Market Rally: Last Chance To Protect Against Coming Crash?

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Includes: CSCO, KO, SPY
by: Peter F. Way, CFA
Summary

Who says there will be a crash? Lots of “gurus” making a living, filling columns, bits & bites with asserted opinion. How about those with real skin in the game? Big skin.

Yeah, the market-makers [MMs]; big everyday bettors. They constantly assess whether this “recovery” has gotten ahead of support. Here are their expectations now – and past 6 months day by day.

But even if the whole “ship” isn’t going to sink, there may be some seriously leaky “lifeboats”.

This article provides a quick perspective of what the market pros see.

Another Seeking Alpha contributor will give you instructions on how to adjust your life-jacket.

Just when you thought the cruise was resuming

And 2019 started out as a refreshing change from a sobering 4Q2018, with the S&P 500 dropping from over 2,900 to 2,350, a -20% Christmas present. Its recovery to 2,737 gets about half of that back. But is it too fast, too soon?

The S&P 500 market index (SPX) does a better job of measuring what may be coming for overall stock prices because those investors (the “institutions”) making bets big enough to move market quotes are less influenced by “street noise” than an investing “public” which acts with bets on SPDR S&P 500 index ETF (SPY). The difference is one group’s yardstick that looks ahead (anticipating), while the public tends to be looking back (reacting) to what has happened. Still, for many practical record-keeping purposes, the two measures closely track one another.

Figure 1 shows how the MMs’ expectations of what may be coming in the next few months have evolved daily over the past half-year. Not as single-point price target guesses, but as well-informed and broadly reasoned evaluations of what are likely upper and lower price limits. Those ranges are shown as vertical lines.

The actual index quote on each day’s forecast is the heavy dot on the vertical line. It separates the forecasts into upside and downside prospects.

Figure 1

(note: all materials from blockdesk.com have been approved for appearance in this article)

The professional investment community would like you to believe that no one can reliably forecast what the equities markets’ prices are likely to do, so that you won’t get in their way of privately doing just that. We have over 20 years of live-logged daily records on over 2,500 widely-held and actively-traded stocks, ETFs, and indexes which shows their accomplishments. This is just one example.

Today’s implied forecast for SPX has 6 times as much upside from 2,737 to 2,943 as downside to 2,703. That downside is 14% of the whole forecast range and is tagged as a Range Index [RI] of 14. The small blue “thumbnail” picture at the bottom of Figure 1 shows how the last 5 years of daily forecasts for SPX have been distributed across a rather narrow array of experiences. Today’s 14 is at a credible midpoint of that distribution.

On Christmas eve, coincidentally, the MM community’s view of its big-money clients’ intentions saw no further downside price prospects for the SPX index. Hence, the low-point of its market quote and the green color of its vertical range forecast.2

We’re not saying that the MMs are perfect forecasters, just because they hit the bottom (currently) of this recent set of experiences. Another five earlier green-colored forecasts are also present. Whether they will be scored as profitable forecasts depends on the definition of what constitutes success.

Your definition quite probably will be quite different from what is typical in the MM community. They have ready (and knowledgeable) access to derivative markets where (for example) options strike prices define profitable circumstances. If the pros were willing to accept a gain from 2,670 to 2,830 (a 6% gain in 7 market days) as a satisfactory experience, then all 3 of the earlier (late October) forecasts were successful. For those familiar with finance industry standards, this was a 70 basis-points per day opportunity. For the unfamiliar, how would you like a security that paid dividends based on ½% A DAY?

In the more recent Christmas present, the top of its forecast in December was 2,711, and we are now at 2,737. That looks like a reasonable example of a forecast success.

The same kind of test, put to ALL other SPX before-the-fact forecasts in the past 5 years with RIs of 14 (251 of them out of 1,261 market days) produced profitable outcomes 84% of the time (210 out of 251). Pretty good odds. Not perfect, but in 5 years, 251 is an average of 50+ a year, or almost one a week, so the frequency of a payoff is worth considering. Not a rare event.

No one can make reliable stock market price forecasts. That’s right, it takes a whole community of MMs, with thousands of world-wide observer employees gathering information and keeping it up to the minute. Goldman Sachs (NYSE:GS) alone has over 36,000.

