Unbeatable Overnight Gains Fuel Theories on Who’s Driving Them

(Bloomberg) -- U.S. stock traders can thank their late-night counterparts for powering this year’s rally.

The bulk of the S&P 500’s historic rebound from the March lows has been driven by after-hours trading, according to data compiled by Bloomberg. A strategy of buying the SPDR S&P 500 exchange-traded fund at the close of trading in New York and selling it at the next day’s open has gained 39% since March 23. That compares to just 9% for those buy the ETF at the start of Wall Street trading hours and sell at the close.

It’s unclear what’s fueling the phenomenon. An easy explanation is that the vast majority of market-moving news -- economic data, earnings reports, analyst recommendations -- are released outside of the U.S. trading day. Some of the more cynical theories suggest that large players abroad could be forcing a short squeeze by bidding up U.S. stock futures overnight. Others posit that it boils down to a quirk in market structure. Whatever the reason, outsize overnight gains tends to attract attention following downturns and rebounds, according to DataTrek Research’s Nicholas Colas.

“It’s been an on-again, off-again topic over many years,” Colas said. “People notice it during periods of volatility and it’s counterintuitive -- the U.S. market is open from 9:30 am to 4pm, that’s when the moves should be.”

With some exceptions, S&P 500 futures outperform outside of the cash market’s trading hours, moves that have been amplified in the latest bout of volatility. Contracts on the S&P 500 gained 1.5% overnight into Monday and then rose 1.3% during the normal trading day. They added 0.7% into Tuesday before rising 0.5% during normal hours. A similar dynamic has occurred with the Nasdaq 100.

Research from the Federal Reserve Bank of New York confirms the overnight bias. From 1998 through 2019, nearly 100% of the U.S. equity premium is earned after European markets open, according to a February 2020 paper.

The explanation could be straightforward as traders in Europe and Asia reacting to overnight news stories and earnings releases, according to Academy Securities. Or it could be as far-fetched as a concentrated effort to steamroll bearish bets against U.S. technology stocks.

“The cynical side of me, and I’m not quite there yet, would wonder if someone was trying to drive the market higher to squeeze out shorts,” said Peter Tchir, head of macro strategy. “Overnight in Nasdaq futures might be the way to do it.”

The Fed paper suggests a more straightforward reason, saying the outperformance is a function of dealer inventory management. Market makers tend to mark down their holdings at the U.S. close, and have been increasingly offloading inventory during Asian trading hours. Then as European traders start their day and liquidity improves, that artificial discount disappears, the authors found.

That theory holds water with DataTrek’s Colas, who contends that the relationship is likely hardwired into trading algorithms.

“The underlying reality is there’s a strong market making component in the system,” Colas said. “I assume that every good high-frequency algo, every fundamental algo has this embedded in it.”

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