Market anomalies, momentum & the gamblers fallacy

Quirks of investor behaviour get magnified in the summer.  Low trading volumes and a lack of company news can make markets behave oddly.  Investors fall back on folklore and succumb to their own psychological biases. Rules like “sell in May” and “never short a dull market” indicate the unwillingness of investors to take a position over the summer months.  Yet, seasonal effects are not consistent, and can be bad advice. Summer is an important time for investors to get to grips with their own behavioural biases, as well as the market’s.

 Sell in May was little help in 2009; those who stayed in the market were rewarded with a gain in the FTSE 100 of more than 20% over the third quarter.  Despite little apparent catalyst, the market relentlessly drifted up on low volumes.  Some wrongly took comfort from the light dealing – it seemed to indicate a lack of conviction.  But, low volumes typically signal relatively little difference in opinion.  There can be no battle between bulls and bears if one side sits on the sidelines, lacking the conviction to enter the fray.

 And last year the September effect did not help.  Academic studies have shown September to be the worst month on average for share performance – the only one in which prices typically fall.  But this conceals a huge range of returns between years.  The absence of the September effect last year – which bears hoped would offer a last chance to climb aboard the rising market – was the last straw.  The FTSE 100 gained almost 5% in September 2009, triggering a capitulation by the bears in the last quarter. 

 Behavioural finance predicts this behaviour from otherwise rational investors. Investment professionals typically suffer from the gamblers’ fallacy, expecting sharp moves to reverse conveniently.  Many professionals took pride in being contrarian last summer, and sat out the rally waiting for a setback.  But private investors know that “too far, too fast” does not prevent the market rising just that bit further.

 Increasing interconnectedness of markets globally is changing some seasonal patterns faster than academic studies can recognise.  Of all market anomalies, seasonal patterns have been the hardest to explain historically, and are also now proving the least consistent.  Possibly in a world of Blackberrys and round the clock financial TV, there are no longer genuinely quiet periods for the stockmarket.  It is a human failing to search for patterns and rely on them, but seasonal anomalies are amongst the least useful.

 Other market behaviours have a better record.  Many studies have examined momentum reversal, which has been one of the most consistent market anomalies over decades.  Shares that performed particularly badly in the previous year, tend to be good bets for recovery over the next 12 months.  This was evident in the sharp recovery of 2009, in which many of the disasters of 2008 were refinanced.  But the momentum pattern is now less supportive in 2010.  Fundamentally, it is clear that refinancing has not solved the problems of companies with weak business strategies.  For many of these shares, last year may prove a brief interruption of a downtrend.  Technically, many recovery stocks have completed their momentum reversal.

 Seasonal anomalies are breaking down; investors should treat the summer with respect.  Politics and macro issues may distract while there is little real company news, but investors should not lose sight of fundamentals.  Investors need to set a strategy that looks beyond what is often a surprising quarter.

 This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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