Disruptive changes create investment opportunity, in risk-laden environments. This is investing. Reward is the payoff for dealing with risk. But not all risks are alike, nor are their payoffs for being involved. Neither are investors all similarly suited to deal with the trade-offs.
Uncertainty is typically higher in risky situations. But so are the payoffs. If uncertainty bothers you as an investor, then stay in those investments that appear safer, not these. The ones that pay 2-4% dividends and “grow” your capital at about the same rate. Meanwhile, they scare holders with 15-25% interim price declines. And recoveries.
As long as you do not need to have emergency cash from them while they’re down, then it turns out they were safer. Next time?
We know by watching what the best-informed investors do to protect themselves and to take advantage of the likely prospects. They are the major investment organizations, pension funds, endowments, mutual funds, hedge funds and others with research staffs constantly exploring the developing potential opportunities for profitable investments. They compete with each other that way in an effort to attract additional Assets Under Management [AUM] on which they can charge management fees. Collectively, they have AUM of multiple trillions of dollars, typically in billion-dollar portfolios.
Some funds like what they see, others are not so sure, and both need to make portfolio changes big enough to make a difference in comparison to the other things in the portfolios.
But they have reputations. “Everyone” wants to know what Warren B. may do next. So, they can’t just put out an offer to buy or sell something and wait to see what “the market” will provide.
What they do is have a major brokerage firm “front” for them (different ones at different times or securities) to negotiate with other potentially-interested big-money fund managers in making transactions in specified securities at a specified price, within a limited (by hours or even minutes) time period. Such “block trades” are initiated typically by one fund, and the “other side of the trade” is typically composed of several other investing organizations. All participants get the same price, with the trade completed in its entirety at one point in time, and is subsequently reported on a public exchange to provide trade transparency to the rest of the market.
Often the broker managing the block trade negotiation will not find an existing appetite to “fill” the trade at the desired price or even one that can be bargained. To strike a balance between buyers and sellers, the broker may become a principal in the trade by taking a position, using the firm’s own capital. But only if the firm can buy price-change insurance to protect its capital’s market risk exposure. They usually can, in the form of hedging deals in derivative securities – options, futures, swaps, other exotic instruments.
The market-making [MM] investors are on opposite sides of trades in two different markets. Their block trade brokers are buying protection insurance, some other broker’s proprietary trade desk is selling it as derivative contracts in those markets. Both MM firms typically have world-wide 24x7 information-gathering staffs of thousands keeping HQ trade desks immediately informed of relevant developments. Public price negotiations for the effective contracts in open markets keep the expectations of coming prices an honest, immediate pertinent statement of what seems likely to happen during the few months or weeks lives of the derivative contracts.
The arcane art of arbitrage is what transmits the underlier price expectations from one market to another. That is how we know the MM forecasts. They cannot always know exactly what will happen in the necessary near future, and sometimes will be wrong. But they are right enough, often enough, to make their forecasts credible.
We keep careful book on what forecasts they have made, day by day in the past. And records of how the equity markets have responded in the face of those forecasts. That is what is shown in the huge Figure 1 collection of Friday, July 20, 2018, forecasts for many of the 50 stocks and ETFs most closely followed by SA readers, commenters, and contributors.
All of this information is the property of blockdesk.com, and they have provided permission to make public what appears in this article.
The MMs' forecasts are in columns [B–D], with the downside proportion of their price range forecasts measured in [G]. All the other data are live records (not back-tests) telling what has happened to similar prior forecasts of the past 5 years in terms of actual market prices, as the portfolio management discipline of TERMD was applied to each of nearly 9,000 forecasts.
Please note that the guidance suggested by the historical data is specific to each security, in terms as they are perceived at today’s circumstances framed only by the upside-to-downside proportions of today’s perceptions. Each security is its own norm, offering the prospect of a parallel to its own past actions, not some assigned group behavior.
There is a commonality to the historic performances of all of these equities, which make them directly comparable to one another. It is the presumption that price gain in the coming 3 months is the most important end result, and each potential investment will be reinvested in the best-available subsequent choice as soon as the opportunity permits.
Put another, simpler way, these stocks are considered to be bought to be sold, with the capital involved now only a staging for subsequent, further productive employment.
The old-fashioned, 20th century view of any security being a “warehouse” of capital until some future, distant, as yet determined date arrives, that view of investing is rejected. Instead, allow for the more time-efficient utilization of capital and information in the building of an evolving-components portfolio. One of a progression of the current best odds of gains at the most rapid scale of achievement in consideration of the involved risks to capital.
We use the experience of prior forecasts and their subsequent exposures to worst-case price drawdowns as measures of the meaningful risks likely in the coming similar forecast period. Against this, we can compare today’s expectations of likely price gains. Figure 2 pictures these relationships of Figure 1’s [E] expected rewards against its [F] experienced risks.
We will come back to the rest of Figure 1 shortly.
The numbered intersections of Figure 1 Risks [F] on the red vertical scale and Figure 1 Rewards [E] on the green horizontal scale are identified by stock or ETF symbols in the blue field. Some positions hold more than one security.
The “efficient frontier” of the Risk-Reward trade-off here runs from SPYDR S&P 500 ETF (SPY) at  to McDonald's (MCD) at  to Tesla (TSLA) at . The securities HP, Inc. (HPQ) at  and General Electric (GE) at  are constrained from visual comparison by the map’s vertical boundary at a maximum of +25%.
That difficulty illustrates the nature of these comparisons. They are interesting, but limited to their quantitative nature, with qualitative considerations not adequately presented. In other words, how likely are these comparisons to be changed by uncertainty?
