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A Rational Approach to an Irrational Market Practical Methods for Exploiting Market Anomalies

This book explores practical methods for taking advantage of financial anomalies in an irrational market. It covers topics such as equity markets, index inclusions/exclusions, market inefficiencies, earnings announcement drift, and behavioral biases. Learn how to capitalize on these anomalies to enhance your investment strategy.

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A Rational Approach to an Irrational Market Practical Methods for Exploiting Market Anomalies

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  1. Practical Methods for Exploiting Financial Anomalies A Rational Approach to an Irrational MarketPractical Methods for Exploiting Market Anomalies

  2. Synopsis “There is nothing so dangerous as the pursuit of a rational investment policy in an irrational world” John Maynard Keynes

  3. Equity Markets - Efficient Markets • How are stocks valued by analysts? • Discounted Cash Flow • Assumption? • “If agents are rational and there are no frictions, a security’s price equals its discounted sum of expected future cash flows” • but... • Are traders “rational agents”?

  4. Index Inclusions/Exclusions • 58.3%1 of the £1.9 trillion assets under management (£400 billion in equity) • On average when a stock is added to the S&P 500 for example, it jumps by 3.5%2 • One dramatic illustration is when Yahoo! was added, it jumped by 24% in one single day • Clearly, its DCF has not altered by its addition to the index • The question is - is this anomaly exploitable? Index Tracking Funds Indices are not static Mispricing? Exploitable? 1 Source: IMA Fund Management Survey, 2002 2 Source: Handbook of Economics of Finance, 2003

  5. ? $142.5 3Com ex Palm Palm $81 Evidence of Inefficient Pricing • Event – 3Com sells 5% of Palm Inc in an IPO and announces that remainder will be sold in Nov ’00 with each 3Com S/H given 1.5 shares of Palm Day 1 Mar ’00 Nov ’00 3Com: $81 Palm : $95 • Arbitrage: Short Palm, Buy 3Com • - but inability to short • Take on Market Risk: Buy 3Com Receive 1.5 shares of Palm for $100 Profit = $100 - $81 = $19 Sell 3Com at $80 : $1 loss Total Profit = $18 • Lesson:Look for mispricing in spin-offs – especially when the spinoff is of a class of security in high demand

  6. Other Evidence of Inefficient Pricing • Stocks independently incorporated, separate legal entities, listed on more than one exchange but control the same assets • Relative market values anything but constant! (eg. Royal Dutch in S&P 500, Shell is not) • Between 1985-2000, 26 documented cases of subsidiaries worth more than their parents (in terms of market cap) • 26% terminated without convergence • often trade at discount to Net Asset Value (NAV) • why do investors buy them in the first place? Twin Shares Parent Company Puzzle Closed End Funds

  7. Earnings Announcement Drift • A wheel with 100 numbers is spun and the person asked whether the number of African countries in the UN is greater or smaller than that number and then to guess how many there are • Estimates biased by spin: 25 and 45 were the mean guesses of those who got 10 and 65 on the wheel respectively • In the US and UK, 60 days following an earnings announcement, stocks with the biggest positive earnings surprises tend to outperform the market by 2% • Stock Markets under-react to fundamental information • Lesson: Buy stocks with positive earnings surprises Anchoring Market Under-reaction

  8. Availability Bias • People “assess the probability of an event by the ease with which occurrences can be recalled” • As a result, there is a persistent over-emphasis on stocks that have received significant press coverage • Stocks with very high levels of press coverage have been shown to underperform the market in the subsequent 2 years Availability Bias Market Over-reaction

  9. Short Term Mean Reversion • Securities that have experienced extreme price movements display significant negative serial correlation – prices are mean reverting • It has been shown that stocks that suffer a 10% one day decline, on average return 3.95% over the next 5 days • Only for large stocks • In line with availability bias Mean Reversion Market Over-reaction • Lesson: Buy stocks that have experienced a very large one day decline - though assess the reasons first: Is it over reaction - or is it another ENRON?

