The efficient market hypothesis is, in general, a good rule when it comes to the market. Most stocks are efficiently priced, and most inefficiencies or arbitrages are quickly whittled away. This is especially the case when it comes to large asset classes, as a growing number of total assets under management (AUM) is chasing down the alpha with bigger computers and more brains. It’s a war for information.
I don’t fight this war. Mainly because I can’t win, and it’s too difficult. But when it comes to market efficiency, you have to believe there are opportunities out there. There’s a running joke in economics about the professor and student walking down a path. The student spots a £20 note lying on the pavement and shouts in glee. The professor retorts: “Nonsense! If it was truly lying there for anyone to take, someone would’ve taken it already.” The professor walks by it, and the student pockets the £20 and buys a round of drinks for his friends.
If you stick to the markets being efficient as a solid rule, you’ll miss the best risk/reward trades out there. Back in February 2020, I talked myself out of shorting the market when Covid was sweeping into Italy. I figured that if Covid was a problem, then everyone would already be shorting. As it happens, they weren’t – and we saw the biggest volatility decline in history.
A few years earlier in 2018, I was aware that the US might potentially make sports betting legal. Once this legislation passed, I bought shares in Webis Holdings (WEB), which owned a large number of licences and stood to potentially benefit significantly. The stock multi-bagged within days, but I realised that all of the big gambling companies didn’t immediately go into auction as I would have expected. They gently started trending upwards and many closed the day in double-digit percentage rises. What I should have done is bought a basket of the gambling companies as I could have done a bigger size and achieved a far better risk/reward due to the smaller spreads.
So while the market is generally efficient, don’t let that stop you from finding trades. One of my favourite trading strategies is what I call the opening drive. It takes advantage of stocks that are likely to benefit from post-earnings announcement drift (PEAD).
PEAD refers to the tendency of a stock’s price to continue to drift in the same direction as its initial reaction to an earnings announcement, even after new information has been incorporated into the market. This phenomenon occurs when the market does not fully adjust the stock price for the earnings news immediately after it is released, and instead the price continues to move in the direction of the initial price reaction over the following weeks or months.
For example, if a company announces better-than-expected earnings, the stock price may initially rise sharply as investors react to the positive news. However, if the market does not fully reflect the true value of the earnings news in the stock price, the stock may continue to increase in value over time as more investors become aware of the positive earnings surprise.
The opposite can also happen in the case of negative earnings announcements, where the stock price may initially decline sharply, but then continue to fall over the following weeks or months as the market becomes increasingly pessimistic about the company’s prospects. PEAD is a well-known phenomenon in finance and has been observed in many markets around the world. And it’s also an inefficiency we can take advantage of.
An inefficiency we can take advantage of
Let’s look at Rolls Royce (RR.). I’ve marked an arrow where the company released numbers that were significantly better than the market was expecting. We know this because the stock is gapping up significantly (more than 10 per cent), which is already more than the average daily volatility.
But if you can spot the earnings announcement before the stock market opens you can take advantage of this by getting involved in the uncrossing trade and riding the uplift for the opening drive.
The volume was also significantly stronger than the average volume of the previous 30 sessions and so this meant that there was a potential PEAD move across the coming sessions.
Rolls Royce has yet to have a down day, and volumes have been consistently higher. Whenever a company announces significantly positive (or significantly negative) news do not assume the stock will open at an efficient price. Information takes time to digest.
Another example is Capita (CPI). Moving to Chart 2, we can see how the results released on 2 March 2022 led to a rise of more than 50 per cent in four sessions. Again, the characteristics were there. Gap up, strong volume, and a close towards the highs of the day.
If a stock closes at the highs of the day then it’s more likely to carry on into the next day, because traders are comfortable with the overnight risk and are clearly happy to roll their positions into the following session. This led to another rise with an even bigger volume and another strong close almost at the day’s highs.
This could well have been institutions buying into the stock. Naturally, bigger players can’t buy all their intended allotment in one go and so buying can be sustained across days, weeks, or even months.
So next time you spot a significantly positive or negative update, it could be that you haven’t missed the move even if you only spot it after the event. PEAD is real.