The Risk element, of price drawdowns, is an actual experience, not a forecast. But it is the experiences of a sample of RIs defined by today’s forecast RI. If that sample is small, it could turn out to be misleading. So, we ought to, in Figure 1, check out the sample sizes [L, M].
The Reward element is a forecast. So, we might check out how credibly this forecast [E] is supported by the prior Realized Payoffs [ I ] of Figure 1, as shown in [N]. There, when [I] = [E] or better then [N] is 1.0 or better.
Also, Figure 2 treats each stock's rewards and risks as though they were of equal weight, or significance, making the comparisons look very suggestive of future performance. But in terms of future performance they may not be equally influential. Figure 3 is one way to infer the differences:
Figure 3 maps on its vertical dimension Figure 1’s Realized Payoffs, against its horizontal dimension of the Figure 1 proportion of each stock’s prior RI forecast sample which resulted in profits (the Win Odds [H]). This arrangement provides the same orientation to attractiveness as Figure 2, where good locations are down and to the right.
The Odds scale puts our attention on those stocks with 80 or more out of 100, with those of odds of 70 to 80 forced into the white area on the left. Stocks with negative net Realized Payoffs would be forced into the grey area at the top of Figure 3, but for simplicity (and their count), we have not shown them.
Figure 3, like Figure 2, has some comparative advantages but is not as complete as may be desired in guiding investors to the strongest wealth-building alternative securities of the time. That is the reason for Figure 1’s columns [O] – [R].
We use the Win-Loss Odds of Figure 1 to provide emphasis and combination of the Reward-Risk tradeoff for each security. The Win Odds in [H] is an integer percentage, or XX out of 100. Its complement, or 100-XX is the proportion of losers. A stock with a high proportion of Wins ought to be more Reward-convincing than one with as many losses as gains. The same type of reasoning applies to the Risk dimension.
To accommodate these differences in Figure 1 we weight the prior Realized Net Payoffs [I] by the Win Odds percentage [H] and weight the Max Drawdown [F] by 100 – [H] as a percent. They are shown in Figure 1 as [O] and [P]. Adding them together algebraically produces a Net Reward-Risk trade-off element in column [Q].
The proportion of negative [Q] securities (in red) suggests that the coming 3 months may contain some disturbing times for many SA reader-commenter-contributors. Time better spent on the beach than in reading the Wall Street Journal or Investors’ Daily.
It also points out that those who may be disturbed probably are following investment strategies other than those which are the purpose of this article – wealth-building. A secondary purpose of this article is investor education. But the intent is not to proselytize “religious conversion” of investors of the passive-strategy persuasion. They may have sound reasons for their path.
Continuing on the wealth-building track, the [Q] Weighted Net Reward-Risk element has a further component of great significance. The investment of TIME required (on average) to produce [Q] determines its operating (not financial) leverage in producing capital growth. That is identified in column [J] of Figure 1, as market days.
In the financial community, the growth “speed” of capital is measured over longer periods as CAGR – the compound annual rate of growth. But over shorter periods, particularly where the time involved varies considerably between alternative choices of actions, a different, more precise unit of measurement is preferred, the “basis point” or 1/100th of a percent. Speed is measured in basis points achieved (compounded) per day, or bp/d. For reference, a speed of 19+ bp/d if sustained for a year of 365 days doubles the capital involved.
In Figure 1 the Odds-weighted net simple percentage gains of [Q] are converted to bp/d using the actual calendar equivalents of [J] and are shown as [R]. It is on the basis of [R] by which Figure 1’s rows are ranked, down to (but not including) the blue rows at its bottom.
The obvious implications are that the Market-Making community (including both block-desk buyers of price-change protection and proprietary-trade-desk sellers of the protection) acting in the privileged positions of seeing the trade “order flow” trends of their big price-moving “institutional” (non-individual) clients, are at present, of the belief that in the next few months the better long positions to have by a wealth-building investor are in TSLA, AVGO, and NFLX. This is as evidenced by their self-interest open market actions.
These are not actions based on which corporate issuer of the shares has the best management, the strongest financial base, or the keenest competitive acumen. Those investment securities preferences are implied by the bets being made at particular prices, in limited-life, highly-leveraged, derivative securities which make the most sense up to the higher and lower extremes of price in the underlying shares being traded by big-money clients.
The game is arbitrage, and it can be played consistently and competitively only by organizations which have invested decades to centuries in building worldwide information gathering systems and by positioning themselves in trusted relationships with clients and regulatory entities. Its players do not talk with others outside of their own circle and they know who within that circle is who.
But they rely on the efficiency of markets for the (highly profitable) conduct of their affairs, and the transparency of those markets provides useful clues to MM community thinking about specific securities’ prices in the coming near future. When adequate history is available on prior forecasts and market price outcomes subsequent to those forecasts, then it can be (and is being) demonstrated that useful Active Investment strategy guidance is available to individual investors who are intent on building the size of their invested capital.
Investing, like the rest of life, is laden with trade-offs. Each investor has preferences and personally-set standards of acceptability. Each investment security candidate for the portfolio has its line-up of advantages and disadvantages to be presented to the investment committee. With a committee of one, the decisions may come more easily than when there are other minds to convince.
But it is important to have the go-nogo decision criteria clearly in mind to apply fairly to each of the available investment candidates. And their attributes need to be stated in terms that are directly comparable to other employable candidates.
We hope to offer selection criteria that aids the investor in framing their investment selection decision parameters fairly and consistently. We believe that the simple TERMD active investment portfolio management discipline works well in the holding period involvement that our information capture process provides.
This article was written by
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.
Additional disclosure: Additional disclosure: Peter Way and generations of the Way Family are long-term providers of perspective information, earlier helping professional investors and now only 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.