The efficient-market hypothesis (EMH) assumes that investors have “rational expectations.” This is the idea that, on average, the population is correct and whenever new information appears, expectations are updated appropriately.

Wonderful in theory, but in the real world investors are anything but “rational.” As human beings, we tend to overreact to new information, behaving in an irrationally exuberant or irrationally despondent fashion (for our own research on a market inefficiency, click here).

A clear example of this irrational behavior was on full display last December.

As I wrote at the time, with the announcement of U.S. policy changes toward Cuba, investors scrambled for ways to “play it.” Their vehicle of choice quickly became the Herzfeld Caribbean Basin Fund, a closed-end fund with the ticker “CUBA.” In the course of a week, the fund more than doubled in a vertical move higher accompanied by a substantial increase in volume.

While the ticker was “CUBA,” there was no actual Cuban companies in the fund’s holdings, only companies that “might benefit” from a shift in policy towards Cuba. This minor detail did not matter. Investors bid up shares in CUBA to an astounding 70% premium over net asset value.

In an efficient market, such a wide divergence would never happen, as arbitrageurs would have stepped in, shorting the fund while buying the underlying holdings to earn a “riskless” profit. In an efficient market, no investor would have chosen to buy CUBA at a 70% premium when they could buy the underlying holdings at no premium at all.

But the market is not entirely efficient and it took a year for the price of CUBA to move back to its NAV. Yesterday, it closed at $6.45, slightly below its NAV of $6.53.

The lesson here is as old as time. The markets are far from efficient and a key reason for that is that investors are far from rational. The CUBA fund is merely one example. It has happened before and it will happen again as long as human behavior is a driving force in markets.

To sign up for our free newsletter, click here.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

A couple weeks ago, President Obama announced that he is ready to relax restrictions for Cuba. The result – a little-known closed end fund trading under the symbol $CUBA skyrocketed. On December 17, it traded 48 times its average daily volume. In the midst of the very same trading day, some of the most read financial bloggers pointed out that CUBA’s current holdings might have very little to do with Cuba.

This fact didn’t stop $CUBA from doubling in five trading days. At some point it was trading at 70% premium above its net asset value, which basically means that everyone could’ve bought $CUBA individual holdings for a lot less. This phenomena didn’t last long. Warren Buffett once said “Time is the friend of the wonderful business, the enemy of the mediocre.” The same thing applies to stocks and ETFs, sometimes.

The big questions here are, why did the market over-react so much and why did it take so much time to correct the excess? In the era of social media, when everyone is supposed to have access to more information (noise) and higher quality analysis, we continue to see the same over-reactions and under-reactions as 10-20 years ago.

In the case of Cuba, people knew that those changes mean repricing. When people and algos have no idea how to play a change, they go with the next best thing – price and volume. Here’s what was probably going on in the mind of a shrewd speculator: “$CUBA is going up on huge volume, so somebody must know something. Even if the market turns out to be wrong, I will be out with a hefty profit long before that. It’s all about risk and reward.”

Intra-day traders and algorithms act on price, volume, key words and momentum and they have plenty of purchasing power to create powerful moves. Those moves are often exacerbated by early short-sellers, who don’t know when to step away from the freight train. Do you remember the huge rallies in ebola related stocks in October, when we saw 100% to 500% moves in less than two weeks?

Sometimes, ignorance is a bliss. The people who made the most money in the late 90s were those who knew nothing (not sure if they kept it) and those who knew a lot, but also knew when their knowledge was a hurdle.

Market is forward-looking, but sometimes it goes a little bonkers. You could complain about its irrationality or accept it as an inherent part of what it is and create a system that could take an advantage of it.

Check out my latest book: “The 5 Secrets to Highly Profitable Swing Trading”

The efficient-market hypothesis (EMH) requires that investors have “rational expectations,” that on average the population is correct and whenever new information appears, expectations are updated appropriately.

Nice theory, but in the real world investors are anything but “rational.” As human beings, we tend to overreact to new information, behaving in an irrationally exuberant or irrationally despondent fashion.

The latest example of this irrational behavior has been in full display over the past week. Even before President Obama’s announcement of policy changes toward Cuba, investors were scrambling for ways to “play it" (as a side note, I doubt many of these "investors" could quantify how  much the policy changes would actually benefit the companies they were buying, but that is a topic for another day).

Their vehicle of choice quickly became the Herzfeld Caribbean Basin Fund, a closed-end fund with the ticker “CUBA.” Over the past week the fund has more than doubled in a vertical move higher accompanied by a substantial increase in volume.

Now here’s where it gets interesting.

While the ticker is “CUBA,” there are no actual Cuban companies in the fund’s holdings. All of the holdings are easily accessible through U.S. shares or ADRs and are traded on the U.S. exchanges.

But it is certainly easier for investors to buy one ticker rather than going through the trouble of replicating the holdings of CUBA. This must be the reason for the increased demand for the fund.

Perhaps, but what if I said you needed to pay a 70% premium for this easy access. You would probably have a few choice words for me. But that is exactly what investors are doing today as the fund’s share price of $14.12 is over 70% higher than the value of its underlying securities ($8.27).

In an act that can only be described as irrational exuberance, investors have bid up shares in this fund to well beyond the value of the underlying holdings. We can see this visually by looking at a few of the fund’s top holdings.

Copa Holdings (CPA), 8.5% position:

Mastec, Inc., 6.3% position:

Coca-Cola Femsa SAB, 6.0% position:

While these shares have advanced over the past week, they have not come close to supporting the gains in the CUBA fund. In an efficient market, such a wide divergence would never happen, as arbitrageurs would step in and short the fund while buying the underlying holdings to earn a “riskless” profit. In an efficient market, no investor would choose to buy CUBA at a 70% premium when they could buy the underlying holdings at no premium at all.

But the markets are far from efficient and a key reason for that is that investors are far from rational. The CUBA fund is merely the latest example. It has happened before and it will happen again as long as human behavior is a driving force in markets.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

Equity markets surge, close near highs (S&P best day since January)! FOMC keeps rates unchanged (expected)/alters language (expected), as still remains “dovish”; Russia/ruble recover after massive losses prior week (and yesterday) after Bank of Russia actions; President Obama unveils plan to normalize US/Cuba relations; Consumer Prices (CPI) drop more than expected/most in 6-years; another volatile move for crude (closes up 1%, but turns negative in after hours – traded up as much as 5.5%); treasuries sell off on FOMC headlines (yields rise); the dollar surges; couple of M&A related news stories; several movie theaters wont screen SNE’s ”The Interview” due to threats; ORCL rpts after the close; Transports underperform on weak FDX earnings.