Market Price Level Worries? What Market-Makers See Coming Next

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Includes: AAPL, CAT, PG, SOXL, SPXL, SPY, SSO
by: Peter F. Way, CFA

Summary

You're a traditional "Technical Chartist"?  Don't waste your time or energy on this article.  It probably will just be aggravating.

You're a blockdesk.com or Market-Maker Intelligence List subscriber?  This will provide an interesting, quick, skip-the-explanations overall market perspective, best specific plays.

You're a traditional fundamental analyst looking to broaden  how you evaluate market-level price environment prospects?  Get exposed to a new,productive perspective here.  Find out where to get more.

Price Perception Paradoxes Persist

Public price perceptions of the stock market promoted by the media are just another dimension of the fear dementia they love to pander.

They know much of the public only can/does compare "now" with sometime "before", so they broadcast big-number prices as being at record highs. Just the numbers, no time or price data references, just assertions of unmeasured altitude.

Worry, worry, worry.

But it's been the same story for over a year, and the price climb persists. What do investment professionals think? Really think, not what "the street" would have "the public" think.

Where do experienced pros put their firm's capital? Not in what may be suggested in the printed "research reports", even those stated to be intended for "institutional investment circulation only".

Market-makers [MMs] at the block-trade desks filling multi-million-dollar transaction orders from portfolio-manager clients who are constantly re-shaping billion-dollar portfolios know that trades have to be done in big lumps to avoid chasing prices away from where they currently offer opportunity.

At least, chased away from the opportunities recognized by those clients. And the MMs problem is that if the client knows something material that they don't, the MM firm gets "bagged" for a big loss. A big enough loss and the MM trader loses his job.

So, many of the MM firm's thousands of employees are world-wide, 24x7 info-gatherers positioned to keep their block desk and proprietary trade desk at least as well (if not better) appraised of important development potentials. Other experienced and qualified employees shape the intelligences into price prospects. For internal use only.

The firm's pro traders talk to their buy-side counterparts many times each market day, and know the clients' persona and typical strategies well. The MMs are essential street agents in getting client volume trade orders "filled" effectively, within specified price limits.

Imagine a poker table where the dealer knows all the cards each player holds, and how they intend to play them. Not a far-fetched analogy.

Now the MM "dealer" commits firm capital to fill the "other side" of the big-volume trade order that the market at large can't swallow at this point in time. But only after a hedge trade has been set up to prevent a loss to the MM firm's capital. Its cost is paid by the buy-side client as part of the trade spread on the block being moved.

The size and shape of the hedge deal tells just how far the MM community, as both buyers and sellers of the price-change insurance, see what changes are likely or possible. Changes both to the upside and the downside.

Knowledgeable Perspective

Do that every day on two thousand or more actively-traded and widely held stocks and ETFs, and a market perspective is formed. Formed as a result, not as a target.

This is a perspective the public never sees, except for the limited views from Seeking Alpha via our analysis and reporting. That takes the form of articles like this, containing issue by issue price range expectations. And containing actuarial histories of how subsequent market prices have behaved following prior forecasts with upside to downside proportions similar to the current ones.

Here is how the MM community has been appraising coming price prospects for the ETF tracker of the SPDR S&P500 Index (SPY).

WARNING: Do not confuse these pictures with "Technical Analysis" backward-in-time looking "price charts". Instead, they are picture histories of forward-in-time looking forecasts of prices expected yet to come, made live daily in "real time" before the fact.

Figure 1

(used with permission)

The vertical lines here are FORECAST price ranges implied as likely by the hedging behaviors of block and "prop" desk professionals to fill volume trade orders beyond the capacities of "regular way" transactions.

Closing market quote prices on the day of the forecast are seen as a dot in each range, separating coming price prospects into upside and downside proportions. Those proportions are measured by a Range Index [RI] which tells what percentage of the range lies to the downside.

The frequency distribution of RIs in the past 5 years is in the lower "thumbnail" picture.

Data in the row between the pictures tells what has happened to the subject security's price when a timely holding would be subjected to the TERMD portfolio management discipline strategy.

TERMD sets the top of the price range forecast as a sell target to close out the holding when first encountered. Otherwise a 3-month (63 market days) time limit forces exit from the position. A position entered into at a cost of the closing price the first market day after the forecast.

Prospective reward is posed by the %upside sell target, and risk experience is formed by the worst price drawdowns encountered while attempting to reach the sell target. Win Odds tell what percentage of prior forecasts (at this RI level) recovered from their drawdowns to post a profit of any size. %Payoff tells the size of the average changes between entry costs and exit realizations. Market days held is used (in a 252-day year) to compound the annual rate of changes experienced.

Sample size is the number of prior forecasts in the last 5 years with a RI like the current forecast.. The Cred.(ibility) Ratio pits the average %Payoff against the current %upside Sell Target.

Comparison is the Essence of valuation

Using SPY as a reference point Figure 2 provides comparisons of some three dozen price-sensitive securities, the Leveraged Long ETFs most widely held and actively traded.

