About: DJ US Oil Exploration iShares ETF (BATS:IEO), used as an illustration of why investment perspective is required when it is recommended as a buy at a time of concern over the general market's elevated price level.
Our regular readers know that we hold three things to be essential ingredients in the investing process: capital, time, and perspective.
Capital is, in many ways the easiest to get and\or replace. Time, which is invested alongside of capital, is impossible to acquire or replace; we all get it for free, but none of us knows for how long. Perspective, which guides us in what to do with the capital and when, can and must be acquired and maintained.
Our mission in these articles is to provide a practical way to augment your perspective.
We do it in a way that few others attempt. We regard stock (and ETF) investing as a very serious game. A game in which every outcome is dependent on the perceptions and actions of other players. That makes it essential to play the players, often more important than playing the game, as it is seen by most investors.
Our approach is to find the players best informed, best resourced, and most highly motivated to succeed, and get them to tell us what they fear most and what they will spend (which could be profit in their pockets) to protect themselves against those "bad" events. It is an approach that employs the intelligent behavior of the best positioned players.
The primo candidates for us to employ this way are the folks that "make markets" in big volume for investing organizations competing for, or charged with, the investment of billions, even trillions of dollars of capital. Every market day they are required to put their firm's capital at risk to complete the stub ends of stock trade deals that their big-money fund clients want to accomplish, when the markets are a bit short of otherwise allowing that to happen.
These market-makers [MMs] hedge against the risks they fear by buying price change insurance. Its cost is built into the trade spread of each deal, and if that cost gets too large, the fund client won't do the deal, or may take it to a different MM. Competition between MMs is fierce, because the rewards can be huge. Huge enough to make 7-figure personal MM annual compensations ordinary.
Perspective can be gained from the competitions involved in this hedging process. What the MM will pay for protection, and the way it is structured, tells just how far it is believed that prices may get pushed by the big-money fund clients. The result is a price range forecast held likely to be seen in the next few weeks to months. What drives the competition is a sense of odds and payoffs in each deal that pits all trades against each other for the temporary employment of MM firm capital in making the deal get done.
It doesn't matter whether the trade involves Coca-Cola or a pharmaceutical developer, Krispy-Kreme Donuts or Las Vegas Sands. They're all fighting for the same accomplishment, one that involves the embedded fundamental prospects of the underlying companies, but now is being expressed in terms of specific stock price change possibilities.
That lets us examine over 2,000 stocks and ETFs every day, and directly compare among them what is currently believed to be possible in the near future.
Because we have been making those comparisons daily for over a decade, we have the live histories of just how well the MM community has foreseen each security's future. So that you have a sense of what the MMs are forecasting for our population at large currently, here is a compilation of the important dimensions.
The quality-control features in our analysis cull out some of our roughly 2500 stocks and ETFs so that on this day 2,146 issues had credible forecast price ranges. We use the top of each price range forecast as a sell target, so that first column of data to the right of the grouping descriptions says that an average upside of +12% above current market quotes is currently held as reasonable.
The Range Index column describes the balance between upside and downside prospects. Its numeric value tells what percentage of the full price range being forecast lies below the market quote. So a RI of 31 puts a bit more than twice as much upside as downside to the forecast.
The forecast's proportions are important, but equally so is a sense of how well subsequent price events are borne out in the real world, where it counts. So we have a standard test procedure that tells how often a stock's range index is followed in the next 3 months by the stock's price either reaching the forecast's sell target or by being at a profit at the end of that time period. Also of significance is the average amount of time the capital must be committed, and the size of the gain earned. That way an annual rate of gain or loss allows comparisons between current investment candidates.
We like to have an adequate span of time in which forecasts are available to be evaluated this way, and five years often covers a wide variety of market conditions. But particularly with ETFs, where new approaches to creating fund groupings occur from time to time, that is not always possible. So we also evaluate those issues where forecasts have only been available for at least 3 years.
