Best Near-Term Price Gains Ahead For: Sector-Tracking ETFs

|
Includes: SPY, VHT, XME, XRT
by: Peter F. Way, CFA

Summary

Market-makers [MMs] every day hedge their firms' capital, temporarily put at risk filling their clients' (big-money-fund portfolio managers) large volume trade orders in these ETFs.

That price-change insurance tells just how far the MMs expect those clients, who have the money muscle to make things happen, to push prices – both up and down.

Histories of these daily forecasts, many made during the past 5 years or more, at all levels of market enthusiasm and despair, provide expectations for the next few months.

Are you looking for better prospects among these ETFs than ones you now have? Or for new entries into this set? Risk-Reward tradeoff comparisons here may help you choose.

We have a special way of looking at stocks and ETFs

If you have seen this explanation before, please jump to the next bold-faced headline.

Technology advances in communications and information have transformed the way securities markets operate, and the way major investors behave as a result. Prices of equities now normally gyrate during one-year elapsed periods in ranges that are typically multiples of the underlier's trend growth.

Which means that during part of the year period their prices are retreating, and are consuming investments of time which cause the "growth" trend rates to be far less than what their better progress periods provide.

Advances in information technology encourage investment professionals (the market-making [MM] community) to protect the capital they must put at risk to do their jobs. Those actions cause the markets for equities and derivatives to become more integrated than they were in much of the 20th century.

So we study what the pros' behavior causes to happen in the price-change "insurance" derivatives markets, to understand just how far it is reasonable to believe specific stock and ETF prices may move, both up and down, in the next few months.

This analysis has been conducted without material change daily for over a decade on more than 2,500 widely-held and actively-traded stocks and ETFs. The resulting price range forecasts provide an actuarial history (unmatched elsewhere in the investment community) of subsequent market prices, as testimony to the strength or weakness of the forecasts made earlier.

Near-term price gains are most important to investors who are now either starting out in building a portfolio's wealth and exploring how it may best be done, or to investors who have come to realize that plans made years earlier are unlikely to be met at current rates of investment wealth accumulation.

Active investing, where capital is constantly put to work in the best odds-on situations to deliver profit within foreseeable time horizons, is the strategy most likely to produce what is needed, at least risk. But active investing needs guidance as to what to do, when to do it, and with what intensity.

Active Investing in Sector-Tracking ETFs

Sector-tracking ETFs at all times are interesting vehicles for active investing. Their price change expectations, derived from the competitive actions of major investment organizations, provides an integrated assessment of overall economic interplay as seen among players with the personnel, information sources, and ample capital to make market prices move.

Which sectors of the overall economic complex most likely to progress, and those most likely to lag, can be seen in one set of two dozen or fewer ETFs.

These ETFs are not high-risk, big short-term price movers, but are the focus of a multitude of money muscle with the power to make expectations and forecasts come to pass.

Interim setbacks and failures keep opportunity valuations in flux among many enterprises. Physical development times and marketing efforts under government regulations and peer review progress vary across international boundaries. Competitive pressures from new organizations' blossoming successes can impact established firms.

Imperfect understanding of the underlying economics by investors, goaded by opportunistic enthusiasm, can create excessive stock price evaluations. Or may lead to undue interim discouragement. These ETFs, based on economic sector indexes of stock prices of major corporations, provide a focus on which areas may have temporarily become overemphasized - for good or bad.

Figure 1 looks at the market activity and dimensions of the sector-tracking ETFs, all of which pass our screens of comparability and attractiveness to institutional investors. There are two dozen of them, and are ranked simply by market capitalization size. Those sizes range from over $100 billion to a small fraction of $1 billion.

Figure 1

Source: Yahoo Finance

Some perspective on this data lies at the bottom of the table. The averages of the more significant columns are compared with their largest and smallest components, and with the same dimensions of the market average NYSEARCA (NYSEARCA:SPY).

