Sat. May 28th, 2022

It has long been said that the “witch hour” was the time of night when demons, ghosts, spirits and witches were at their most powerful. It seems that this is also when the US stock market is at its most powerful.

U.S. stock exchanges officially open between 9:30 a.m. and 4:00 p.m. in New York, but oddly enough, most of the profits actually come in the leaner, more informal after-market trade this happens on various electronic exchanges, according to a study by the New York Federal Reserve. Early morning returns, on the other hand, tend to be negative. The phenomenon has long confused many analysts.

It’s getting weirder. Research by Bruce Knuteson, a former quantitative analyst at hedge fund DE Shaw, indicates that “overnight shifts” and “intraday reversals” are also occurring in international markets, from Japan to Norway. Knuteson also has a much more controversial, conspiratorial interpretation of the pattern than other researchers who have researched it over the years. He reckons that it is caused by systematic market manipulation on a Herculean scale by some quantitative hedge funds.

Line chart of Cumulative returns (%) showing Shares work best at night

Here’s how Knuteson thinks it works. “Quant” funds who use algorithmic or systemic strategies take advantage of the greater impact that trades can have when markets are closed and liquidity is thinner. They aggressively buy shares they already own, which causes their price to rise higher.

Then, as markets open up and trading conditions improve, they can gradually abandon purchases without undoing all their past impact. By the end of the day, Knuteson says they should be left with a slightly higher valued portfolio. Doing this systematically, day-in-day-out, would produce the pattern of overnight gains and gentle intraday declines, he argues.

Given his DE Shaw background, Knuteson’s theory is certainly more intriguing than the usual conspiracy theories that clog the internet. DE Shaw declined to comment. But how plausible is that? Not much.

First, the US stock market is only officially open for a fraction of the hours in a day. But in practice you can trade stocks all day long. George Pearkes at Bespoke Investment Group calculated that if one adapts to the different lengths of trading windows, then the average intraday and overnight returns are not that different.

Secondly, a New York Federal Reserve Study of S&P 500 futures patterns have shown that yields actually rise especially between 02:00 and 03:00 in New York. Interestingly enough, this is about when European traders come to work, and not what Knuteson’s theory would suggest.

Third, a quarter of U.S. corporate earnings releases are published just after the market closes, and another 60 percent before trading begins in the morning. Most companies tend to beat estimates and therefore enjoy subsequent price increases in the overnight trading session, which helps explain the phenomenon.

US stocks enjoy upward momentum when European traders get to work

There are many other technical factors that are likely to play a major role, such as e.g. derivatives or index funds that buy in the closing auction. Quants mocks Knuteson’s theory and argues that the cost of trading and insurance against any disastrous tumbles while the portfolio is inflated, will in any case almost certainly swallow any profits from such a strategy.

And the idea that large hedge funds can systematically manipulate markets on an astonishing scale over several decades and across multiple countries without a single regulator, trading firm or money manager realizing it resists belief.

Of course, these explanations do not satisfy Knuteson. He suggests that regulators are either incompetent and unable to even discern the obvious market footprint that this trade would allow, or to deliberately turn a blind eye because people like stock markets to rise.

Over the years he has tried to persuade some journalists to write about his newspaper and when they mostly refused to start publishing his anonymous correspondence with them (including me) in a newspaper he titled “They chose not to tell you”. Earlier this month, he published a follow-up story called “They still did not tell you, which in turn elicits unfortunate regulators and journalists. “Their insensitive self-interest, intellectually dishonest and cowardly contribution continue,” he wrote.

Given my skepticism, why even write about this? Partly to let others decide. But mostly to show how markets, in their infinite madness, can produce all sorts of deliciously strange anomalies caused by undervalued, often boring technical factors, most of which are practically impossible to exploit, but can lead to all sorts of fantastic theories.

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