Providing liquidity to motivated buyers and sellers has worked throughout history. It’s an enduring trading edge that I expect to work forever – both in and out of the trading arena. In life, a person highly motivated to purchase a specific house, a specific car or the latest consumer gadget pays a price that’s higher than a reasonable substitute. A person forced to sell a house will likely concede a not-so-small financial penalty because of the need to sell immediately.
Consistently being a motivated buyer of things will act as a drag on the personal balance sheet. Taking advantage of sales or the occasional motivated seller provides a little alpha in the growth of personal wealth.
Similar opportunities occur in the financial markets. With respect to the motivated buying/selling (MB/MS) edge, we’re searching for moments in time when the price action is affected by a large amount of buying/selling that is price-insensitive AND is occurring due to reasons unrelated to enhancing portfolio risk-adjusted returns.
We distinguish MB/MS from everyday price volatility by understanding the motivations and techniques used by other market participants, and identifying instances when a price is perhaps being pushed away from equilibrium value for non-economic reasons. We sell into the price strength or buy into price weakness created by the MB/MS and then wait for prices to snap back when done.
This trading edge takes experience and educated guesswork. You might ask if there’s too much competition in this space from market makers, Wall Street trading desks, high frequency traders, statistical arbitrage hedge funds and others. The answer is absolutely yes, and I’m not asking you to compete with these pros. The goal is to be on the lookout for when market makers and other arbs need some help pushing prices back to the equilibrium value.
By the way, market makers are in this game to generate profits for themselves, so they’re also on the lookout for motivated buyers and sellers. If they sense price-insensitive buying/selling is occurring, they’ll immediately back away from the market (shift limit orders away from the current price) to maximize profits and reduce risk. They’ve done this throughout history, and in this case, we can also join them as they seek to generate profits from a motivated trader.
With respect to automating a search among individual securities and asset classes, it’s certainly possible to develop price pattern rules, such as looking for parabolic price drops on increasingly higher volume or relative price deviations between two highly correlated securities, as is done with classic pair trading. This type of trading is a staple for statistical arbitrage firms, so we aren’t interested in competing with them. These efforts may be a starting point to investigate why a security is fitting an MB/MS profile; however, these price-only methods are not good enough and are probably too easy to arbitrage away. We need more information, and that comes from understanding your opponents in the game.
Here are some examples with respect to motivated selling:
- Forced selling due to margin calls.
- Forced selling due to the unwinding of a crowded, levered trade.1,2,3
- Forced selling due to fund liquidations.
- Tax-loss selling.
- Index reconstitution selling.4
- A popular market guru issues a sell order, such as that issued by Joe Granville on January 6, 1981.5 Meredith Whitney’s call for massive defaults among municipal bonds on December 19, 2010, causing a multi-week sell-off in municipal bonds.6
- Bond selling triggered by a ratings agency downgrade, especially below investment grade.
- Influential analyst downgrade of a stock or asset class. Stocks removed from an influential “preferred” list.
- Flash crashes and “fat finger” trading errors.7
- Major stock market crashes such as those in 1929, 1962, 1987, 1998, and 2008, triggered by forced selling by levered investors and funds.
- Selling due to unexpected crises that have a minimal effect on the economy, such as assassinations, resignations, natural disasters and terrorist attacks.
- A major seller weighing on a stock or ETF.
- Selling triggered by dividend cuts, stock splits, IPO lock-up periods, secondary offerings, spin-offs8 and merger announcements.9
- Window-dressing sales.10
- Securities sold in sympathy with others while unaffected by the bad news.
- Banks forced to sell assets due to new regulations, reporting deadlines or to meet capital requirements.
- Price-insensitive government agencies selling securities purchased/assumed during a crisis, especially if the sale is politically motivated.
- Companies selling large stakes of another company’s stock.
- Index rules-based selling – for example, selling associated with an MSCI country downgrade from developed to emerging, or emerging to frontier. The selling of a stock associated with a company changing its home country. Selling due to a merged company being too big with respect to index position limits.
- Any sort of market order to sell, including market-on-close and stop orders.11
- Selling of securities associated with a company nearing bankruptcy by portfolio managers due to increased complexity.
