Have you ever heard of the efficient market hypothesis? The basis of the hypothesis is that stocks trade based on all known information. In other words, there is never news that the market hasn’t already priced in. The implication is that the market is never inefficient.

If you’re looking at that and thinking about how much of a bummer it is, I don’t blame you. I found out about the theory when I first started learning about the markets back when I was 16 (yeah, I was young).

I thought that it meant that there was no sure-fire way to beat the market. After all, if there were no inefficiencies to take advantage of, how could I trade the market for quick profits?

But truthfully, the markets aren’t nearly as efficient as you might think.

The Reg SHO Inefficiency

One of those inefficiencies was pretty recent.

On July 15, the SEC placed naked-shorting limits on 17 banks and brokerages. These banks and brokerages were favorites of naked short sellers. So when these limits were placed, traders had to buy to cover their naked positions.

This started what is known as a short-squeeze. But the squeeze didn’t just last one day…

Over the next month, the financial sector went on to rise 26 percent. Some financial stocks even recovered 50 percent of their losses.

If the markets were efficient then the sector would have finished moving up in just a day. Actually, in just a few ticks after the open.

But that didn’t happen at all. It took time for these brokerages to unwind their naked positions. And as time went by and buying kept occurring, it created a bottom in the price of those stocks.

Any savvy investor could have simply gone long after the rule reversal, or bought a two-month call option. Had you done that, you’d be up 300-500 percent easily.

That would have been one hell of a market inefficiency to take advantage of. And it’s just one bit of evidence proving that the markets aren’t really all that efficient.

The Trade Deficit Inefficiency

Here’s a bit of knowledge most people don’t know.

When the US trade deficit begins to flatten out and shrink, it coincides with a slowing US economy. If you simply wait until the end of the year and see a trade deficit that shrunk from the year before, you could short the major indexes and make some good money.

Well, the trade deficit peaked in 2006. And you would’ve known about that peak at the end of 2007, when the new yearly trade figures came in.

Had you shorted the market then, you’d have made 10 percent or more. Had you bought a double-inverse ETF, you’d be up 20 percent or more. And for all intents and purposes, the market should continue to drop.

If the markets were truly efficient, this would have already been priced in, right?

I guess in a sense it is, but in this case you’re using the trade deficit as a broad economic indicator that takes a lot of time to generate a buy or sell signal.

Inefficiencies are everywhere… you just have to look

When all is said and done, the markets are never as efficient as the hypothesis lets on. In fact, I’d argue the markets are completely inefficient.

Just look at a long-term chart of the Dow and try and convince me that the market was being efficient.

Seriously, should the market have continued to hit record highs nearly every day during the second half of 2006, even though signs were everywhere that the economy would slow down?

No, it shouldn’t have. And the fact that it did presented a huge inefficiency; one you could’ve taken advantage of.

Or look at the precious metals markets today. Last time I checked inflation is soaring. Import prices have gone up over 20 percent since last year. Producer and consumer prices are up too. So why are gold and silver selling off? It’s an inefficiency, and you can take advantage of it.

But here’s one of my favorites…

The tax credit for wind and solar producers expired. Look at solar stocks and you’ll see a big drop. But as soon as those tax credits get reinstated (believe me, they will) you can expect orders for solar and wind infrastructure to move higher. And the stocks should follow suit.

As an investor, one of the surest ways to make money in the markets is by taking advantage of the little inefficiencies you see. It might take a little bit of searching, but the work is well worth the reward once you do find it.

Stay free,

Charles

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Source: The Efficient Market Lie