Patterns Unlock Profits in Stocks

In the most general terms, there are two types of investors – those who think they are failures and those who believe they can succeed.

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  • Investors who believe they are failures will cling to index funds. They tell others that no one can beat the market and to try is futile. So, they settle for funds whose goal is to lose 50% or more in a bear market. This is shown in the chart below.

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  • iShares S&P 500 Index Fund (NYSE: IVV) lost as much as the stock market in the bear market that ended in 2009. Investors who believe they are failures tell us that’s nothing to worry about because the stock market always comes back. This statement ignores reality as the next chart shows.

    The Nikkei 225 Index, a benchmark index tracking the stock market in Japan, has been in a bear market since 1989. Investors have spent 27 years waiting for the market to come back and they are still more than 40% below the highest high set in December 1989.

    Investors putting their hopes into index funds are following a theory known as the Efficient Market Hypothesis (EMH) which says the current price of a stock accurately incorporates all known information. Since prices are efficient, the theory argues, it is impossible to beat the market.

    Under the EMH, index funds are the only investment that makes sense. Investors who believe “you can’t beat them, so you might as well join them” give up on outperforming the market and accept that they could spend decades nursing losses.

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  • A Nobel Prize Winner Proves You Can Beat the Market

    This year’s Nobel prize in Economics went to Dr. Richard Thaler who has done ground breaking work in behavioral economics. Thaler has proven that investors are not always rational and that they tend to make mistakes like overreacting to news.

    Thaler has done more than write papers about behavioral economics. He also manages money using these ideas. His firm offers separately managed accounts and mutual funds. The firm manages more than $9 billion and has delivered impressive results.

    Market beating performance of the firm’s Undiscovered Managers Behavioral Value Fund (UBVLX) is shown below.

    Thaler has also published a number of papers and books about his research. He has found that a number of patterns exist in the market. This is, of course, impossible if markets are efficient but no one in the academic community continues to argue that markets are completely efficient.

    In the academic community, researchers like Thaler have found a number of anomalies to the EMH exist and these anomalies can be exploited to outperform the market. Firms that make billions of dollars managing index funds don’t really publicize this research because it undermines their business model.

    However, some index fund providers are introducing funds based on anomalies. They are offering indexes with tilts towards momentum, value, low volatility and other factors that have been shown to beat the market.

    Individual Investors Can Beat the Market With Well Known Patterns

    Momentum is among the most robust patterns that researchers have identified. Momentum simply refers to the performance of a stock over the recent past. For example, stocks that have outperformed the market over the past six months are likely to outperform over the next six months.

    Likewise, stocks with low momentum are likely to see that pattern continue over the near term. So, stocks that lagged the market over the past six months are likely to continue underperforming in the next six months.

    These are general tendencies and there will be stocks that move opposite to the general tendency. This is not proof that momentum works. This pattern is best when applied to a portfolio of stocks. This was demonstrated in a paper called “Value and Momentum Everywhere”, an article published in The Journal of Finance.

    In 2013, the researchers found, “consistent value and momentum return premia across eight diverse markets and asset classes…” and noted that “Global funding liquidity risk is a partial source of these patterns, which are identifiable only when examining value and momentum jointly across markets.”

    In other words, value and momentum work around the world. These are two patterns that are relatively easy to identify and could help investors beat the market.

    Value can be measured in a number of ways. Researchers have found investors could use the price to book (P/B) ratio, the price to earnings (P/E) ratio, measures involving cash flow or profit margins, or a variety of other value metrics. They all work well in the long run for a portfolio of stocks.

    Momentum is also robust and can be measured in a variety of ways. It can be calculated by looking back three months, six months or twelve months. The most recent month’s performance can be ignored or over weighted. There are other ways and again, they all work well in the long run for portfolios of stocks.

    Thaler has also found a number of recurring patterns in the stock market. He has written about seasonal anomalies.

    In particular, Thaler has noted that stock prices tend to perform better in the month of January. This is especially true, he wrote, for small firms and for the stocks of companies that have not done well over the previous few years. He considers this to be a pattern that occurs at the turn of the year.

    Thaler also wrote about what he called “abnormal returns” that occur around the turn of the week, the turn of the month and the turn of the day. All of these patterns could be the basis of a trading strategy. He also identified abnormal returns around holiday periods that could be profitable for traders.

    Chart Patterns Can Also Boost Profits

    Other researchers have found that traders who make trading decisions based on chart patterns could be profitable. One paper, “Head and Shoulders: Not Just a Flaky Pattern,” was prepared by a team that included a Federal Reserve economist.

    This paper identified the “patterns using an objective, computer-implemented algorithm based on criteria in published technical analysis manuals. The resulting profits, replicable in real-time, are then compared with the distribution of profits for 10,000 simulated series generated with the bootstrap technique under the null hypothesis of a random walk.”

    The paper was peer reviewed and published in the top ranked Economic Journal. The conclusion noted that “if one had speculated in all six currencies simultaneously, the profits would have been both statistically and economically significant.”

    Other research has shown that a variety of other chart patterns can be traded profitably. Despite the extensive research, some investors continue to argue that markets are efficient and it’s impossible to beat the market using patterns.

    This could be true for a number of investors. The research all assumes that patterns are followed with discipline.

    The truth is many investors do not follow a disciplined approach. Many buy after a big run up and sell after a large decline. They miss the bull market by overreacting and blame the market rather than themselves.

    Thaler has built his firm on the principle that investors will make mistakes. His process looks for those mistakes and profits from them. He believes there are two kinds of mistakes that produce buying opportunities: over-reaction and under-reaction.

    Other investors may over-react to bad news and losses (e.g., panic). Or they may under-react to good news (e.g., not pay attention). These mistakes both produce patterns on charts that could be exploited for profits.

    The Stock Trading Tips service, PPK System, is designed to exploit patterns associated with value and momentum, with overreaction and underreaction. You can learn more about this trading service by clicking here.

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