Here are some examples with respect to motivated buying:
- Index reconstitution buys.4
- A renowned market guru issues a buy recommendation, such as Joe Granville’s buy recommendation on April 22, 1980. 5
- A positive Barron’s or Wall Street Journal article causes lots of buying the next trading day. 12
- Automated dividend reinvestment programs.13
- A short squeeze.
- A price spike associated with stock recommended on CNBC. 14
- Marking the close at quarter-end and other forms of manipulation of illiquid securities.
- Nationalistic or patriotic buying.
- An influential analyst upgrades a stock. A stock is added to a “preferred” list.
- Buying associated with MSCI country upgrade from emerging to developed, and frontier to emerging.
- A major buyer weighing on a stock or ETF. 15
- Any sort of market order to buy, including market-on-close and stop orders.11
How to Get Started
How do you add this edge to your trader toolbox? To start, become aware of these opportunities when reading Bloomberg, the Wall Street Journal and other financial news sources. Even if you miss an MB/MS trade, study and learn from it. When reading interviews16 of successful investors, traders and hedge fund managers, keep an eye out for examples of when they exploited MB/MS. Read quarterly letters of successful investors and hedge fund managers and see how they used this technique.17 Learn from as many examples as you can. Also peruse academic journal articles with the search terms “price pressure hypothesis” or “information hypothesis,” but keep in mind that by the time a trading edge is studied and documented by the academics, the edge is probably gone.
Next, be on the lookout for short-term opportunities. For MB/MS trades that are short term in nature, you will be buying weakness and selling strength with limit orders. Start small, keep track of your results and learn from your successes and failures to get better at it.
It’s also important to get the time scale right. You can’t use a short-term motivated selling opportunity as an edge for a year-long hold. On the flip side, knife-catching a major stock market collapse, such as the 2008 to 2009 bear market, may take months or even a year before realizing the benefits associated with buying into the panic. For longer-time-scale MS events, it may be preferable to wait for a bottom before establishing a trade, with the educated guess that the price is well below fair value due to the forced selling.
The opportunities are perpetually evolving as the major players, the popular investment approaches and investment stars come and go, each potentially creating a new MB/MS trading opportunity. The goal is for you to be comfortable enough to make trades without a statistical sample of back-tested results. By the time a statistical sample is available, too many traders will be competing with you, and the opportunity will shrink away. Back-testing is also complicated by the fact that your limit orders will likely affect prices, which is not modeled during the back-tested period. This makes the MB/MS edge very difficult to back-test, which is a good thing with respect to limiting competition. Furthermore, in the asset class trading space, MB/MS events may only occur at a frequency of once a month or less. This is also good for limiting competition, because no one can build a dedicated fund to exploit this edge.
You must have an educated guess as to who is on the other side of an MB/MS trade and why they are trading. The trade should be motivated by non-investment reasons and have little informational content. If a stock falls 20% on heavy volume due to an earnings miss, the price is reacting to a heavy dose of new information. Even though there may be a lot of selling pressure pushing prices lower, this is not an MS event. Many examples given above are cases where there is little information content in the price move, and thus we can make an educated guess that the price move was driven by too many sellers overwhelming market makers.
An influential analyst who declares that now is the time to sell the stock market just can’t have much information content. Market tops are gradual affairs, and no one can call a top with that sort of accuracy. Yet if the analyst has a huge retail-investor following, then the news may push stock index prices down a couple percent. In this case, there is no information content in the price move, so we can buy this dip for an expected short-term gain.
The market player on the other side of the trade can significantly affect the attractiveness of an MB/MS event. We obviously prefer less sophisticated or mechanically driven investors, such as retail investors, brokers/financial advisors, foreigners, governments or index funds. If portfolio managers or traders are doing the transacting, then care is needed to scrutinize the reason for the buying/selling. Forced selling to reduce leverage or to meet redemption requests has little information content, and is likely an MB/MS trade opportunity.
Not every price-insensitive buying/selling moment sets up for a good trade. For example, when an asset class triggers a trend-following sell signal, perhaps due to the breaking of a price support level, this is probably not an MS event, even if the selling is at high volume and is price-insensitive. These traders are selling for financial reasons and there may be information content in the breaking of a support level, even if there’s no fundamental news causing the sell-off.
