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Market Anomalies

Jan 15, 2014   //   by Profitly   //   Market  //  Comments Off on Market Anomalies

I’ve said this before and I’ll say it again, Investopedia is a fantastic website for financial information. If there is ever a term or topic that you don’t understand and it relates to finance, chances are there will be a great definition on this site. Here is a recent post that they did on six market anomalies that investors should know about, especially if they are just starting out and want to learn how to trade stocks.

Certain tradable anomalies seem to persist in the stock market, and those understandably fascinate many investors. While these anomalies are worth exploring, investors should keep this warning in mind – anomalies can appear, disappear and re-appear with almost no warning.

1. Small Firms Outperform

The first stock market anomaly is that smaller firms (small cap stocks) tend to outperform large caps. As anomalies go, the small-firm effect makes sense. A company’s economic growth is ultimately the driving force behind its stock’s performance, and smaller companies have much longer runways for growth than larger companies. Think of it like this, a company like Microsoft (MSFT) might need to find an extra $6 billion in sales to grow 10%, while a smaller company might only need an extra $70 million in sales for the same growth rate. Therefore, smaller firms typically are able to grow much faster than larger companies, and the stocks reflect this.

2. January Effect

This is a pretty well-known anomaly. It’s also the most important right now since, guess what, it’s January! The idea here is that stocks that underperformed in the fourth quarter of the prior year tend to outperform the markets in January. Investors will often look to abandon underperforming stocks late in the year so that they can use their losses to offset capital gains taxes.

As this selling pressure is sometimes independent of the company’s actual fundamentals or valuation, this selling can push these stocks to levels where they become attractive to buyers in January. Likewise, investors will often avoid buying underperforming stocks in the fourth quarter and wait until January to avoid getting caught up in this tax-loss selling.

3. Low Book Value

First note, the Price to Book (P/B) Value is equal to the stock price divided by the total assets of the companies less their intangible assets and liabilities (book value). Broad academic research has shown that stocks with below-average price-to-book ratios tend to outperform the market. Numerous test portfolios have shown that buying a collection of stocks with low price/book ratios will deliver market-beating performance. However, even though it is true that low price-to-book stocks outperform as a group, individual performance is idiosyncratic, and it takes very large portfolios of low price-to-book stocks to see the benefits.

4. Neglected Stocks

So-called neglected stocks are also thought to outperform the broad market averages. The neglected-firm effect occurs on stocks that are less liquid, meaning they have a lower trading volume, and tend to have minimal analyst support, meaning there aren’t many analysts covering the stock. The idea here is that as these companies are “discovered” by investors, the stocks will outperform.

Research suggests that this anomaly actually is not true – once the effects of the difference in market capitalization are removed, there is no real outperformance. Consequently, companies that are neglected and small tend to outperform (because they are small), but larger neglected stocks do not appear to perform any better than would otherwise be expected.

5. Reversals

Some evidence suggests that stocks at either end of the performance spectrum, over periods of time, do tend to reverse course in the following period – yesterday’s top performers become tomorrow’s underperformers, and vice versa. Essentially, just because a company outperformed in the prior year, doesn’t mean that it will outperform in the coming year. You should probably steer clear of stocks like TSLA (up nearly 350% in 2013), NFLX (up nearly 300%), BBY (up nearly 240%), TWTR (up nearly 150%) and HLF (up nearly 140%). Not to say that they won’t do well, but outperforming two years in a row? That’s wishful thinking.

Not only does statistical evidence back this up, the anomaly makes sense according to investment fundamentals. If a stock is a top performer in the market, odds are that its performance has made it expensive; likewise, the reverse is true for underperformers. It would seem like common sense, then, to expect that the over-priced stocks then underperform while the under-priced stocks outperform.

6. Days of the Week

Efficient market supporters hate the Days of the Week anomaly because it not only appears to be true; it makes no sense. Research has shown that stocks tend to move more on Fridays than Mondays, and that there is a bias toward positive market performance on Fridays. This is something that Tim makes note of in his teaching. One big rule is to be careful about shorting a company going into the weekend, since many people do not want to be short over that time. This can lead to a Friday afternoon short squeeze. This doesn’t always happen, but Tim tells you to keep it in mind when taking positions on a Friday afternoon.

Attempting to trade anomalies is a risky way to invest since they are unpredictable. However, with that said, anomalies can still be useful to an extent, especially since many of them lead back to the basic principles of investing. Example 1: it would seem to make sense to try to sell losing investments before tax-loss selling really picks up and to hold off buying underperformers until at least well into December. Example 2: small companies do better because they grow faster, and undervalued companies tend to outperform because investors scour the markets for them and drive the stocks back up to more equitable levels.

Ultimately, there is nothing really strange about that at all – the notion of buying good companies at below-market valuations is a tried-and-true investment philosophy that has held up for generations.