Many of these ETFs are fairly liquid, given their size, when looked at from a capital investment turnover point of view. Total group market capitalizations are $140 billion. The average sector-tracking ETF takes over a year to trade its entire stock capitalization. The extremes exceed 6 years. In contrast, the market proxy ETF, SPY, turns over its $200 billion market cap in two weeks, $20 billion a day.

The market activity is strong enough to make transaction trade spreads of little concern, with worst-case costs less than 1/10th of 1%. SPY trade spreads are typically only 1 basis point, 1/100th of a percent.

There is no short interest in ETFs since their market open positions (Capitalizations, third column) are a balance of buyers and sellers, maintained by exchange authorized market-makers creating and eliminating ETF shares by adding or subtracting the stock shares (or equivalent) held by the ETF.

But so much for history, what is yet to come? The street (sell-side) investment analysts offer 1-year price targets for many of these ETFs directly, and others are imputed from current P/Es and estimated 1-year EPS of their holdings collected by Yahoo Finance. On average, these targets are above present prices by +2%.

But street estimates for the future are tinged with employer conflicts of interest, a condition unfortunately displayed many times in the past.

We find a much more reliable set of future price estimates coming from the same employers when they act in a different, but essential role. That role is as negotiators for big-money investment funds attempting to adjust the holdings in their portfolios.

Due to the clients' typical billion dollar portfolio sizes, multi-million dollar trades would flash-crash the automated transaction system of "regular-way" trades. So such "block trades" must be negotiated between clients issuing desired trade orders and other prospective big-money investment funds to be on the other side of the trade.

It is rare to be able to "cross" the desired volume of shares at the limit price specified by the trade-originating client, so the market-maker [MM] may become a principal in the trade temporarily, picking up a long or short "stub end" of the block. But that is done only when an acceptable hedging deal can be arranged to protect the MM's capital put at market risk.

The cost of that price insurance is borne by the trade-originating client, so it must not be so large as to kill the trade. So the terms of the hedge, which define the outer limits of near-future prices of the subject stock in the block trade order, are a consensus of all three parties, the trade originator, the MM, and the seller(s) of the other side of the hedge.

It turns out that the sellers of the price protection hedge are often the proprietary trade desks of other MM firms, who are as equally well-informed as the MM firm negotiating the block trade.

Thus, we have specific, honest unbiased forecasts of future price limits, both up and down, motivated by the self-serving competing interests of the participants in an open-market negotiation.

Those limits can help define prospective investment reward and risk on an issue-by-issue basis that is directly comparable between alternatives, regardless of their underlying competitive or economic circumstances. Those essential minutiae have been subsumed in the hedging negotiations.

Figure 2 uses those forecasts in making comparisons of price Risk vs. Reward tradeoffs between alternative investments.

Figure 2

(Used with permission)

Each ETF is positioned in this map by its intersection of upside price change forecast on the green horizontal scale and experienced price drawdown exposures (on the red vertical scale) typical after prior forecasts like today's. Any issue above the dotted diagonal has more potential risk than return at its present price.

A market reference by SPY is at [11]. Notably, some of the sector-tracking ETFs have less downside risk (and less prospective return) than SPY, but two of them have higher reward prospects along with their greater price drawdown exposures.

These are Vanguard Health Care ETF (NYSEARCA:VHT) at [2] and the SPDR S&P Metals and Mining ETF (NYSEARCA:XME) at [12].

Since price-change risk is a dynamic, not a constant, in time these exposure relationships will change. It is these changes that provide fresh opportunities for active investment capital gains on a shorter-term recurring basis. Besides just the downside price exposure, there may be other investment attributes investors will want to consider. Figure 3 provides some of these.

Figure 3

Source: blockdesk.com

Columns (5) and (6) are the source for Figure 2 coordinates. The (7) metric tells what % of the (2) to (3) range lies below (4). It discriminates among column (12) prior forecasts to select the similar sample from which columns (8) to (14) data is provided. (13) compares (5)'s promise with (9)'s prior delivery; (14) compares (5) to (6). (15) is a figure of merit combining the several qualitative measures into an odds-weighted, risk-conditioned number.

