Trader’s Narrative

By Robert Folsom

The following article discusses Robert Prechter’s view of the Efficient Market Hypothesis. For more information, download this free 10-page issue of Prechter’s Elliott Wave Theorist.

When a maverick idea becomes vindicated, there’s a good story to tell. It usually involves a person (or small group of people) who courageously challenge the orthodoxy of the day — and, over time, the unorthodox yet better idea prevails.

A “good story” of this sort has surfaced during the current financial crisis. A chapter of the story appeared in a recent New York Times article, “Poking Holes in a Theory on Markets.” The theory in question is the efficient market hypothesis (EMH), which the article suggested is so hazardous that it “is more or less responsible for the financial crisis.” This quote tells you most of what you need to know:

“In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.”

In case your Latin is rusty, Quod erat demonstrandum means “which was to be demonstrated.” Its abbreviation (QED) appears at the conclusion of a mathematical proof. In this case, the massive financial bubbles of recent years are the proof that refutes the efficient market hypothesis, which argues that markets move in a “random walk” and are not patterned.

Similar articles in the financial press have reported the demise of the EMH. Just this week an Economist magazine blog included this bold declaration:

“No one has yet produced a version of the EMH which can be tested and fits the evidence. Thus, the EMH must logically be discarded, as a valid hypothesis must be testable.”

QED, indeed — I agreed years ago that the random walk was implausible. But I didn’t come to this view because of behavioral economists, although their work over the past decade has certainly been valuable. Instead, I was persuaded by the work of someone who first challenged the financial orthodoxy more than three decades ago, specifically April 1977. As a young technical analyst at Merrill Lynch in New York, his research circulated among several of Merrill’s clients. His name for these studies was the Elliott Wave Theorist: the April ‘77 study was a detailed analysis of the 1975-76 stock market, which offered this comment on the random walk model:

“If market moves are arbitrary (as the random walk proponents suggest), then internal components would rarely ‘make sense’ mathematically, and then only by statistically insignificant fluke occurrences. However, there seems to be enough evidence that mass psychology, as recorded in the Dow Jones Industrials, form patterns that are uncannily interrelated….At least this much can be fairly reliably stated as a result of this work: This idea that the market is a ‘random walk’ is probably false.”

Robert Prechter left Merrill soon after; he has published the Elliott Wave Theorist in every month since. Every issue has, in one way or another, “convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices.”

So while there may be a good story to tell about behavioral economists, I trust you see why I believe there is a vastly better one to tell.

The “enormous effect” of “mass psychology” and “herd behavior” is exactly what explains the financial downturn that began in late 2007. Prechter’s Elliott Wave Theorist anticipated the crisis and warned subscribers beforehand. Likewise, he alerted them to the bear market rally that began last March.

For more information from Robert Prechter, download a FREE 10-page issue of The Elliott Wave Theorist. It challenges current recovery hype with hard facts, independent analysis, and insightful charts. You’ll find out why the worst is NOT over and what you can do to safeguard your financial future.

Related:

• Did Overconfidence Cause The Financial Crisis?

As this annus horribilis draws to a close, we are left ducking shoe after shoe that drops or is flung at us. But this year’s abysmal performance has a silver lining. It offers a sumptuous buffet for those who finish off the year with a play on the January effect.

For the novice, this is the trading pattern at the end of the year which the efficient market hypothesis says shouldn’t even exist. Usually it is small or micro capitalization stocks which have declined and are then pushed down further by tax-loss selling. The opportunity is to play these for a short term bounce into the new year.

Personally, I focus on closed end funds (CEFs) and within them usually fixed income or municipal bond CEFs. I go into great detail explaining the background, rationale and several actual trades: My Year End Strategy

I won’t repeat myself because you can get all the info you need from the above link. This is a very high return, high probability trade but it depends on how poorly the target securities have fared.

This year, I feel like a kid in a candy store. While this abundance is great, it does make it a bit more challenging to filter all the potential plays and find the best ones.

You can sift through the CEFs through a publication like Barron’s which not only prints their prices but also their year to date performance and premium/discount to NAV. Online you can use the CEF Association’s database or check out ETF Connect and use their Fund Sorter or do an advanced search to only look at certain sub-sections of securities like municipal bond fund CEFs.

Here’s an example of the sort of securities to choose from:

Continue reading ‘How To Play The January Effect This Year With CEFs’