"Pockets of Predictability" - Markets are not always unpredictable

 

Markets are efficient. That is a good null hypothesis and a good basis for investing. Making money by trading is not easy. Investors will get a premium for taking on risk, but making any excess return is not easy. Most should just invest in passive indices. 

Yet, this general conclusion is not the end of the story.  There are opportunities in markets at specific times. What factors may be less unpredictable or marginal on average may actually have high predictability and make money during focused times. This idea changes how you think about trading and the importance of different factors. As recently put by in a Journal of Finance research paper, there are "Pockets of Predictability".  I love this term.

A given feature or predictor may not make significant money over a long period. The models may have limited significance and r-squared, but there may be selected out of sample periods when there is strong predictability and the opportunity to make money. Predictability may be associated with local or short periods of time. The researchers generate a simple way of testing predictability through time to find these pockets. These pockets are associated with a sticky expectations model where beliefs are slowly updated which allow some factors to make improved expectations.

A key issue is not identifying these pockets but being able to predict these pockets so capital can be husbanded for the right time. These pockets can be found in both daily and monthly data and are associated with simple predictors like the lagged divided price ratio, the yield on 3-month Treasury bills, the Treasury term spread between 10-year bonds and 3-month bills, and realized volatility.

Looking for or finding pockets of predictability is easy and not the secret to riches, but it changes our perspective on how we should look at models and opportunities. When expectations are sticky, a model may provide better insights at a specific or local time. Using a combination of factors may identify opportunities that can provide a slight edge. Predictive models can provide an alternative way of assessing the market environment that offer support over localized periods. This is worth exploring in more detail.