From the April 01, 2009 issue of Futures Magazine • Subscribe!

Profiting from temporary market anomalies

When the stock market is volatile, stocks can rally or break unevenly. They can move at different speeds at different times. This unevenness creates opportunities for a market timer.

In a rally or break, some stocks will lead their sector and the broad market. Generally, you should long the strongest stocks in a rally and short the weakest in a break. You should ignore followers. But, under certain circumstances, a follower may be a good choice. After a late start, an aggressive follower may run to catch up with or overtake a leader. This gives you at least two ways to profit: start by running with a leader, and then shift your money and run with an aggressive follower.

The divergences between leaders and aggressive followers are anomalies; market volatility will temporarily open a gap between the two then close the gap. Understanding how these gaps may occur and how they may close is key to taking advantage of them.

INEFFICIENCY = OPPORTUNITY

Market theory includes two viewpoints. Inefficient market theory holds that markets can be timed. Efficient market theory contends that market timing is impossible.

Inefficient market theory is grounded in the idea that different participants in a market may become aware of market-moving information at different times. Given the same information, two people can reach different conclusions. In addition, different participants can have different reasons for buying, holding or selling a stock. Markets need buyers and sellers. A market cannot exist if every participant wants to buy or every participant wants to sell.

In time, imbalances are corrected, but new circumstances create new imbalances. To a market timer, these temporary imbalances are windows of opportunity that open and close.

MONKEYS AND DARTS

Efficient market theorists say this is nonsense. They may excitedly argue that a monkey throwing darts at stock listings in a newspaper has as good a chance at picking a winning stock as a market timer.

Efficient market theory is grounded in the idea that the ups and downs of a market are random. Passivity is best. Passive investors are committed to minimal effort, minimal diversity, stock-index mutual funds, dollar-cost averaging, fixed percentage allocations, buy-and-hold and compounding. Some passive investors diversify into bond-index funds. Bonds and stocks tend to move inversely. Passive investing has a large following.

Mutual fund investors are efficient market theorists whether they know it or not. Mutual funds tend to be long only. Mutual fund managers tend to buy and hold. Investors who contribute to retirement plans are efficient market theorists. These investors make regular contributions to a plan whether the broad stock market is rising or falling. Pension funds tend to be efficient market theorists. They receive money, invest money and pay out money on a regular basis. They favor the long side.

The Achilles’ heel of efficient market theory (passive investing) is a long-term bear equity market. The Achilles’ heel of inefficient market theory (market timing and active trading) is the time and skill required; market timers can be bad at market timing. A hybrid market theory advises participants to split money between passive investing and active trading.

Market activity of 2008 was a shock to efficient market theorists: the speed and extent of the meltdown caused long-only portfolios to be savaged. Market timers, on the other hand, moved to cash or to U.S. Treasuries or played the long and short side of multiple markets. Not all did well, but most did far better than passive long-only investors.

CAVEAT EMPTOR

Market timing involves multiple risks. A trade could go against you; you could buy the wrong stock or exchange-traded fund, or get in on the wrong side of a futures contract. You could buy too early or too late. Good timing depends on other market participants eventually agreeing with you. There is no point in buying a distressed stock (bad fundamentals, bad technicals but a possible buyout/turnaround) or a value stock (good fundamentals, bad technicals) or a follower (good fundamentals, good technicals) if you cannot sell at a higher price.

Outside of having inside information, four keys to timing are: 1) staying on top of market fundamentals, 2) watching multiple indexes, 3) being aware of related markets, such as crude oil, bonds and stocks and 4) constantly looking for connections and anomalies. Context drives success and helps you detect a follower that may suddenly run after or overtake a leader. You will not know where the next anomaly may appear, but you can be confident that an anomaly will appear somewhere, sometime.

QUICK TIME

In “Chop suey” you see a daily chart for SPY, the exchange-traded fund for the S&P 500. The chart is a volatile mix of up and down days. It covers most of the last quarter of 2008. Though the market was in the midst of a large down move, the chart shows a volatile mix of significant up and down moves.

In “Follow the leader”, you see Exxon (symbol XOM), a major component of the S&P 500 and the February 2009 crude oil futures contract. During the week of Dec. 15, crude oil put in a fresh run to the downside. Exxon was pulled lower by crude oil, which, in turn, helped to pull the S&P 500 lower. Now look at “Going up”. TLT, the ETF for long-term U.S. bonds is rising. As money flowed out of crude oil, Exxon and the S&P 500, money flowed into bonds.

Market timing is hard, but not impossible. These charts show that, during the week of Dec. 15, many market participants were quite aware that pressing the long side of the S&P 500 was a losing proposition. The break in crude oil was an anomaly, a warning. There was ample news coverage of the break in crude oil. If you do not trade futures, you could have gone short XOM as it ran after crude oil, or gone long bonds (TLT) as they inversely ran higher.

Anomalies are temporary windows of opportunity. When a stock or index runs abruptly, it disrupts the balance among the stocks and indexes with which it is connected. Investors and traders buy and sell in order to rebalance relative values. That rebalancing presents market-timing opportunities. If you keep your eyes open, understand which markets impact others and don’t overthink the concept, market timing works.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day-trade his own account. He publishes a day-trading diary on his web site: www.DayTradingWithLinesInTheSky.com . E-mail him at richardmue@yahoo.com.

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