Yesterday I discussed my take on the different forms of the efficient market hypothesis (EMH) and how I use that information to make trades. Today I'll give you three examples of specific market inefficiencies I've observed that I try to take advantage of.
The Weekend Effect
On most Fridays I see the U.S. equity markets sag from 1 p.m. until the close, regardless of price movements earlier in the day or week. Why would this happen? Market makers and daytraders don't like carrying positions over the weekend, and because these participants are net long during the week, they sell off their positions into the close.
So if I have new funds to invest on a Friday, I'll typically wait until Monday to make the trades. Net of transaction costs, I could not short stocks on Friday and make money covering on Monday, but at least I can get into long positions at 0.1% to 0.5% lower cost, on average.
Mutual Fund Tax Sales
Mutual fund fiscal years end on Oct. 31, so capital and income gains can be computed and distributed to fund shareholders by December. Fund managers generally have net capital gains, so in October they look to sell losing stocks to reduce those gains. Likely candidates for sale are any stocks down 20% or more on the year.
How do I play this? Two ways: First, I take my tax losses in September, getting ahead of the crowd. Second, I generally maintain higher cash balances through the fourth quarter, jumping back in after mutual fund and individual tax sales are over.
Forced Sales
There are times when market participants are selling stock not because they think companies are overvalued, but because they have to raise cash in a hurry. In April, for example, I saw a wave of selling related to individuals who were raising cash to pay taxes on gains taken in 2000. This triggered margin calls on other investors, causing a sharp downdraft in the major averages. I had to raise cash for some of our clients for the same reason, and I accomplished this with a margin loan that I closed out four weeks later when stock prices had recovered.
During the week of Sept. 17 we saw some very ugly markets (e.g., a gap down 6% at the open, down 2% by the close). On Thursday, Sept. 20, insurance companies liquidated assets to cover claims; on Friday, market makers sold stocks to settle short stock futures and put options contracts. We told our clients before the markets opened that week that, with a couple of exceptions, we were holding tight to our client positions. By the following Monday, we were investing new cash, so far with excellent results: Markets have recovered to their preattack levels.
If you'd like to read more about the efficient market hypothesis, two terrific books are Burton Malkiel's A Random Walk Down Wall Street, which supports the hypothesis, and James O'Shaughnessy's What Works on Wall Street, which argues against it. I recommend that you read both to shorten your learning curve about successful strategies.
