Breakdowns in Market Efficiency
Stockscores.com Perspectives for the week ending October 19, 2008
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In this week's issue:
Traders need to understand the source of trading opportunities, and that requires some understanding of financial theory. Since the stock market is usually efficient and since efficiency dictates that trades should only yield random results, it is important to know how breakdowns in market efficiency creates the opportunity to make winning trades.
There are two assumptions of market efficiency and if either of these assumption do not hold true then there is an opportunity for market beating profits.
First, it is assumed that all investors have equitable access to information. This means that no one can have an advantage because they have better information that lets them predict prices moves with the benefit of that information.
Second, it is assumed that investors act rationally. Their estimation of price is based on a rational analysis of the stock, the economy and what ever other factors contribute to price.
Now, ask yourself if you have ever seen investors act irrationally or if you have ever witnessed stocks making strong price moves without any information to justify it.
We all know that fear and greed play a big role in how stock prices change and we have all seen stocks make moves before the news come out. Buy on rumor, sell on news
It is these situations that create opportunity. Buying or selling under any other circumstances, if you believe in financial theory, will only yield random results. Therefore, unless you are leveraging breakdowns in market efficiency, you may as well just buy an index fund that gives you the return of the overall market.
But, if you can learn how to identify situations where there are breakdowns in market efficiency, it is possible to beat the market, provided you practice good risk management techniques.
How do you find these situations? Each breakdown, whether on emotion or on people trading with private information, has characteristics that can be identified. Fundamental analysts who really know what they are doing can uncover information that is not widely known to find opportunity or see where emotion has caused a mispricing of stocks. However, most of us do not have the knowledge, contacts or skill to make these kind of discoveries.
Therefore, I prefer to use the analysis of stock charts to find breakdowns in market efficiency. If I want to find stocks trading on new information that is not widely disseminated, I look for abnormal activity out of predictive chart patterns. Abnormal breaks through resistance from sideways trading and optimism is one thing that I look for, it tends to come at the start of many long term upward trends that are motivated by positive fundamental change.
Finding emotion in trading is a bit more short term in nature and less obvious, but still quite simple to find. If you can find stocks that are in long term trends, either up or down, then you can see emotion when price runs far away from the long term trend. Trend lines are linear, but there are times when price movement follows a steepening curve. This signals emotion. Eventually emotion reverses and price comes back to the trend line.
Right now, the market we are in is one where there is widespread emotion. If you look at the charts of the major market indexes, you will find that price is far below the long term linear downward trend line. That means that eventually price has to come back to the trend line, which is why I have been looking for a short term bounce back in the market.
I believe that most stocks, most of the time, trade in an efficient manner. That means buying or selling them will only yield random results. If you want to beat the market and trade for predictable profits, you will have to create strategies that seek ways to exploit the occasional breakdowns in market efficiency.
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This week, I went through the charts of the major Canadian Exchange Traded Funds, seeking those that were trading on emotion, that is, were trading far below their downward trend lines. This makes it likely that they will come back up to the trend line, giving a short term buy trade which takes advantage of their emotional mispricing.Back To Top
1. T.XRE
T.XRE has fallen fast and hard and made a bounce signal last Friday and confirmed it again this Thursday. Support at $8.
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2. T.XMA
The downward trend line on T.XMA is at about $15 while the stock is at $10.67 with support at $10. That gives the trade a good risk reward ratio, making it worth considering even if the probability of this not being a bottom is not great.
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3. T.XMD
T.XMD is another trading well below its downward trend line, it has support at $12 and resistance at the downward trend line at $19.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
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Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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