A Few Examples
Figure 1 shows a chart of the TCW Strategic Income Fund (Symbol: TSI) from September 2009 to September 2010. On December 4, 2009, TCW fired star manager Jeffrey Gundlach, causing the closed-end fund to sell off on high volume. The fund discount widened from 5% to 11% by the close that day. While the long-term impact on the fund may be adversely affected by the firing, TCW acquired a very capable management team (Metropolitan West Asset Management) to take over fund management. In addition, the portfolio was the same as on the previous day, and was loaded with attractive non-agency mortgaged-back securities. Prices subsequently bounced over the next few days (note that the second drop in December was due to a large dividend). Gundlach’s new firm, DoubleLine, commenced operation in April as shown by the purple line (mutual fund ticker DBLTX).
Bill Gross’s departure from PIMCO on September 26, 2014, had a similar effect on PIMCO closed-end funds. Again, the PIMCO portfolios were the same before and after that news, PIMCO had a very deep talent bench and for many of the funds, Bill Gross wasn’t even the portfolio manager.
Figure 2 shows a chart of the iShares National AMT-Free Muni Bond ETF (Symbol: MUB), along with a similar duration iShares 7-10 Year Treasury Bond ETF (the purple line, Symbol: IEF) from November 2007 to May 2008. The bottom clip shows the relative strength line of MUB versus IEF. Normally MUB and IEF move in sync with each other due to similar interest rate sensitivity and credit quality.
In late February 2008, municipal bonds sold off sharply near the end of the month, without any fundamental news. Around that time, the Wall Street Journal began running stories about hedge funds frantically unwinding levered long-muni/short treasury trades.3 Municipal bonds are much less liquid than treasuries, which explains why prices were getting hammered. Also, muni bonds began yielding higher than treasuries, which due to their tax benefits, had never happened in data going back to 1966.18 Interestingly, since the 2008 to 2009 crisis, munis have consistently yielded higher than treasuries while the Fed has held short-term interest rates near zero. All the evidence suggested that this was an MS opportunity, which was pounced on by Wilber Ross and Bill Gross.19 Municipal bond prices rebounded versus treasuries over the next couple months.
Every June, Russell Investments reconstitutes their widely followed Russell 2000 small cap index. The next chart is taken from an academic article written by Adam Reed, showing the effect of Russell 2000 reconstitution trades from 1990 to 1999.4 The chart shows normalized cumulative returns of index additions, deletions and unchanged holdings averaged over all Russell 2000 equities over 10 reconstitutions. These averages are normalized by an equal-weighted portfolio of representative small cap stocks (CRSP 4-9). Once Russell announces the index changes, traders bid up additions (shown by the very narrow diamonds, the top line), and sell deletions (the squares) ahead of the reconstitution date where index funds adjust their holdings at the market close. The index funds, focused on zero-tracking error, are price-insensitive buyers and sellers. As expected, at the close of the reconstitution date, the additions had been bid up by about 2% compared to all small stocks, and the deletions had their prices pushed lower by a relative 3%. After the reconstitution date, prices trend back to their correct equilibrium values as proxied by the unchanged (triangles) over the next month or two.
Everyone knows about the Russell 2000 reconstitution effect, with many traders and hedge funds attempting to exploit this MB/MS event every June. As this effect has become more well known, index fund managers and index designers have also worked to engineer solutions to mitigate this drag on portfolio returns. There are many other index funds, some very poorly constructed, that can be exploited in this way.
Figure 3. Cumulative Adjusted Returns 1990-1999
Equally-weighted portfolios of stocks added to (Diamond) kept in (Triangle) and dropped from (Square) the Russell 2000 from 1990 through 1999. Returns are adjusted for market movements by subtracting the return on an equally-weighted portfolio of stocks in CRSP deciles 4 through 9. The results are presented with 11 trading days between the announcement date and the reconstitution date. For years with more than 11 trading days between announcement and reconstitution, returns are compounded into the fifth event day after the announcement date so that there are 11 days of returns.
Figure 4 shows a chart of Herbalife Ltd. (Symbol: HLF) from July 2012 to July 2013. On December 20, 2012, billionaire hedge fund manager Bill Ackman of Pershing Square Capital Management announced he was short HLF with high conviction and a price target of $0, as justified in a 342-page presentation.20
HLF stock fell from $42.50 to $26.06 at the closing low on December 24, 2012 – a 39% decline on heavy volume. I don’t like taking the other side of hedge fund managers with great track records, but two other billionaires did – Carl Icahn and Dan Loeb.20 The latter two fellows, obviously after performing much due diligence, convinced themselves that the presentation had no merit, and then purchased an enormous amount of stock during the panic selling. Prices rebounded considerably once the selling was done.