An even better job, stock by stock

The MMs fill an essential function in today’s Trillion$-a-day equities market volumes. A big part of that activity is from “institutional” investment organizations (including Mutual Funds) which manage equity portfolios with assets under management [AUM] frequently of a $billion or more. Not so much from your or my 10 shares trade of AT&T (NYSE:T) (for example).

But because there are millions of us that need to be accommodated (and who at least threaten to vote on election day) and because information technology’s advances make it possible, the “regular” stock transaction process has evolved into a highly-automated process. Pity the ever-diminishing “retail” stockbroker and $50+ trade-ticket costs of the 20th century, done now for as little as $1.

The real $-value market traffic gets done in million-$+ “block trades” between “institutions”, arranged by MMs where each investment organization involved gets the same quoted price, with the trade closed at the same time, and the execution is promptly reported publicly on a registered exchange. Often the MM must balance supply and demand by putting some of its own capital at temporary risk. That’s done only where a derivatives-security hedging protection can be arranged at an acceptable cost.

The cost of the protection is the source of the forecasts from the MM community.

Stocks which get ample traffic in block trades are ones that are institutional favorites. The Dow-Jones 30 index stocks are a prime example. Their current price range forecasts are used to make Reward-Risk tradeoff comparisons in Figure 2.

Figure 2

“Good” in this map is down and to the right where the upside price change potential (green scale) is increasing and the price drawdown experiences (red scale) are diminishing. Each stock is located by number on the map’s field at the intersection of the upside and downside prospects. We have put SPDR S&P 500 ETF (SPY) into the comparison at location [12] for perspective of what a buyable version of “the market” offers.

Any stocks above the dotted diagonal have larger price risk content than price gain opportunity. Cisco Corporation (CSCO) at [5] and Coca-Cola (KO) at [2] are examples.

What to do here?

After looking at the MMs’ rather positive outlook for the market in terms of SPX in Figure 1, if you still are concerned about a declining price environment, you may want to lighten up your exposure in more vulnerable issues like CSCO and KO. But if you are a true buy & hold advocate, you may seek some other means of protection than an outright sale. In that case, SA contributor David Pinsen has the mechanics in place to suggest the best choices of options strategies and specific contracts to accomplish what may be important to you in your particular situation and preferences.

By coincidence, he happens to have just (February 3) written on Coca-Cola.

To have the MMs’ outlook for KO in more specific terms, here in Figure 3 is the same kind of forecast data and picture presented in Figure 1 for SPX.

Figure 3

Worth noting here is the abysmally low Win Odds of only 20 for KO. Only one out of 5 experiences at a Range Index of 57 resulted in a gain. Now that sample size of only 5 is too small for statistical significance, but comes as a warning. Looking in the thumbnail picture at KO’s distribution of 5 years' array of Range Indexes, it is clear that the stock is now selling at the high end of its experiences.

KO’s prior worst-case price drawdowns from RIs of 57 are only -5%, which may be partly or fully recovered in the coming 3-month holding time limit used to evaluate its reward-risk tradeoff. But, at the same time, its upside prospect of +3.4% is less than the risk exposure. The payoff from protection here appears limited.

The case for CSCO is more compelling.

Figure 4

Here, price drawdowns of more than -11% have been encountered at Range Indexes of 52. As with KO, the current RI for CSCO is in the upper tail of the past 5 years' experiences, indicating a weak price prospect. There probably will be better protection economics in hand at Pinsen's Bulletproof Investing for CSCO than for KO.

Conclusion

Regular readers will recognize that we do not look for negative investing situations. Our present sense of market professionals’ market price expectations is that they see little to no serious declines in the averages and can quickly identify a dozen or more equities offering next 3-month gain prospects where average CAGR payoffs above +50% may reasonably be expected.

But we are also aware that many SA readers are inclined to “grin and bear it” when old favorites and “demonstrated technology masters” are confronted by difficulties which might make them be compared to the likes of IBM (NYSE:IBM), GE (NYSE:GE), Xerox (NYSE:XRX), or EK. Our intent here is to point out that the investing scene offers tactical alternatives which may provide protection and or amelioration of possible dangers to accumulated capital.

There may come a time when passive strategies need a cost-analysis, and competent contributors at SA may be helpful in that direction. Find out what it costs to be protected, compared to a capital redeployment in a more promising and comfortable investment alternative.

Disclaimer: 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 in the SA blog of my name. January has produced over a hundred profitable position closeouts.

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.