Efficient Market Hypothesis vs. Relative Strength

We all know investors’ bottom-lines can be summed up with that one-liner from Jerry Maguire:

“Show me the money!”

But for ambitious money managers, the quest for a profitable investment strategy begins with a different cry:

“Show me the research!”

I know, I know… It doesn’t have the same ring to it. And I won’t even bother pitching it to Hollywood. But seriously, investors that want to come out ahead over the long run need an edge… a unique competitive advantage that turns the odds in their favor and allows them to outperform the market over the long run.

The Efficient Market Hypothesis, of course, claims there is no such thing as an edge. This theory suggests there is simply no way to “beat the market.” You’ve no doubt heard sayings like, “everything is always priced in,” and “there’s no such thing as a free lunch.” That’s this hypothesis in a nut shell.

And I think the Efficient Market Hypothesis is bunk.

I can point to many examples of traders and money managers who do consistently beat the market. This would be impossible if the Efficient Market Hypothesis were actually true.

I think the theory simply overemphasizes the millions of investors who trade without a plan… who place bets on mere hunches… and who have no quantifiable edge.

To me, saying it’s impossible to “beat the market” is like saying “everybody loses in Vegas.”

While that may be true for most, it’s not true for everyone.

Think about card counters, for example. A number of smart, disciplined card players have made a fortune in Vegas by “counting cards” at the Blackjack table. The casinos hate this of course, because it flips the odds, which usually favor the house.

The ability to count cards, instead of merely playing Blackjack on hunches and gut feel, is the edge that allows a small group of card players to make money consistently at the casino.

The same theory applies to trading and investing.

An investor’s edge could be his knack for reading between the lines of annual reports. Or, it could be a unique price pattern that accurately predicts market tops or bottoms.

My edge is relative strength.

Through countless hours of research, I’ve found a unique way of picking up on shifts in momentum. This helps me stay invested in sectors and stocks that are outperforming the broad market.

In fact, the profitability of my edge is so convincing I’m beta testing a service – called Cycle 9 Alert – with the plan to share my edge with you in the New Year.

While the analysis underpinning my service is unique, its roots lie in research conducted decades ago…

Relative Strength: 1967 to 1995

In 1967, Robert Levy, Ph.D. wrote a paper in the Journal of Finance that flew in the face of the then popular Efficient Market Hypothesis. Basically, Levy’s research showed that relative price strength was a phenomenon that lasted long enough into the future that it could be exploited for profit.

Two finance professors, Narasimhan Jegadeesh and Sheridan Titman, further proved Levy’s theory in the early ’90s. Their findings, also published in the Journal of Finance, showed that stocks with strong performance over the last three to 12 months earn, on average, about 1% more each month for the following year.

Jegadeesh and Titman’s research also showed that those same stocks later went on to underperform the market during months 13 through 60. This evidence shows relative strength momentum lasts long enough to make profitable investments, but it doesn’t last forever.

Aha! Now that’s an edge. It’s precisely the type of odds-enhancer investors need to beat the market.

Putting the Pieces Together

I won’t get into the detailed math behind it, but Jegadeesh and Titman’s research into relative strength gave clear criteria to follow for making new buys. There was just one problem. It didn’t alert investors to the best time to cut losses or take profits.

With that downfall in mind, I developed a system that would not only help investors get into the best trades, but that would give clear signals when it’s time to get out. As I mentioned earlier, we’re beta testing this right now.

Let me walk you through one example…

At the beginning of this year, the Utilities Sector (XLU) was moving sideways as the broad market moved higher. So I steered clear of utilities stocks.

Then, in early April, XLU began outperforming the market. I waited patiently to see if the outperformance would last or if it was merely a false signal.

Sure enough, by May 2, XLU was outperforming the market with enough strength to trigger my “Buy Alert.” Back then I was only paper trading while I put my system through its paces, so I added shares of XLU to my model portfolio the very next day.

From there, XLU broke into a strong uptrend, trading as high as $38.54 by August 1, three months after I got in.

However, XLU’s strength against the broad market began to wane. On August 6, the sector went into underperformance territory, prompting an exit signal… so I go out.

Here’s what the whole play looked like:

See larger image

And this is how I run Cycle 9 Alert. I use the edge that Levy first uncovered, plus some honing of my own, to find the sectors and stocks set to outperform the market’s average return.

My advice? Forget the Efficient Market Hypothesis… with an edge like this it is possible to beat the house. Stay tuned for more details on Cycle 9 Alert.

Adam

 

 

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Categories: Markets

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.