I’ve always struggled to short a stock recommend by someone I truly respect. For instance, when the market hears that Warren Buffet has a new holding, I generally avoid shorting the price jump because I worry that there’s some information content in the price move and also because I know portfolio managers around the world will be looking at that stock as a potential buy.
I also respect Jim Cramer quite a bit, but when he recommends a stock on his TV show Mad Money, price pops are potentially shortable because it’s usually price-insensitive retail investors doing the buying.14
Figure 5 shows a plot of the Cohen & Steers Limited Duration Preferred and Income Fund (Symbol: LDP), a closed-end fund, along with its net asset value (Symbol: XLDPX.O) from January 2013 to June 2014. The lower clips show the trading volume and relative price performance of the above two, which gives an idea of the widening and narrowing of the fund’s discount to net asset value (NAV). The closed-end fund’s IPO occurred in July 2012 at $25 per share, rose as high as $27/share, only to sell off with all bonds in mid-2013 during the infamous “taper tantrum” caused by Fed Chief Ben Bernanke’s hint that bond purchases associated with their quantitative easing program may slow by year end.
While the fund NAV bottomed in September, the price continued to underperform the NAV, making new lows in mid-December when the price traded around $22/share. Volume also picked up throughout December, and the discount widened from an average of -7% to about -11%. At this point, it’s reasonable to make an educated guess that the price action in December was associated with tax-loss selling by retail investors and the brokers representing them.
In late December 2013 through January 2014, prices snapped back and the discount narrowed to -8%.
Hints for Finding Opportunities Among Asset Class Trading Vehicles
I’m not going to lay out in fine detail how to do this sort of trading. However, here are some hints in finding opportunities among ETFs and closed-end funds.
- Look for asset classes that have suffered a parabolic plunge in prices on high volume. High volume is generally a sign of an MB/MS opportunity due to the need for the buying/selling pressure to overwhelm market makers.
- Look for ETFs and closed-end funds trading at discounts that are wider than usual.
- Search through rules institutions and index funds use to add or delete securities from their universe.
- Search for widely followed analysts who can move markets with their words.
- Search the news for any hedge fund liquidation event or pain associated with a particular asset class or trading strategy. Wall Street is always creating levered products to sell that can eventually lead to forced selling.
- The less liquid the asset class or trading vehicle, the better the MB/MS opportunities.
- Focus on selling associated with retail investors, brokers and financial advisors. While brokers and financial advisors are generally rational and not prone to panic selling, they must ultimately answer to clients who are quite emotional.
Favorite Moments to Implement Motivated Selling Trades
There seem to be more MS opportunities than MB events. Here are some of my favorite moments to apply this edge with motivated selling.
- A security is being sold during a bull market. At this time, it’s very easy to just buy more during the price weakness caused by the motivated sellers.
- Selling that occurs among vehicles in an asset class I’m already attracted to due to other trading edges.
- When I’m indifferent about which securities I hold within an asset class. This is a great time to exploit price deviations among them.
- In the midst of high volatility and panic associated with a bear market or crisis. In this situation, there is much more emotional and forced buying and selling, while market makers are either overwhelmed, dramatically increasing bid/ask spreads or de-risking. This is a great time to step in and provide liquidity.
The most difficult time to exploit motivated selling is when the entire market is beginning to roll over. Then it’s harder to know when the selling will stop, plus you’re not sure how much of the selling is due to the markets incorporating new bearish information.
Summary of Advantages and Disadvantages
Exploiting MB/MS trades has a number of advantages.
First, providing liquidity to motivated buyers/sellers leads to trades with a much higher IRR compared to the market as the price moves back to equilibrium. If an asset class has been especially hurt during a bear market due to forced selling, then we can expect that once the bear market is done, the asset class may outperform for the next 6 to 12 months as its price catches up to fair value
Second, it’s a trade that will be executed only when there’s a significant price deviation. Contrast this with other trading approaches, such as front-running, where too many traders in the same trade can lead to losses for all. By definition, MB/MS trades are created by the lack of arb firepower to hold the price near fair value. It’s an uncrowded trade since there would be no price deviation if the market makers were doing their job.