Friday Morning Reading – Big Day for Transparency and Teaching

Jan 10, 2014   //   by Profitly   //   Market, News, Press, Profitly  //  Comments Off on Friday Morning Reading – Big Day for Transparency and Teaching

Tim on Fox

Strategies for investing in Penny Stocks (by your very own Tim Sykes!) (Fox Business Network)

The U.S. posted the smallest job gains in 3 years and the participation rate dropped to a 35-year low (MarketWatch)

Fed’s taper plans are in question after dismal jobs numbers (MarketWatch)

Congress may have a low approval rate amongst American’s, but that doesn’t seem to be hurting their pocket books. (CNBC)

After a rough year, Bill Gross still has faith in bonds (WSJ)

Target’s troubles continue, as the retailer reveals new information from ongoing investigation of the massive security breach. (Fox Business Network)

Monday Morning Reading – Suit Up

Jan 6, 2014   //   by Profitly   //   Market, News  //  Comments Off on Monday Morning Reading – Suit Up

suit

The saga continues between Men’s Wearhouse and Jos. A. Bank, as Men’s Wearhouse has now launched a hostile $1.61 billion bid for the other retailer. (Reuters)

Five key factors determining whether the economy is going to take off (WSJ)

Drones, drones and more drones. Catch a preview of the “commercial drone” at CES. (USA Today)

One company is taking publicity to another level. (FOX News)

Coldest air in two decades invades U.S. (Bloomberg)

Humans: 1 ; Technology: 0 (WSJ)

The turnaround for Facebook and CEO Mark Zuckerberg (WSJ)

Friday Morning Reading – Snowpocalypse!

Jan 3, 2014   //   by Profitly   //   Market, News  //  Comments Off on Friday Morning Reading – Snowpocalypse!

snowpocalypse

What I’m reading this morning

Northeast hit by snowstorm Hercules; Roughly 2,000 flights were canceled nationwide on Thursday (WSJ)

More bad news for hedge fund titan Steve Cohen (WSJ)

Careful what you’re sending in private messages on Facebook; social network is sued over allegedly scanning private messages (Bloomberg)

Dr. Doom now bullish on the economy?! (CNBC)

Brokers with a high number of complaints to see a crackdown from regulators (WSJ)

U.S. Dollar starts off 2014 full speed ahead (WSJ)

What actually makes you want to do the right thing? Doing the right thing voluntarily vs. doing it to avoid punishment (WSJ)

 

 

Monday Morning Reading for the New Year

Dec 30, 2013   //   by Profitly   //   Market, News  //  Comments Off on Monday Morning Reading for the New Year

What I’m watching going into the New Year:

A record run for stocks has investors nervous about 2014 according to MarketWatch. The S&P 500 is set to end the year at a record high with a return of nearly 30% in 2014. (MarketWatch)

It’s no secret that equities did well this year. The S&P 500 has climbed 29% this year, meaning it beat government debt by 32 percentage points. That’s the largest spread since at least 1978, according to data compiled by Bank of America Merrill Lynch and Bloomberg. (Bloomberg)

One hedge fund titan is set to have a record year and take the title of highest paid hedgie. David Tepper of Appaloosa Management could see a $3 billion-plus payday in 2013 (New York Post)

Virtual currency bitcoin is becoming more mainstream. Some small-business owners in New York City are accepting bitcoin currency at their brick-and-mortar shops, The NYP reports. (New York Post)

Twitter is falling for a second consecutive day after hitting all time highs last week. It opened down more than 4% this morning. (MarketWatch)

Here are a few extremely unlikely predictions for 2014, including GM buying Tesla and United Airlines filing for bankruptcy. (Bloomberg)

Commodities Risks

Dec 14, 2013   //   by Profitly   //   Market, Risks  //  Comments Off on Commodities Risks

A lot of people like to diversify their investments by finding alternative ways of trading. The large world of commodities is one way to do that. Particularly after the 2008 financial crisis, people wanted to put their hard earned cash to work in places other than equities. Corn, coffee, gold, orange juice, oil, and even cattle are different types of commodities that are traded on exchanges. This is a stark change from when commodities used to only be used for hedging, where for example farmers could ensure a certain price for their crops.

Some of these have turned out to be great investments since 2008; gold is up from $850 in January 2008 to about $1200 now. But actively trading commodities is an extremely tricky business and a lot of people don’t really understand what they are getting into.

In case you weren’t aware, most people who trade commodities lose money. A majority of the estimates are in the range of 80 to 95 percent who have lost or who are losing trading commodities. Pretty bleak statistics if you ask me. Yet, people continue to trade commodities every day and more and more people give it a try as well. Fortunately, there are several commonalities in terms of the mistakes that people make while trading commodities, meaning that if you read this and learn from it, you have far better odds of making money.

According to about.com, here are some of the most common trading mistakes:

First is lack of education. Just like I said above, a lot of people don’t know what they are getting into when they start trading commodities. This is just like people that try to trade penny stocks without learning from Tim or the other gurus. Sure, even without education you will get lucky and have a good trade or two, but the odds are not in your favor. Far too many new traders neglect to educate themselves on how to trade commodities before diving in head first. Commodities is a zero sum game, meaning for every person that makes $100, another person lost $100.

