The early bird doesn’t just get the worm. It also gets most of the exchange’s profits.
That’s because most of the S&P 500
SPX, + 1.18%
Profits occur overnight. The US benchmark index hardly gains on average while the New York Stock Exchange is open.
This is the result of a recently updated study entitled “24/7 Market Return: A Puzzle. ”Its authors are Oleg Bondarenko from the University of Illinois at Chicago and Dmitriy Muravyev from Michigan State University.
The professors analyzed tick-by-tick trading data for S&P 500 E-Mini-Futures between 2004 and 2018. Crucially, their data reflected business outside of normal trading hours when the NYSE is open. They were therefore able to measure the proportion of stock market return since 2004 that was achieved during the NYSE’s closure.
The graph below shows what they found: During the period under review, the total net return on the S&P 500 was between 11:30 p.m. and 3:30 a.m. Eastern time, with an average annualized return of 7.6%. On average for the rest of the time, the market posted an annualized loss of 0.8%.
This overall result is based on a 14 year average and of course the pattern has not worked in every trading session. Even so, Muravyev told me in an interview that the pattern was remarkably consistent. A clue to this consistency, even if you remove the 10 of those 14 years when the pattern was strongest, the pattern remains statistically significant for the remaining four years.
Last year was a real test of this market pattern and that is what the professors analyzed in their recently completed update of their original study. Not only did they find the pattern persisted in 2020, it was much stronger than the 2004-2018 average.
Why should this overnight pattern exist?
Muravyev said he believed the main cause of this night-versus-day pattern was due to the stock market’s reaction to uncertainty. He and his co-author received tick-by-tick histories for the CBOE Volatility Index
Futures (VIX) and found that it and the E-Mini S&P futures are inversely correlated. That said, the VIX drops significantly on average from 11:30 p.m. Eastern Time, right when the S&P 500 futures start to rise.
This inverse relationship between the stock market and the VIX makes theoretical sense, of course. Investors react negatively to increasing uncertainties, just as they tend to react positively to falling volatility.
But why should the uncertainty drop around 11:30 p.m.? Muravyev said that is when European investors are starting to do business in their portfolios and their collective actions are helping to reduce the uncertainty that has built up since the NYSE closed the previous trading day.
Of course, at any given time, there will be some investors who are just waking up, looking at their terminals, and adjusting their portfolios. However, a critical mass of investors is required to reduce uncertainty, and it seems like Europe is the only non-US region in the world that offers this critical mass.
Confirmation of this statement comes from the S&P 500’s performance overnight prior to a vacation in Europe. Many European traders will be less focused on the stock market, and on average there is no overnight pattern in the S&P 500 on average these days.
Impact on the investment
The most obvious impact of this investigation on investment is that traders buy Eastern S&P 500 e-mini futures at 11:30 p.m. and sell them at 3:30 p.m. “Despite trading twice a day,” say the professors, this trading strategy “remains profitable minus conservative estimates of trading costs – exchange fees, commissions and bid-ask spread. The Sharpe ratio after costs exceeds that of the buy-and-hold alternative. “
Futures trading is not for amateurs and can be especially risky for those unfamiliar with it. Even if you are otherwise tempted by this strategy, it is a good idea to consult a qualified financial professional first. You should also trade on paper for at least a month or two before risking any of your money.
Finally, you should know that, on average, this overnight pattern manifests itself over many trading sessions. So either be ready to be consistent and disciplined in pursuing this trading strategy over a long period of time, or don’t bother with it.
Given these qualifications, you can decide that a good night’s sleep is worth more than overnight profits from trading. However, this study shows why you shouldn’t be surprised the next time you see the S&P 500 perform so much better overnight than it does during the day.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings track investment newsletters that pay a flat fee for testing. He can be reached at firstname.lastname@example.org