Third, there is often a known time when the MB/MS ends. If a popular stock market guru recommends a stock, then the motivated buying is probably done in a day. You can short that day with the expectation that the selling will be done by day-end. If it’s tax-loss selling, you can expect the selling to be done near the end of the year. Index reconstitution trades occur at dates known ahead of time.
Fourth, it’s a trade that exploits another market player, which leads to much higher conviction than a back-tested trading system or a manager’s guess at how fundamentals will unfold.
Fifth, it’s a trade that’s practically unbacktestable, which is good for limiting competition.
The primary disadvantage of the MB/MS edge is that the frequency of trades is very low. You can go a long time without a trade, perhaps a few months or longer. You will also need to be creative in discovering these opportunities before other traders. The approach takes time to master.
No matter the investing or trading discipline, adding the motivated buying/selling edge may enhance performance. Even if such moments do not occur very often, if you devote a lifetime to managing money, there will be plenty of opportunities to exploit, as long as you’re prepared to pounce when they occur.
- Khandani, A.E. and Lo, A.W, “What Happened to the Quants in August 2007?”, Journal of Investment Management, Vol. 5, No. 4, Fourth Quarter 2007.
- Lowenstein, R., When Genius Failed: The Rise and Fall of Long-Term Capital Management, 2001.
- Quint, M. and Cooke, J.R., “Muni Bonds Fall for 13th Day Amid Hedge-Fund Squeeze”, Bloomberg, February 29, 2008.
- Reed, A.V., The Life Cycle of an Arbitrage Opportunity: Reconstitutions of the Russell 2000, Working Paper, August 2000. See also Russell Research Commentary, “Price Pressure at Russell Index Reconstitution”, April 2007 and references included.
- Shiller, R.J., Irrational Exuberance, 2005.
- Abelson, M. and McDonald, M., “Whitney Municipal-Bond Apocalypse Short on Specifics”, Bloomberg Business, February 1, 2011.
- For example, see news associated with the following dates for minicrashes caused by trade errors: November 23, 1998; May 14, 2001; October 2, 2002; December 8, 2005; April 28, 2009; May 6, 2010 and August 1, 2012, and most recently – August 24, 2015.
- Greenblatt, J., You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits, 1999.
- Swenson, D.F., Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, 2000.
- Lakonishok, J., et al., “Window Dressing by Pension Fund Managers”, American Economic Review, May 1991, pp. 227-231.
- Farrell, Christopher, Day Trade Online, 1999.
- Liang, B. “Price Pressure: Evidence from the ‘Dartboard Column’, Journal of Business, Vol. 72, No. 1, January 1999.
- Berkman, H. and Koch, P.D., “DRIPs and the Dividend Pay Date Effect”, Working Paper, November 2014.
- Alpert, B., “Shorting Cramer”, Barron’s, August 20, 2007, pp. 23-25.
- Dietrich, C., “Traders Keep an Eye Out for Good Harbor”, Wall Street Journal, February 2 2014.
- For example, all the excellent “Wizards” trader interview books by Jack Schwager. Also, the books by Steven Drobny.
- For example, the annual and quarterly letters associated with Warren Buffett, Howard Marks, Seth Klarman and Daniel Loeb.
- Zuckerman, G. and Rappaport, L., “Muni Market Gets a Lift as Wilbur Ross and Bill Gross Hop In”, Wall Street Journal, March 6, 2008.
- Fontevecchia, A., “Dan Loeb on Trumping Bill Ackman In Herbalife: It Wasn’t Personal, There Was No Pump And Dump”, Forbes, November 22, 2013.
The content contained within this blog reflects the personal views and opinions of Dennis Tilley, and not necessarily those of Merriman Wealth Management, LLC. This website is for educational and/or entertainment purposes only. Use this information at your own risk, and the content should not be considered legal, tax, or investment advice. The views contained in this blog may change at any time without notice, and may be inappropriate for an individual’s investment portfolio. There is no guarantee that securities and/or the techniques mentioned in this blog will make money or enhance risk-adjusted returns. The information contained in this blog may use views, estimates, assumptions, facts, and information from other sources that are believed to be accurate and reliable as of the date of each blog entry. The content provided within this blog is the property of Dennis Tilley & Merriman Wealth Management, LLC (“Merriman”). For more details, please consult the Important Disclosure link here.
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