It has long been said that “the hour of the witches” is the hour of the night when demons, ghosts, ghouls and witches are most powerful. It also happens to be the time when the US stock market is strongest.
U.S. exchanges officially open between 9:30 a.m. and 4:00 p.m. in New York, but strangely, most of the gains accrue in the sparser, more informal after-market trading that occurs on various electronic exchanges, according to a study by the Federal Reserve of New York. Early morning returns, on the other hand, tend to be negative. The phenomenon has long intrigued many analysts.
It gets weirder. Research by Bruce Knuteson, a former quantitative analyst at hedge fund DE Shaw, indicates that “overnight drift” and “intraday reversal” are also happening in international markets, from Japan to Norway. Knuteson also has a much more controversial conspiratorial interpretation of the model than other researchers who have probed him over the years. He believes it is caused by systematic market manipulation on a Herculean scale by some quantitative hedge funds.
Here’s how Knuteson thinks it works. Quant funds that use algorithmic or systemic strategies take advantage of the greater impact trades can have when markets are closed and liquidity is thinner. They aggressively buy stocks they already own, driving up their price.
Then, as markets open and trading conditions improve, they can gradually abandon buying without undoing all of their earlier impact. At the end of the day, Knuteson says they should end up with a slightly more valued portfolio. Doing this consistently, day after day, would produce a pattern of overnight gains and slight intraday declines, he argues.
Given his experience as DE Shaw, Knuteson’s theory is certainly more intriguing than the usual conspiracy theories cluttering the internet. DE Shaw declined to comment. But is it plausible? Not very.
First, the US stock market is only officially open for a fraction of a day’s hours. But you can practically trade stocks around the clock. George Pearkes of Bespoke Investment Group calculated that if you adjust for the different lengths of the trading windows, the average intraday and overnight returns are not that different.
Second, a New York Federal Reserve study of S&P 500 futures trends showed that returns actually peaked between 2 a.m. and 3 a.m. in New York. Tellingly, this is around this time that European traders get down to business, not what Knuteson’s theory would suggest.
Third, a quarter of US corporate earnings are released just after market close, and another 60% before the start of morning trading. Most companies tend to exceed estimates and therefore benefit from subsequent price spikes in the overnight trading session, which helps explain the phenomenon.
There are many other technical factors that probably play an important role, such as derivatives or index funds buying at the closing auction. Quants scoff at Knuteson’s theory, arguing that the costs of trading and insuring against any disastrous drops while the portfolio is inflated would almost certainly eat up the gains from such a strategy anyway.
And the idea that large hedge funds could systematically manipulate the markets on an astonishing scale over several decades and in several countries without a single regulator, trading firm or fund manager noticing defies belief. .
Of course, these explanations do not satisfy Knuteson. He suggests that regulators are either incompetent and unable to discern even the obvious imprint on the market that this trade would leave, or they are consciously turning a blind eye because people like stock markets to go up.
Over the years he tried to convince some journalists to write about his article and when they mostly refused he started publishing his anonymous correspondence with them (including me) in an article he titled “They chose not to tell you.” Earlier this month, he released a catchy sequel titled “They Still Haven’t Told You”, again excoriating hapless regulators and reporters. “Their ruthlessly self-serving, intellectually dishonest and cowardly contribution continues,” he wrote.
Given my skepticism, why even write about it? Partly to let others decide. But mostly to show how markets, in their endless madness, can produce all sorts of delightfully bizarre anomalies caused by underappreciated, often annoying technical factors, most of which are practically impossible to exploit but can lead to all sorts of fanciful theories.