Figure 2

(used with permission)

Upside price rewards come from the behavioral analysis (of what to do right, not of errors) by Market-Makers [MMs] as they protect their at-risk capital from possible damaging future price moves. Their potential reward (best upside likely price change) forecasts are measured by the green horizontal scale.

The risk dimension is of actual-experience price drawdowns at their most extreme point while being held in previous pursuit of upside rewards similar to the ones currently being seen. They are measured on the red vertical scale.

Both scales are of percent change from zero to 25%. Any stock or ETF whose historical risk exposure exceeds its reward prospect will be above the dotted diagonal line.

Best reward-to-risk tradeoffs are to be found at the map's frontier of alternatives down and to the right. Notably, the only one really there is SPY, while a 2x leveraged Semiconductor ETF and a 3x Real Estate ETF hover on the Up=Down boundary.

Figure 2 makes it look like leveraged long positions are a high-risk posture to be taking now. Does this concern extend to the whole market? Let's take a Reward~Risk look at the Dow-Jones Stocks as a "core holding" sample:

Figure 3

(used with permission)

Well, that's different, and reassuring. Only Caterpillar (CAT) at [1] is being viewed as having negative near-term prospects at this point in time. Several of the usual "defensive" stocks have forecasts which have previously encountered "worst case" price drawdowns of -3%.

Apple, Inc. (AAPL) at [15] is the only other DJ stock with double-digit price drawdown prior exposures from forecasts like their present ones.

But while there are healthy upside forecasts for these stocks, have they actually delivered on their promises? Let's take a look at Procter & Gamble (PG) at [5] in the same detail as Figure 1 did for SPY.

Figure 3

(used with permission)

Hmm. PG promises +6% price gain in 3 months, delivers +2%. On a forecast credibility scale of (%payoff / forecast upside) = 1, PG's Cred.Ratio =0.3. Not so encouraging. Perhaps we might look at the other DJ stocks the same way. See Figure 4.

Figure 4

(used with permission)

As in Figure 2, more desirable results are down and to the right, and less attractive ones are in the upper left direction. Locations in the green area are most desirable.

Here the SPDR S&P500 Index ETF (SPY) at [3] is offered as an indication of a market average norm. Figure 4's scales are set to include outstanding performances, so a few of these issues appear modestly attractive, in comparison to the market average.

(Apologies for securities with WinOdds less than 80 appearing in the white Payoffs vertical scale space at the left of Figure 4. Additionally, those with negative payoffs, like AAPL and CAT, are at [6] in its upper left corner.)

This is starting to look scary for the Leveraged Long ETF crowd. Let's see how they do.

Figure 5

(used with permission)

Surprise! What is seen here is the combination of volatile price natures, momentum, and small relative upside distances needed to reach sell price targets.

When big enough carrots are put out in front of carts driven with small odds of feeling the stick, price progress gets made. Details for the 3x Big Cap Bull ETF (SPXL) at [18] are in Figure 6, for the 3x Semiconductor ETF (SOXL) in Figure 7, and the 2x Leveraged S&P500 index-tracking ETF (SSO) are in Figure 8.

Figure 6

(used with permission)

Figure 7

(used with permission)

Figure 8

(used with permission)

Please note that the high levels of Range Index and the small remaining upside price change distances to the sell targets produce high odds for reaching, even exceeding, the sell targets. The leverages built into these ETFs produce one-day price moves, which this close to sell targets, frequently result in average % Payoff achievements in excess of the targets and Cred. Ratios of 1.0 or higher.

Additionally, the smaller moves required and greater price volatility combine to shorten holding periods, magnifying CAGR annual rates of return.

Why would any sane investor (not speculator) take such a downside gamble? Strong odds for a big payoff is why.

But what does this tell us about the market?

Rather little. Instead, a look at the over 2,500 stocks being evaluated daily by the MM community provides a Range Index perspective for this one day, similar in nature to the single stock or ETF perspectives over 5 years at the bottom of the Block Trader Forecast pictures. Here is what they are saying today.

Figure 9

(used with permission)

From the MM perspective, equity markets are fully priced when their population Range Index average approaches 50, and are cheap when it falls under 20. Now it is 35, a bit higher than it was a couple of weeks ago at 30, but far from any danger point.

Only a couple dozen stocks have RIs above 50, including some of the Leveraged Long ETFs. But out of a population of over 2,500, that is only 1%.

Conclusion

We'll let you know when/if the average gets over a Range Index average of 40, or the proportion of equities with RIs above 50 (more downside than upside) gets to 10%.

Additional disclosure: Peter Way and generations of the Way Family are long-term providers of perspective information, earlier helping professional investors 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 D-I-Y investor guidance what the arguably best-informed professional investors are thinking. Their insights, revealed through their own self-protective hedging actions, tell what they 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.

But knowing likely limits to the specific securities, and how they are changing, becomes valuable competitive intelligence for investors, large and small.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SOXL over 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.