  10. The Disposition Effect • Game 1: • Which do you prefer? • (A) a sure gain of £2500 • (B) a 25% chance of a £10,000 gain and a 75% chance of winning nothing • Game 2: • Which do you prefer? • (A) a sure loss of £7500 • (B) a 75% chance of £10k loss & 25% chance of losing nothing at all

  11. The Disposition Effect

  12. The Disposition Effect • Fact: People dislike losses and are willing to gamble with them • Game 1: • Which do you prefer? • (A) a sure gain of £2500 • (B) a 25% chance of a £10,000 gain and a 75% chance of winning nothing • Game 2: • Which do you prefer? • (A) a sure loss of £7500 • (B) a 75% chance of £10k loss & 25% chance of losing nothing at all • Translated into private investor behaviour? • Analysis of discount broker accounts shows 15% of gains realised against 10% of losses • Unsold losers then return 5% in next year while sold winners return a further 11.6% • Follow the market maxim: Sell your losses (stop loss) and ride your winners

  13. Calendar Effects Turn of Month Most return in DJIA occurs over 4 days Turn of year : January Effect (1/3 of annual returns) Equity Calendar Effects1 Turn of Week: Index rises on Fridays, falls on Mondays Intraday Effects: FallsMon in first 45mins but rises on other days 1 as identified in the early ‘90s and most have since disappeared

  14. Why do calendar effects arise? • Pension and mutual funds receive payments at given dates • Individual investors ratio of buy orders to sell orders (according to Merrill Lynch) are high in early Jan and low in late Dec • Window dressing by fund managers (dump ‘embarrassing holdings’) • Risk adjusted trading depending on firm’s financial year • well known fact that suicides are most common on Mondays Flow of Funds? Investor Behavior? Plain psychology?

  15. The Fixed Income Markets • What is a bond? • A bond is a simple loan • The buyer lends a given amount of money to the borrower for a predefined period of time • In return, the lender is paid interest for the duration of the loan, usually in semi-annual instalments • When the loan expires, the borrower repays the money to the holder of the bond. • Who issues bonds? • Governments: issue bonds to raise funds to cover expenses which general taxation income does not meet. • Corporations: To fund large-scale investments, acquisitions, leveraged buy-outs, or to provide working capital to finance aggressive growth

  16. Credit Ratings Junk Bonds

  17. Credit Ratings • Arbitrary cutoff- yet lots of investment managers are precluded by their mandates from holding high-yield bonds • When a bond is downgraded, it must be dumped by the managers resulting in higher yields for these bonds than implied by their probability of default • All airline bonds had been assigned junk status after the events of 11-9-01, as passengers evaporated and cash flows were decimated Junk Bonds Eg. Airline Industry

  18. Other Fixed Income Market Mispricing • A bond allowing the issuer to repurchase it for a specified price on certain dates prior to the bond's maturity. • Clearly, holder is short a call option. The price should therefore be worth less than the non-callable version. This is not always the case • T-bonds with no remaining intermediate coupon payments and identical maturity dates to T-bills should have the same price (as they have an identical cash flow) • Studies have shown that T-bonds sell at a premium on average of 10% • Referred to as a liquidity premium • Popularized by Salomon Bond traders of the 80s and by LTCM • On the run treasuries are cheaper due to higher liquidity but as they become off-the-run treasuries, the spreads with other off-the-runs narrow • No longer a profitable trade due to transaction costs Callable Bonds T-bills vs T-bonds? On/Off Run Treasuries

  19. Foreign Exchange • Buying currencies with high interest rate differential consistently yields positive returns • Inconsistent with Interest Rate Parity! • Intraday, FX rates mean revert while daily, they trend • Traders place stops at particular numbers - resulting in cascade effects Forward Rate Bias Momentum Trader Behaviour

  20. A Word of Warning . . . “The market can stay irrational longer than you can stay solvent” John Maynard Keynes

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