Making Sense Of Market Anomalies

By Tisa Silver AAA

In the non-investing world, an anomaly is a strange or unusual occurrence. In financial markets, anomalies refer to situations when a security or group of securities performs contrary to the notion of efficient markets, where security prices are said to reflect all available information at any point in time.

With the constant release and rapid dissemination of new information, sometimes efficient markets are hard to achieve and even more difficult to maintain. There are many market anomalies; some occur once and disappear, while others are continuously observed. (To learn more about efficient markets, see What Is Market Efficiency?)

Can anyone profit from such strange behavior? We'll look at some popular recurring anomalies and examine whether any attempt to exploit them could be worthwhile.

Calendar Effects
Anomalies that are linked to a particular time are called calendar effects. Some of the most popular calendar effects include the weekend effect, the turn-of-the-month effect, the turn-of-the-year effect and the January effect.

  • Weekend Effect: The weekend effect describes the tendency of stock prices to decrease on Mondays, meaning that closing prices on Monday are lower than closing prices on the previous Friday. For some unknown reason, returns on Mondays have been consistently lower than every other day of the week. In fact, Monday is the only weekday with a negative average rate of return.
    Years Monday Tuesday Wednesday Thursday Friday
    1950-2004 -0.072% 0.032% 0.089% 0.041% 0.080%
    Source: Fundamentals of Investments, McGraw Hill, 2006
  • Turn-of-the-Month Effect: The turn-of-the-month effect refers to the tendency of stock prices to rise on the last trading day of the month and the first three trading days of the next month.
    Years Turn of the Month Rest of Days
    1962-2004 0.138% 0.024%
    Source: Fundamentals of Investments, McGraw Hill, 2006
  • Turn-of-the-Year Effect: The turn-of-the-year effect describes a pattern of increased trading volume and higher stock prices in the last week of December and the first two weeks of January.
    Years Turn of the Year Rest of Days
    1950-2004 0.144% 0.039%
    Source: Fundamentals of Investments, McGraw Hill, 2006
  • January Effect: Amid the turn-of-the-year market optimism, there is one class of securities that consistently outperforms the rest. Small-company stocks outperform the market and other asset classes during the first two to three weeks of January. This phenomenon is referred to as the January effect. (Keep reading about this effect in January Effect Revives Battered Stocks.)Occasionally, the turn-of-the-year effect and the January effect may be addressed as the same trend, because much of the January effect can be attributed to the returns of small-company stocks.

Why Do Calendar Effects Occur?
So, what's with Mondays? Why are turning days better than any other days? It has been jokingly suggested that people are happier heading into the weekend and not so happy heading back to work on Mondays, but there is no universally accepted reason for the negative returns on Mondays.

Unfortunately, this is the case for many calendar anomalies. The January effect may have the most valid explanation. It is often attributed to the turn of the tax calendar; investors sell off stocks at year's end to cash in gains and sell losing stocks to offset their gains for tax purposes. Once the New Year begins, there is a rush back into the market and particularly into small-cap stocks.

Announcements and Anomalies
Not all anomalies are related to the time of week, month or year. Some are linked to the announcement of information regarding stock splits, earnings, and mergers and acquisitions.

  • Stock Split Effect: Stock splits increase the number of shares outstanding and decrease the value of each outstanding share, with a net effect of zero on the company's market capitalization. However, before and after a company announces a stock split, the stock price normally rises. The increase in price is known as the stock split effect.

    M

    any companies issue stock splits when their stock has risen to a price that may be too expensive for the average investor. As such, stock splits are often viewed by investors as a signal that the company's stock will continue to rise. Empirical evidence suggests that the signal is correct. (For related reading, see Understanding Stock Splits.)

  • Short-Term Price Drift: After announcements, stock prices react and often continue to move in the same direction. For example, if a positive earnings surprise is announced, the stock price may immediately move higher. Short-term price drift occurs when stock price movements related to the announcement continue long after the announcement.Short-term price drift occurs because information may not be immediately reflected in the stock's price.
  • Merger Arbitrage: When companies announce a merger or acquisition, the value of the company being acquired tends to rise while the value of the bidding firm tends to fall. Merger arbitrage plays on potential mispricing after the announcement of a merger or acquisition.The bid submitted for an acquisition may not be an accurate reflection of the target firm's intrinsic value; this represents the market anomaly that arbitrageurs aim to exploit. Arbitrageurs aim to take advantage of the pattern that bidders usually offer premium rates to purchase target firms. (To read more about M&As, see The Merger - What To Do When Companies Converge and Biggest Merger and Acquisition Disasters.)

Superstitious Indicators
Aside from anomalies, there are some nonmarket signals that some people believe will accurately indicate the direction of the market. Here is a short list of superstitious market indicators:

  • The Super Bowl Indicator: When a team from the old American Football League wins the game, the market will close lower for the year. When an old National Football League team wins, the market will end the year higher. Silly as it may seem, the Super Bowl indicator was correct more than 80% of the time over a 40-year period ending in 2008 . However, the indicator has one limitation: It contains no allowance for an expansion-team victory.
  • The Hemline Indicator: The market rises and falls with the length of skirts. Sometimes this indicator is referred to as the "bare knees, bull market" theory. To its merit, the hemline indicator was accurate in 1987, when designers switched from miniskirts to floor-length skirts just before the market crashed. A similar change also took place in 1929, but many argue as to which came first, the crash or the hemline shifts.
  • The Aspirin Indicator: Stock prices and aspirin production are inversely related. This indicator suggests that when the market is rising, fewer people need aspirin to heal market-induced headaches. Lower aspirin sales should indicate a rising market. (See more superstitious anomalies at World's Wackiest Stock Indicators.)

Why Do Anomalies Persist?
These effects are called anomalies for a reason: they should not occur and they definitely should not persist. No one knows exactly why anomalies happen. People have offered several different opinions, but many of the anomalies have no conclusive explanations. There seems to be a chicken-or-the-egg scenario with them too - which came first is highly debatable.

Profiting From Anomalies
It is highly unlikely that anyone could consistently profit from exploiting anomalies. The first problem lies in the need for history to repeat itself. Second, even if the anomalies recurred like clockwork, once trading costs and taxes are taken into account, profits could dwindle or disappear. Finally, any returns will have to be risk-adjusted to determine whether trading on the anomaly allowed an investor to beat the market. (To learn much more about efficient markets, read Working Through The Efficient Market Hypothesis.)

Conclusion
Anomalies reflect inefficiency within markets. Some anomalies occur once and disappear, while others occur repeatedly. History is no predictor of future performance, so you should not expect every Monday to be disastrous and every January to be great, but there also will be days that will "prove" these anomalies true!

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