Learn The Tricks of The Traders

ARE there bargains to be had in the stock market? Anyone who invests in shares would like to think so. Buy low, sell high is the ultimate goal of all investors. Not everyone, however, has the time or inclination to analyse every share they might buy. Nor do they have to. A number of Wall Street traders have long put their faith in simple axioms that can point to value in the market. They are so straightforward that anyone can do the same. The recently published Beyond the Random Walk: A Guide to Stock Market Anomalies and Low-Risk Investing by Vijay Singal, a professor at Virginia Tech, gathers many of these adages together. Savvy investors can significantly boost their profits by taking advantage of market inefficiencies, says Singal -and many Irish analysts agree with him. Here are seven indicators that can alert investors to the fact that the stock market is not always as efficient as it should be when it comes to reflecting the fair value of shares.

Index Changes

When firms are added or deleted from an index such as the S&P 500 or the FTSE 100, fund managers who track these indices are forced to buy the stocks being added and to sell those being dropped. Accordingly, the share price of firms being added usually rises, while that of firms being dropped usually declines. The rise or decline begins on the announcement date and continues until the effective date. A recent study showed that shares added to the S&P 500 rose by an average of 6.4% when changes to the index were announced, and had advanced another 3.7% by the time the changes were implemented. Those removed lost an average of 4.2% on announcement date and another 6.2% before the changes became effective. After this, however, new firms tended to give up some of their gains and deleted firms usually regained value. Savvy traders are wise to these trends and profit accordingly. Patrick Sexton, of Fexco Stockbrokers, says that firms being added are on a "strong upward trend anyway" and are likely to be good growth candidates, but the theory, he believes, may have become a victim of its own success. "Nowadays you have to move faster because people have seen the pattern. Look for stocks likely to be added and move in advance of the announcement."

Merger Arbitrage

It sounds posh, but it's pretty simple. When a merger or takeover is announced, the price of the company being acquired doesn't actually rise as high as the price being offered. Why? Because there is always a possibility the deal will fall through. Research shows, however, that the difference in price tends to be larger than it should be. Singal says investors can earn returns of 4%-10% by buying the target and shorting the acquiring company between the announcement and the closure of the deal. Shorting involves selling shares you don't own in the hope of buying them back at a lower price. Pramit Ghose, head of investment strategy at Bloxham Stockbrokers, says that merger arbitrage "generally works but may not be a worthwhile arbitrage for private investors as the percentage gains are too small". Spread-betters can circumvent this problem and make sizeable gains by gambling on small percentage moves in share prices. Option traders, who trade the right to buy or sell shares at a specific price during a set period of time, can do the same. Such activity is not for the faint of heart, however.

The Weekend Effect

History shows Friday to be the stock market's most positive day and Monday its worst. Therefore, Friday is the best day to sell, Monday to buy. Again, however, minute profit margins make this strategy more suitable for spread betters. Sexton has exploited the weekend effect in the past but warns investors of some obvious exceptions. "Don't try this on stocks tipped in the Sunday papers. They tend to be marked up come Monday morning," he says. It's also worth noting that when a downward Monday follows a downward Friday, it may be time to run for cover. Six out of seven times that this happens, shares will fall even further within five days.

Short-term Price Drift

Sometimes news or events that cause large changes in share prices take time to be properly priced in. Singal recommends buying shares that have gone up significantly and shorting stocks that have fallen noticeably before unwinding these positions over the next month. Singal's research shows that such a tactic can yield annual returns of 15%-36%. A good example of short-term price drift is Elan. In 2002, when the firm faced questions concerning its accounting procedures and its Alzheimer's drug, its share price suffered a sudden drop. As the market attempted to gauge the exact significance of these developments, the decline continued. By 2004, the company was able to release positive data on Tysabri, its multiple sclerosis drug. The share price immediately leapt, but continually updated analyst estimates and improved market sentiment meant the share price continued to rise. Of course, the stock recently capitulated once more, following the shock withdrawal of Tysabri from the market. Singal's theory would suggest that Elan shareholders will continue to suffer short-term pain, a viewpoint shared by Stuart Draper, head of research at Dolmen Butler Briscoe. "Elan will probably be significantly higher in a year's time but we are not recommending the stock to our clients," he said.

The December Effect

Shares that have done well in the January-November period are likely to continue on their merry way. Investors holding winners are loath to cash in, as this results in taxable capital gains. By waiting until January, these taxes can be postponed by almost a year as the CGT won't be due until the following October. With little selling pressure, it is easier for these stocks to continue appreciating. Sexton suggests that investors may profit further by postponing any planned sales until February. "Historically, December has been the second best month for the stock market. January is the top performer."

Stock Splits

These occur when a firm increases the number of shares it has. If you own 100 shares of XYZ at E20 per share and there is a 2-1 stock split, you would then own 200 shares worth E10 each. You might ask: isn't this irrelevant? Theoretically, yes. But although splits may not seem important, they tend to affect psychology. A lower share price can entice new investors, for example. Splits are usually undertaken by successful companies that have seen a rapid rise in their share price. Issuing a split draws attention to this success, generally resulting in increased buying. Announcement of a forthcoming split usually gives the stock an immediate boost. As the split date nears, the price is usually bid up further, before retreating after the split becomes effective. A stock split alone should never entice an investor into buying shares. Nevertheless, the odds of short-term gain invariably increase when a company declares an ensuing stock split. Draper sees splits as an excellent sentiment indicator that "usually, if not always, occurs in companies that are getting things right". Ghose says splits generally work and adds that "buying a stock just before it goes ex-dividend can also be profitable". There are a host of other stock market anomalies that the canny investor can exploit: the so-called Santa Claus rally that tends to cheer Wall Street at Christmas; the underperformance of the market in the summer months; and the usually stellar performance of the market on the day before St Patrick's Day.