Second we have the leverage problem. This is probably the number one issue when it comes to trading commodities. There is huge leverage when trading commodity futures, so a couple bad trades can wipeout the over leveraged trader. Do not trade a contract that is too large for your account size. For instance, do not trade three futures contracts that average a $2,000 move a day when you have a $10,000 account.

Third we have money management. This is another biggie and relates to the tip we previously discussed regarding leverage. You should not risk more than a small percentage on any given trade. There are statistics showing that most professional money managers risk less than 2 percent on any one trade. This becomes more difficult when trading commodities and other futures contracts.

Finally, remember to have a plan. How many times have Tim and I written about having a PLAN before making a trade?! Traders get so lazy and impatient when it comes to this. You have to have a plan.

So now that you have that advice, let move in to the elevated risks of trading commodities. You can’t help but think about risk when you think about trading commodities.

The key reason why commodities are considered risky is that commodities are traded in futures contracts and they are highly leveraged (addressed in the four tips above). A commodities trader normally only has to put up 5 to 20 percent of the contract in futures margin value to control the commodity investment. When you buy one contract of crude oil, you aren’t just buying one barrel, unlike when you buy a stock, you can buy one stock. You are actually buying 1,000 barrels of crude oil when you purchase one contract. That means in crude oil is trading at $90 a barrel, you are buying $90,000 worth of oil, not $90. However, a trader doesn’t need to put up the full $90,000. They would be required to put up a much smaller percentage, around $6,000 in this case. This also means that if oil moves from $90 a barrel to $89, the value of your position would change by $1,000. That’s leverage since you don’t have to put up the full amount. How do you feel about entering a commodity trade with $5,100 in margin and realize that position can move for or against you by about 40 percent every day?

The fact that uneducated traders do this without even realizing what they are getting themselves into is very, very scary. This kind of leverage in the hands of an undisciplined trader is the reason so many new commodity traders lose money. It is commonly discussed in the futures industry that anywhere from 80 to 95 percent of traders lose money in commodities, slightly more than the average number of people that lose money trading stocks. Those educated in trading commodities, such as commodity trading advisors (CTA’s) have a much better track record with managed futures. The popular Barclay CTA Index has CTA’s making an average compound annual return of 11.56% from 1980 to 2009. There were only 3 losing years and the worst was -1.19%.

Why Profitly Traders Don’t Care If This Is A Market Top

Nov 29, 2013   //   by Profitly   //   Market, Profitly  //  Comments Off on Why Profitly Traders Don’t Care If This Is A Market Top

Every day it seems like we hear about the stock market hitting another all-time high. The major averages headed into the day after Thanksgiving poised for their 8th consecutive week of gains, which was the longest winning streak for the Dow in almost three years (since Jan. 21, 2011) and for the S&P 500 in almost 10 years, yes 10 years! (since a 9-week string of gains that ended Jan. 23, 2004). The NASDAQ Composite is on track for its third week of gains, with the Russell 2000 looking at four in a row.  The Dow Jones Industrial Average has closed at new record levels more than 40 times this year alone. The S&P 500 has also hit record levels, up more than 25% for the year. The Nasdaq recently hit 4000 for the first time since the tech bubble burst 13 years ago.

One post from David Merkel in 2004 elaborates on some of the signs of the market top, reposted from Josh Brown of thereformedbroker.com:

The first is when the investor base becomes momentum-driven. This is when absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down. You can also recognize when a market top is probably coming when:

a) The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for their conservatism. In early 2000, we saw many eminent value investors give up around the same time.

c) Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this.

d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.

e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.

f) Markets driven by momentum favor inexperienced investors. The author says that his favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends.

g) Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.

Item 2: Corporate Behavior

Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.

Here are ways that corporate behaviors change near a market top:

a)  The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period. Twitter isn’t even profitable yet, and it was one of the most talked about IPOs of the year.

b) Venture capitalists can do no wrong, so lots of money is attracted to venture capital.

c) Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.

d)  There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.

e) Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.

f) Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.

g) Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

But you know what, traders on Profitly don’t need to worry about this. Most of them are not buy and hold investors, and they actually LOVE when momentum takes hold. They can make more in a shorter amount of time on the market’s irrational exuberance. Sure, the market may turn on them and swing the other direction, but again, most of them do not hold for long and likely have tight stop-loss orders (whether mental or actually in their trading systems) so they won’t lose a lot of money, if any.

For example, lx21 is currently the all-time top trader on Profitly, and if you look at his recent trades, you see that most of them are only one-day trades. He hardly ever holds his positions for multiple months, weeks, or even days. I guarantee he is very unconcerned about whether the market is getting “frothy.” Another example is that stock ticker OXBT is the most popular traded stock according to Profitly during the past 30 days. I looked through about 15 of the recently recorded trades in that stock, and the longest holding period I found was two days.

So in conclusion, when you hear everyone getting worried about their 401k’s and other long-term investments due to a potential market top, remember that Profitly traders are sitting back and enjoying the ride, raking in the profits on a daily basis.

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