Old news? Inattentive investors create opportunity for savvy arbitrageurs
October 18, 2012
Economic news drives the financial markets up or down. But what if the news is not actually new?
A study co-authored by Thomas Gilbert of the University of Washington Foster School of Business demonstrates that many investors react to old macroeconomic information when it’s newly presented. This lack of attention creates an opportunity for savvier investors to turn a quick profit at their expense.
The paper is a follow-up to Gilbert’s recent work that demonstrated that the market, as an aggregation of investors, knows the true state of the economy better than the myriad macroeconomic indices which are often inaccurate at their release.
“According to efficient market theory, the release of old information should have no impact on prices,” explains Gilbert, an assistant professor of finance at the Foster School. “But if a significant number of investors have not paid attention to the old information, they will move the price when it is re-released. Importantly, we found that this deviation in price gets corrected fairly quickly.”
The agents of this market correction are savvy investors known as arbitrageurs.
A public recipe
To investigate the effect of chasing old economic news, Gilbert collaborated with Shiman Kogan of UT-Austin, Lars Lochstoer of Columbia University, and Ataman Ozyildririm of The Conference Board.
They studied market reactions to the Leading Economic Indicator (LEI), a summary statistic that is compiled from a variety of key macroeconomic activities in the United States—among them new manufacturing orders, building permits for new housing, stock prices, and consumer expectations. The Conference Board publishes the LEI each month, and makes public its composition and calculation.
“The recipe is online, and its component parts are available at least a day before the LEI is released,” says Gilbert. “So any reasonably savvy investor could put this information together ahead of its announcement.”
As a proxy for the overall market, the researchers tracked S&P 500 Index futures from 1997 to 2010. Specifically, they measured price changes occurring from 24 hours before each monthly release of the LEI until the closing bell the day after its release.
The study reveals that savvy investors don’t wait until the Leading Economic Indicator is released. When the final component of the LEI is available—a full day before its release—they calculate the index themselves and trade according to the anticipated news. They buy S&P futures when the LEI is going to be up and sell when it is going to be down.
But when the LEI is finally released the next day, S&P futures prices move again as inattentive investors react or, in this case, overreact. If the latecomers are buying, then arbitrageurs start selling, and vice-versa. This brings the S&P futures back to fundamental equilibrium: the right price given the true state of the economy.
The study indicates similar patterns in the Treasury bond market, as well for individual stocks, in particular stocks that are harder to arbitrage.
But Gilbert says the finding is most revealing of the overall market’s efficiency. “What’s interesting is not just that the shares of some obscure companies in the dusty corners of the financial markets are going up and then down,” Gilbert says. “The market as a whole is allowed to deviate from fundamentals temporarily, then arbitrageurs come in and push prices back to fundamental levels.”
Profit from loss
This strategy, called front-running, allows arbitrageurs to turn a healthy profit—an eight percent annual return during the years of the study—off the inattention of less-sophisticated investors.
It begs the question: why does anyone wait until the release of old news to react?
Gilbert suggests that many of the LEI’s component statistics are pretty complex for the average investor to truly understand. Plus, the index is well marketed. “The Conference Board has been around a long time,” he says. “They package the LEI well, and make sure that all of the media are aware of its release. It’s perfectly realistic that inattentive investors would pay attention to this.”
Gilbert adds that inattentive investors have been a part of financial markets since their inception. “There are always people in the market who are less sophisticated and will, on average, lose money. That’s the way it always has been and probably always will be.
“There’s an expression in poker: if you can’t spot the fish at the table, then it’s probably you.”
“Investor Inattention and the Market Impact of Summary Statistics” is published in the February 2012 Management Science special issue on behavioral economics and finance.