That will include some market conditions that are present in the 5-year minimum group, but exclude some of the market pressures and opportunities of the earlier two years, perhaps providing different norms for comparison. So we look at that group of stocks and ETFs separately. Their averages are shown in the lower section of the table.
As we pointed out in an earlier article, finding forecast conditions that have been exceptionally high in frequency of profitable opportunities is a very valuable dimension. We use a ratio of 7 wins out of every 8 to discriminate (that used to be a positive term, remember?) between candidates that may have just been lucky identifications, and others whose subsequent price actions demonstrate a convincing insight on the part of the forecasters.
There is no guarantee that the future will be exactly like the past, but for many investors it is comforting to know that they are following guidance that has worked well in the past. If an investor has the courage of his convictions, he/she is far less likely to let emotion trigger a dumb action.
Now let's see how the most interesting of the 250+ ETFs for which we regularly have forecasts compare to the overall population, and which ones offer the better promises.
When comparing the subset of 228 ETFs with forecasts to the entire population of 2146 with forecasts, it is evident that, as a class, ETFs are less likely (odds 60 vs. 65) to be profitable, even with the same overall upside to downside forecast balance (both at Range Indexes of 31). They have smaller upside prospects (10% vs. 12.6%) and have, in fact, been unprofitable as a group under an identical sell discipline, with average return rates of -4%, compared to +22%.
Part of this difference can be explained by the presence of 43 inverse (short-structured) ETFs, which have been notoriously poor performers. At the same time, those ETFs' forecasts contemplated their prospects from a "short" holding in their components, so it is not as simple as expecting these to be losers in an up market. Instead, the poorer performance of ETFs overall may just be one of the costs of diversification achieved by the ETF form.
Still, there are ETFs that are quite competitive in the price-gain arena. Perhaps the best of these at this point in time is the DJ US Oil Exploration iShares. In recent times this subset of the energy group, the so-called "E&P outfits" is among the better and more consistent price gainers. The group is benefiting enormously from technological advances in the extraction of energy resources. Here is a picture of how the market-makers' forecasts for IEO have evolved over the past 6 months.
Note that the market-maker forecasts have been a bit less volatile than IEO's market price, making the (heavy dot) quote's position in the vertical range of the forecasts (its Range Index) a useful guide to profitable buys.
Here is a measure of how IEO's prices have behaved in the 3-4 months following every day's forecast during the past 4-5 years. The forecasts have been grouped in their upside-to downside balances from the extremes of upside (top row) and downside (bottom row) cumulatively to averages of all days at the blue line at the middle row. At that point the Range Index averages 39-40.
The first column of numbers to the right of the colored Range Index descriptions is a count of the days during the 4-5 years in that condition. The columns to the right contain their average annual rate of change between IEO's price at the forecast day and the number of days later, indicated by the yellow footers of each column.
Clearly, when IEO forecasts produce Range Indexes above 40, its future price gains drop below its average 20% per year gain rate. Range Indexes above 50 tend to be associated with declining prices. IEO is now in the "below 29 RI" row (with the magenta numbers of days counted), a row where +50% annual rates of gain are common.
The only other ETF among the 8 identified above with as good an annual rate of gain as IEO is SSO, a (2x) leveraged ETF tracking the market average index, the S&P500. Since this period, indicated in the table above, runs from just before the March 2009 bottom of the 2008 market collapse, SSO naturally begs the question. If concern about an overextended market is an issue, as it appears to be, then a double dose of the same is not a rational choice.
We have in our last few ETF articles cautioned that this has looked like a poor time to be investing in most ETFs to achieve price gains. That notion has not changed, although IEO has backed down to the point where its odds start to make it attractive. It is the best (by our standards) ETF at this point to offer potential near-term gain.
Disclosure: The author has an investment interest in the website blockdesk.com which, while not yet open to the public, is in conversion from being a delivery medium of information to institutional investors to a new life of providing similar help to do-it-yourself investors. Announcement of its opening is hoped for in the 4th quarter of this year.
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.