Short-term vs Long-Term Market Efficiency
One topic that is rarely discussed in both the academic and practitioner literature is the division between short-term and long-term market efficiency. The common assumption often drawn from research that implies markets are efficient is that this theory applies uniformly across the board to both short and long- term strategies. In theory, this is accepted to be true, however in practice this is far from the case because of the many structural factors that interfere with making markets efficient at all levels.
Here are the major agents that drive efficiency in both time frames:
Short-Term: intraday to 3 days: market makers, specialists, proprietary trading firms and trading desks, hedge funds, day traders
Long-term:1 month to 1 year): mutual funds, hedge funds, pension funds
Most of the liquidity in the markets in the short term are driven by computerized trading algorithms and this area is highly competitive. All agents can go both long and short with few restrictions, and have the ability to harness significant leverage to their capital to take advantage of discrepancies. In the short-term, the market is much more likely to be efficient and the commission/per trade return is higher making it even more difficult to make a profit. This is where the statistics that 95-97% of short-term traders lose comes in, because making a gross profit is not sufficient, you have to overcome the trade commissions as well.
At the long-term time frame we start bringing in the titantics of the world: large mutual funds, pension funds, and long-term hedge funds. At the fundamental level, these funds have the greatest leeway to make decisions whether they use qualitative (assessment of business strategy, management etc) or quantitative research (P/E, ROE, Debt to Capital, estimate revisions etc). This makes the fundamental game very competitive and also more difficult to make a profit. While alpha still exists using various simple fundamental data, it may be ephemeral, and I would argue having researched these variables significantly that the market is fairly micro efficient for highly liquid stocks. That is, selecting the best stocks especially using fundamentals is highly difficult. The only lasting alpha in the future will reside in effectively combining information from fundamental variables into a composite signal.
However at the technical level, the possibilities are far more promising. Most of these agents cannot go short, and even if they do it is often for less money and on only the largest stocks or ETFs. They often have significant constraints on position sizing, and also on sector composition. Furthermore, they are significantly restricted from market timing and dynamic asset allocation in the conventional sense whether by regulations, or investment mandate. The percentage of funds that are permitted to perform these sorts of activities is very small, and they still don’t have much flexibility in making major bets. Thus in a macro sense, the market is very likely to be inefficient: ie the decision to allocate across industries, sectors, asset classes vs generating alpha within the same category. This is why relative strength strategies are so successful whether across asset classes or just market sectors, or even individual stocks. Jeff Pietsch of Market Rewind has published a good article on relative strength recently and just how durable it is over time: http://marketrewind.blogspot.com/2009/10/two-simple-relative-strength-rotation.html Money has to flow somewhere, and ultimately it will flow to the most promising areas. Indeed the father of the efficient markets hypothesis himself: Eugene Fama has stated that momentum is the strongest and most robust anomaly in financial markets. Now you know why!
Well what about the intermediate term? Say 1 week to 1 month? I would argue that this is an area of inefficiency and a sweet spot for individual traders with a short-term horizon as well as medium sized hedge funds with short-term horizons and complete flexibility. Most of my indicators are designed to target this area specifically because it is the easiest area to succeed in my opinion if you are a short term trader. The average holding period for DV2 and many others is between 5 and 20 days not coincidentally. To receive a very unique “Zone Report” for the S&P500, Oil and Gold that tells you when and how to use various DV Indicators like the supercharged DV (the more powerful version of the DV2 to be released) email us at firstname.lastname@example.org