Technical trading and value investing rarely mix. Indeed, it often feels as if the most committed practitioners of these two discipline live in totally different universes.
Yet, while distinctions like “trader vs. investor” and “technical vs. value” do have real meaning, their portrayal as diametric opposites is more than a little overdone. In reality, few market participants can truly be said to obey a single discipline. Even Warren Buffett (Trades, Portfolio), the world’s most famous value investor, acknowledges that a part of his investment philosophy (about 15%, according to one statement) is based on the ideas of Philip Fisher, the father of growth stock investing.
Thus, even the most hardened of value investors should be able to acknowledge that there are times when a bit of flexibility is warranted. While it is rarely wise (or profitable) to play exclusively in the arena of technical trading, whether it is looking for momentum or something more esoteric, there are certain scenarios that can present savvy investors with opportunities to attain outsized profits in the short run. In a report published last month, Blue Mountain Capital Management presented the case for three such special situations. By keeping an eye out for these opportunities, investors may be able to add a bit of “technical edge” to their portfolios.
Exploit forced buying and selling
The first technical inefficiency discussed in Blue Mountain’s report involves the phenomenon of forced buying and selling:
“Optimistic buyers who have bid up asset prices fueled by debt create a setup for a crash. First, asset prices drop because of bad news, which heightens volatility, uncertainty, and disagreement. The price decrease commonly follows a sharp price increase.
“The initial drop in asset prices triggers a big decline in the wealth of optimistic asset owners. The drawdown in asset prices forces the optimists to sell assets to meet their margin requirements. This leads to additional declines in asset values, which triggers further selling, and so forth. These optimistic asset owners are selling for reasons that are unrelated to their view of fundamental value.
“Before prices find a new equilibrium, lenders make borrowing harder by requiring owners to put up more equity against their assets. This wipes out some buyers, leaving even fewer investors to support asset prices. Spillovers, when owners in one asset class cover their losses by selling assets in other classes, become a risk.”
Value investors are always seeking opportunities in which the market has fundamentally mispriced securities. Usually, they look for opportunities with a bit of persistence, i.e. they tend to be general price dislocations rather than short-term overreactions.
However, periods of panic or pessimism can present some of the very best buying opportunities. Hence one of Buffett’s favorite (and most famous) aphorisms: “Buy when others are fearful.”
Overstretched investors forced to alter their positions by market surprises can dislocate prices, allowing prepared value investors to scoop up these temporarily discounted securities.
Watch for the impact of fund flows
Investor flows between funds are anything but random, and these flows can have marked (and exploitable) effects on the prices of various securities:
“Investors tend to give money to investment funds that have done well and withdraw money from investment funds that have done poorly. Investment managers who receive additional capital tend to buy the securities they already own, and those who face withdrawals have to sell securities in the portfolio.
“As a result, positive flows tend to create positive price pressure and negative flows create negative price pressure. These effects are particularly pronounced for securities that are hard to trade and hence have a high cost of liquidity. This adds or detracts from fund results in the short run, but the price effects reverse within months or in some cases years. One analysis concludes that one-third of hedge fund excess return, or alpha, is attributable to investor flows.”
Hedge funds may benefit from the tailwind created by fund flows, but they are not the only ones that can profit from such actions. Investors with exposure to thinly traded securities, especially, fund flows can have quite extreme effects.
While it is hardly possible to predict the performance of a particular hedge fund, or that of a group of funds, with any real accuracy, knowing the ownership structure of the securities one follows can provide useful insights on price behavior. If one has exposure to a security held disproportionately by one -- or a few -- funds, then their offloading could put considerable, though probably temporary, pressure on the price of that security.
Hence, savvy investors can watch fund flows to understand seemingly irrational price movements, as well as to potentially time more optimal exits or entries into certain securities.
Look for arbitrage while others retrench
The game of arbitrage is usually reserved for more sophisticated market participants, such as institutional investors. However, there are times when the usual players are forced out of the picture, opening opportunities for others to seize the initiative:
“Arbitrageurs are plentiful in the investment community, and under normal conditions they have sufficient capital to profitably remove divergences between price and value. But they do not have unlimited capital.
“Professional arbitrageurs are generally agents. Their capital comes from principals such as wealthy individuals, endowments, or pension funds. They negotiate with prime brokers to set the amount and cost of leverage they can use. History shows that both principals and lenders retrench in instances of extreme stress, and meaningful arbitrage opportunities persist.”
Thanks to the ever-increasing depth and extent of information available to individual and institutional investors alike, opportunities for arbitrage have become increasingly scarce. This has been exacerbated in recent years by the rise of high-frequency trading, which tends to iron out most small-scale arbitrage opportunities before ordinary mortal investors even know they are there.
Despite these difficulties created by contemporary market infrastructure and the sophistication of its inhabitants, there are still times when market conditions still create such opportunities, provided the investor is prepared to act with resolve. When the regular arbitrageurs are thrown into disarray for some reason, such as a general market shock, the funding sources on which they conventionally rely can dry up. Even arbitrageurs will retrench when things look choppy. When this occurs, the inefficiencies they usually hunt can stick around long enough for others to find.
Verdict
Prudent investors generally avoid being overstretched. Too much margin or other leverage has been the undoing of many otherwise excellent players of the money game. But that does not stop even the most sophisticated and experienced money-managers from getting out over their skis from time to time. When they do, they often create opportunities for others to exploit.
The three technical trading strategies highlighted by Blue Mountain share two features in common:
- They are highly situational.
- They can only be exploited if one has dry powder.
By always keeping a reserve, or at least avoiding any position in which they might conceivably be boxed in or crushed by surprise shocks, investors can jump at these technical trading opportunities when they arise from time to time.
If whales are making waves, it is usually best to try to ride them to shore rather than expose oneself to getting swamped.
Disclosure: No positions.