For this exercise, we ranked the top equity interests by the (15) figure of merit. At the bottom of the table, in blue, we have averages for the 27 sector-tracking ETFs, along with a forecast population of ~2,500 stocks and ETFs. Also included is an average of the currently best-ranked 20 issues from that population using the (15) figure of merit. The current parallel statistics for market-average SPY are also present.

Conclusion

In our recent article on the major integrated oil producer stocks, we remarked on how little prospect there is for that group to deliver satisfying investment results without some major rise in crude oil prices. This is because the resources and costs of production of those companies are well-known. Those limitations are reflected in Figure 2 positions for energy-related ETFs, Energy Select Sector SPDR ETF (NYSEARCA:XLE) at [3], Vanguard Energy ETF (NYSEARCA:VDE) at [5], and iShares U.S. Energy ETF (NYSEARCA:IYE) at [10].

The better prospects for healthcare are evident in the VHT at [2]. Concern over markets and world currencies are reflected in enthusiasm for precious metals prices in XME at [12]. Whether those enthusiasms will come into justification or not is reflected by the downside exposures also present. At least XME has those upside prospects, significantly less in the SPDR S&P Retail ETF (NYSEARCA:XRT) at [4].

This discussion is intended to provide some broad perspective on major investment sectors as seen by big-money investment organizations through the lenses of the market-making community which is alert to those clients' current portfolio adjustment programs.

Normally, these articles are intended to bring attention to specific stocks within industry groups or sectors embracing related industries. They are drawn from daily monitoring of over 2,500 equity investment alternatives, including over 450 ETFs.

We regard the 20 Best-Odds Forecasts from the population of 2600 forecast-able equity securities as the competition in any capital commitment contest to improve a portfolio's prospects. Since Figure 3 is ranked by (15), the average of the 20 Best of (15) at 34.6 is a bogey of sorts. If half of the 20 Best (15) of 17.3 might be a lower limit, none of the sector-tracking ETFs in Figure 3 is worth potential consideration as a capital commitment candidate.

The appeal of the top 20 is in their achieved +10.6% gains in periods following prior price range forecasts like those of today's. Their doing it in average holding periods of 42 market days, or two months, provides the opportunity to compound such results 6 times in a year, for a CAGR of +82%.

We every day examine and rank over 2,500 stocks and ETFs to find the most promising 20. No guarantees, but so far in 2016 some 2,930 of these top 20s have shown position closeouts at a CAGR rate of +32.5%, while SPY as a buy & hold has logged only +5.8%.

The current best 20 offer average upsides of +10.5%, with actual prior gains in the same stocks averaging +10.6% net gains under the standard TERMD discipline following 4,200 forecasts just like those of today. Winning positions in those prior forecast experiences were 84 out of every 100, and worst-case price drawdowns on all 4,200 averaged only -6.6%. In every one of each win position in the 84 average, those drawdowns were recovered from, and went on further to produce gains sufficient to offset the losses in the 17 out of 100, to reach that net of +10.6%.

These best of the forecast population are what we regard as the competition, against which other investment candidates should be compared. At this point in time, the other sector-tracking ETFs fall short of being competitive.

Additional disclosure: Peter Way and generations of the Way Family are long-term providers of perspective information (earlier) helping professional and [now] individual investors discriminate between wealth-building opportunities in individual stocks and ETFs. We do not manage money for others outside of the family but do provide pro bono consulting for a limited number of not-for-profit organizations.

We firmly believe investors need to maintain skin in their game by actively initiating commitment choices of capital and time investments in their personal portfolios. So our information presents for their guidance what the arguably best-informed professional investors, revealed through their own self-protective hedging actions, believe is most likely to happen to the prices of specific issues in coming weeks and months. Evidences of how such prior forecasts have worked out are routinely provided. Our website, blockdesk.com has further information.

Disclosure: I/we 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.