No Time for Buy and Hold

01/18/2012 8:30 am EST

Focus: STRATEGIES

Peter Way

Founder and CIO, Peter Way Associates

Instead of theorizing about how to play the markets, just look at what the big money is doing to make money, writes Peter Way of Block Traders’ Oil & Gold Monitor.

When broad market averages like the S&P 500 show no long-term gains over a decade or more, as they have at times in the past, the whole notion of being a long-term investor is seriously drawn into question. It is evident that there is no shortage of opportunity—and risk—in being an active, time-efficient investor.

The key is to enlist the help of the best informed players in the game, who are driven by their self-interests to maximize their information advantages to earn obscene rewards. We can’t hope to beat them, but we hardly need to. A minor fraction of their gains easily outdoes what most investors earn.

Outlooks by many commentators for 2012 range from the optimistic to the sharply negative. As usual, the well-seasoned advice from Niccolo Machiavelli (1469-1527) is that “everyone has his reasons.” With stocks, as at the poker table, the implication is that his (everyone’s) reasons may not be communicated to you in a way that will suit your desires as well as his.

A more recent philosopher, whose identity has become cloaked in the turmoil of the age, advises “follow the money” if you want to know what people really think, and may be planning. We do that, examining how those folks who make markets spend their money protecting themselves from the possible ravages of time, nature, and the probable intentions of other players in the game—those with enough capital and resources to push prices around.

What those market pros are willing to spend to protect themselves, and the way in which they do it, tells just how far up and how far down prices are likely to go—at least as they collectively see it, at this point in time.

In the fourth quarter of 2008, when prices began to plummet, the initial reaction was to see increased upside opportunity and reduced downside exposures. But as the declines persisted, panic set in and fear took over, reducing upside expectations and increasing downside concerns.

Not until mid-January through early March of 2009, when expectations started rising as the market continued its decline, was the stage set for a turnaround. That rise was sustained as fear diminished and downside apprehensions shrank. Then, logically, higher market prices ate into upside prospects until April and May of 2010, when market prices again took a spill.

The vertical range of market-maker price forecasts is what the VIX uncertainty index is all about. It is derived from an entirely different process, but is parallel in its purpose. The problem of guessing about where the market is going by looking at the VIX is that it has no sense of the balance between upside and downside components of that uncertainty.

All the VIX followers know is that when the index is low, the market tends to be overconfident and is exposed to decline from a shift in attitudes. The opposite is also evident: a high VIX, which has been produced by a scary market decline, may be the sign of a market rally to come.

But when, in either case?

Using our information, we have actuarial tables on the VIX showing that when market pros use that index to protect themselves from market change as they are now, past gains have averaged 44%, in 458 instances over the last five years. Average holding periods to target sell points earning that average were only 17 market days, less than a 21-day market month.

The “bad news” is that such a rise in the VIX index usually means a pronounced drop in the S&P 500. This is not a calamity forecast, but it might be a caution.

Our reservation comes from the knowledge that the 458 experiences produced index gains in only 61% of the cases. That is illustrative of the difficulty in making broad market index forecasts. Additionally, as an index the VIX cannot be traded directly.

Which is why we prefer to find single issue situations where far better odds of success have been present, even if the payoffs may be smaller, as long as the time to be held produces attractive and competitive returns.

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