The graveyards of Wall Street are filled with those who bet that they knew more than the market.
Yet it would be a mistake to conclude that the market never makes mistakes. Though errors may not be common, they do occur. You should be on the lookout for them, since they create opportunities for easy profits.
A good example, according to a study published in mid-April, is how investors react to a stock split. Since the per-share values of the stock’s fundamentals (earnings, cash flow, sales, book value, and so forth) split in lockstep with its price, there is no fundamental reason why the change in price should have an impact on the stock’s subsequent volatility. And, yet, far more often than not, it does.
The reason, according to Kelly Shue, a Yale University finance professor, and Richard Townsend, a professor of finance and accounting at the University of California, San Diego, is that investors don’t know how to multiply or divide. They focus on the dollar magnitude of a stock’s daily changes, without realizing that those dollar amounts represent a far bigger percentage after a split than before.
Take W.R. Berkley (ticker: WRB), an insurance company whose shares underwent a 3-for-2 split on April 3. According to FactSet, the stock’s daily price volatility since that split has been 68% greater than it was over the comparable period before the split.
Try as we might, we can’t find a rational explanation for this marked increase. The broad stock market has experienced a decrease in volatility over the same time frame, for example. Nor could the split have taken investors by surprise, since the company announced it in February. Furthermore, there was no big news story about W.R. Berkley that would cause an increase in volatility.
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What happened to W.R. Berkley over the past month is the rule rather than the exception, according to the professors’ research, which they present in a study that the National Bureau of Economic Research recently began circulating. They based their conclusions on analyzing the impact on volatility of stock splits over a 90-year period (1926-2016).
The title of their study is “Can the Market Multiply and Divide?”
The professors found that even sophisticated option traders are guilty of a similar error, as measured by implied volatility derived from option prices. In effect, the traders fail to foresee the increase in volatility that typically comes after a stock split.
This points to one way in which you can profit from the error: Enter into a so-called long straddle on a stock right before the “ex-dividend date”—the date a preannounced split takes effect. This strategy, which involves buying both a call and a put option with the same strike price and expiration, should turn a profit if the stock’s volatility is greater than the market had anticipated (Call options confer the right, but not the obligation, to buy a security at a set price within a specified period; put options confer the right to sell a security under similar conditions.)
Upon backtesting one version of this strategy, the professors found that it produced an average 15% profit over the 40 trading days after a stock split. (That’s not an annualized number, by the way, but the raw return—impressive for just a 40-trading day holding period.)
The professors suspect that investors’ inability to multiply and divide applies to all low-price stocks, not just those that have undergone a split. They focused on splits only because they provide the perfect test of their theory, since everything else is being held constant.
If investors are systematically making mathematical mistakes on all low-price stocks, then there are other ways of profiting from their error than with options. One strategy would be to focus on low-price stocks when betting that investors have overreacted and that large price moves will soon reverse themselves. The professors’ research shows that there is a significantly greater probability among low-price than high-price stocks that prices have deviated significantly from fundamental value.
A discussion of this new study wouldn’t be complete without acknowledging another study nearly two decades ago that the professors say was the inspiration for their study’s title. That earlier study, titled “Can the Market Add and Subtract?,” was written by Richard Thaler, the University of Chicago economics professor (and Nobel laureate), and Owen Lamont, a lecturer in Harvard University’s economics department. They answered in the negative.
An often-told joke in academia is about two economists who are walking down the street when the younger one finds a $20 bill on the sidewalk. As he is about to bend down to pick it up, the older and wiser economist tells him not to bother, since if it really were a $20 bill someone would have already picked it up.
The point of this new study is that sometimes it really is a $20 bill.
Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
https://www.barrons.com/articles/how-to-profit-from-the-stock-markets-mistakes-51556533800
2019-04-29 14:26:00Z
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