The Official Winston Kotzan Website

Why Not to Make Trades at the Monday Morning Open

08/02/2011:

“When we made the mistake of letting the news out of the bag, we are confronted with the latest reasons that mankind is doomed: recession, the high cost of healthcare, fundamentalist Muslims, the budget deficit. Even the sports pages can make you sick…. That’s the kind of weekend logic that’s in force, sub rosa, when the sell orders come pouring in on Mondays. It’s no accident that Mondays historically are the biggest down days in stocks.”>

This was the writing of the legendary investor Peter Lynch, circa 1993. I enjoy the time-tested wisdom of his investing book Beating the Street. Despite being published in the early 1990s, much of what Peter has to say seems to still make very much sense even in today’s stock market. Interestingly, if you compounded the daily returns of every Monday since the beginning of 1980, you would find that over time investing in Mondays would have led you to slightly weaker results than had you compounded the daily returns of any other day of the week:

However, this pent up weekend worry can just as easily work in the opposite direction, especially in the anticipation of good news. On the Friday, July 29 edition of Mad Money, Jim Cramer suggested that the upward spikes during the day were caused by cautious short sellers closing out their positions in fear of a hospitable debt ceiling deal being struck by Congress over the weekend.

If there is any credence to Cramer’s theory, then whichever short sellers hung on to their positions through the weekend must have waited for Monday’s market open in nail-biting suspense. Sunday evening, just before the opening of the Asian markets on the other side of the globe, President Obama declared that a deal had been struck. The markets overseas responded with a 1%+ rally.

When it came turn for the US markets to open Monday morning, irrational exuberance over the debt deal immediately set in and all three indices opened with a pop higher. Any short sellers who spent the weekend worrying about the possibility of a positive debt ceiling outcome were no doubt covering their shorts at that time. However, it would not take long for the buyback spree to get crushed, as from the point the gates opened, the market began a quick and hasty decline.

Perhaps the reason for this quick decline after the opening pop was perhaps that the cold realities of the situation began to sink into the overall market psyche:

The so-called “deal” struck by the government that would raise the Federal debt ceiling was only between the leading negotiators. It had yet to win the support of both quarreling chambers of Congress. Although it seemed the Senate would be more apt to pass, nobody could have known for certain yet how the stonewalled “Tea Party” Republicans would view the deal.

While a disaster may have been averted by the absence of a deal, damage may have already been done by the debt ceiling debate. As of Monday morning, it wasn’t yet clear how good or bad the compromise would be concerning an overall economy impact, let alone whether the deal was strong enough to remove the scrutiny over whether US debt should maintain its ‘AAA’ rating by creditors.

In other words, could a cool-headed short seller have seen the rapid cooling off of the buying spree coming despite the buying exuberance that set in at the market open? Could a savvy trader have seen through the irrational panic at the market open, stuck to his guns, and stayed short? I think so.

The lesson here: sometimes market openings can be skewed by panic and irrational trading. On certain high-stakes days like we saw on August 1st, the opening play may not reflect the true underlying sentiment of the “smart money”.

Additionally, I think we can learn from the last few weeks in hindsight that the Washington debt debacle had little direct impact on the market. The debt ceiling issue and its potential ramifications if a deal would not get done has been known to the public all summer long. But the markets didn’t even flinch. What really prompted the ~5% decline over the last few weeks has instead been a flurry of negative economic data:

July 22: CAT reported a cautious outlook due to a deceleration of international business.

July 27: Questionable earnings results spooked the market.

Emerson Electric noted a “general slowdown in business activity” during their quarterly results conference call.

Juniper Networks missed profit and revenue expectations. The company’s Q3 expectations were much below their normally lofty outlook: estimating 12-14% sales growth through year end vs. Wall Street’s expectation of 18%, blamed on decelerating sales growth.

Corning had a disappointing outlook. On conference call it was stated, “The display industry has been behaving more cautiously in recent weeks, driven primarily by weaker retail expectations for the second half… We have seen most of the major television brands reduce their sales forecasts.”

The Fed Beige Book came out at 3pm, sinking the markets lower). It noted that durable goods orders dropped 2.1% (unexpectedly) as orders for transportation equipment such as aircraft and autos fell. Growth slowed in six districts vs. four in the prior beige book.

July 29: The market was torpedoed by the newly released GDP figures. The economy was revealed to have meandered at a 0.4% pace (with a possible downward revision of that figure later on). The anemic 1.9% GDP growth for Q1 was revised down to an even more startling 1.3%.

August 1: Despite the cooling of the initial market “pop”, the real whammy that plunged the market into negative territory was the ISM manufacturing figure of 50.9. The report seems to have gotten around at ~10am. It is difficult to tell exactly how soon it could have further fueled the market’s decline because the actual press release does not have a timestamp. I am using ZeroHedge’s report as a proxy for the time the information was dessimated.

Conclusion: While the debt ceiling debate was a topic of media interest, the outcomes of the political discussions seemed to have a weak correlation to the actual declines in the market. Some short sellers may have been preparing in anticipation for a disastrous outcome leading to the pop on Monday morning, but does not seem to have been the primary driver of the drops. While the debt ceiling talk may have been loosely related to the market’s decline, the real reason for the stock market malaise has been a more nefarious unraveling of economic and earnings data which hints at a slowing of economy and dimmer picture than that painted by the optimism of economists’ 2H:11 expectations.