienced modest drawdown risk exposures at their worst. Their payoff percentages at these Range Index levels give AAPL a slight edge. But that advantage is dulled a bit by a longer holding period (of a market-week), which puts the annual rate of return difference between them (45% vs. 42%) of academic insignificance.

Can Google Compete? (as a "now" investment)

Let's then look at GOOG, to see if any of its dimensions make it more competitive at present price:

GOOG's most unfortunate parameter is in its comparison between the forecast upside and its experiences with large drawdowns. At the present-day level of Range Index, prior positions would have endured underwater (below cost) experiences at their worst that were larger monetary frights (-10.7%) than the average prize being sought on the upside (+9.3%).

GOOG's average win odds at this forecast level are below 8 out of 10 (80 out of 100) while both AAPL and AMZN are better. Only its shorter holding periods have been able to boost its annual rate of return, but not by enough to surpass the A stocks.

Making Comparisons

In every investment buy decision, the comparisons that matter should be in terms of what prices are right now, with the best expectational perspective that can be had right now.

Since these two "A" contestants are so close, we offer a further insight. It is of what has happened to their prices over a wider array of Range Indexes (forecast upside-to-downside balances). The distinction may be pertinent, since AAPL's past has been colored so severely by Range Index extremes, while AMZN's has been much more stable.

Here are their past 4-5 year price change experiences, shown in annual rate of change terms, first for APPL and then for AMZN and for GOOG. They may have decision import if a current tactic is to defer a buy decision in hopes of a more favorable opportunity.

These tables go back over a number of years and each day looks at how actual prices subsequently changed over comparable periods of days after each forecast. We then group like Range Index results together to see the average price change performance they produced.

Here time periods are in 5-day column intervals. Range Indexes are arranged in rows cumulating from extremes of under 29 and over 49 to meet at a total in the 38 to 40 blue row at the middle.

The #BUYS column tells how many days out of the past 4½ years met the description to their left. The magenta number indicates the current level of Range Index.

Each table's data is of price changes, expressed in compound annual rates of change to make comparisons between differences in time period columns easier.

AAPL and AMZN both have average annual rates of price change on the order of +45% to +50%, while GOOG's blue line average is about half of those.

All three evidence the "momentum stock" characteristic of higher rates of return as Range Indexes rise from below average to above average. That trait is strongest in AMZN, where most higher Range Index experiences are in triple-digit price return rates.

The bolder-white numbers are an indication of that particular cell intersection being statistically significantly different from the average (BLUE) row of that column.

Better Performance Than "Mr. Market"?

Finally, to keep these stocks in proportion to what might be an implementable (gutless) alternative, here are the comparable metrics for SPY, the S&P500 index ETF.

SPY is characteristic of a "Value" security, where low Range Indexes are an indication of good upside potentials. Hence its price changes decline in size as Range Indexes increase.

At present RI levels the upside forecast of +6.9% is almost matched by a downside of -6.2%, hardly encouraging. It is likely the reason for the +1.9% average payoff with a 9-week holding that gives up a +11% annual rate -- a mere quarter of what AMZN and AAPL have produced.


Both AMZN and AAPL are attractive buys in comparison with other tech giants like HPQ, YHOO, and the lesser "giant" BBRY. What makes them attractive is their past experience with minimizing drawdown exposures. This gains sizable payoff percentage averages from a disciplined investment management strategy that avoids expending the commitment of both time and capital that are likely to be unrewarding.

The avoidance of price round-trips, plus the price and time disciplines generates annual rate of return increments that should substantially benefit the performance of most portfolios. Certainly wasting capital and time commitment in a SPY position is grossly deficient to what ought to be forthcoming from either AMZN or AAPL.

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.