Market Anomalies

The efficient market hypothesis (EMH) states that all stocks are properly priced, and that abnormal returns cannot be earned by searching for mispriced stocks. Furthermore, because future stock prices follow a random walk pattern, they cannot be predicted. However, there does seem to be some market patterns that can lead to abnormal returns, thus violating the efficient market hypothesis, particularly the semi-strong EMH, which predicates that abnormal returns cannot be earned by learning all the available public information on companies and their stocks, and any other variables that may affect stock prices, such as economic factors. Hence, the semi-strong EMH would seem to negate the value of fundamental analysis. (The weak form of the EMH negates the value of technical analysis.)

Market anomalies are market patterns that do seem to lead to abnormal returns more often than not, and since some of these patterns are based on information in financial reports, market anomalies present a challenge to the semi-strong form of the EMH, indicating that fundamental analysis does have some value for the individual investor.

P/E Effect

Portfolios composed of low P/E stocks often outperform portfolios composed of high P/E stocks. Some have hypothesized, based on the capital asset pricing model and other models relating risk to returns, that the reason for this is because low P/E stocks have greater risk, and therefore potentially greater returns. In other words, if 2 stocks have the same return, then the one with the lower P/E ratio is riskier; otherwise they would have the same P/E ratio. (Some of you will be thinking, "Wait, high P/E stocks are riskier!" This is generally true, but those riskier stocks are also expected to yield higher returns to compensate investors for their risk. In other words, if 2 stocks have the same return, why would you pay the same price for the riskier stock?)

Book-to-Market Ratios

It has generally been observed that stocks of companies with high book-to-market ratios outperform stocks with low book-to-market ratios. Studies have shown that this effect seems to be independent of the stock's beta, and therefore, independent of systematic risk. This effect could be explained by the fact that companies with low book-to-market ratios tend to be companies that investors expect to grow rapidly. However, rapid growth continually declines as companies grow larger — hence, growth in stock prices will be diminished as the P/E ratio declines as future expectations of further growth are lowered. As the P/E ratio drops, the return also drops. Furthermore, stocks with high book-to-market ratios tend to decline less in bear markets, since there is less risk when the market value of a company is close to its book value.

Earnings Announcements

Earnings announcements can have variable effects on stock prices. Sometimes stock prices go up until the earnings are announced, then decline on the news — or they may decline before the announcement if expectations are not positive. Expectations usually are based on analysts' reports, and their forecast of future earnings. Many websites publish a consensus of earnings expectations. If the actual reported earnings differs significantly from what was expected, then this earnings surprise can have a large effect on the subsequent stock price for an extended time. A study by Foster, Olsen, and Shevlin^[1] has shown that the more dramatic the earnings surprise, the more effect it had on the stock price, with positive surprises causing the stock price to rise for up to 2 months after the announcement, and negative surprises causing declines — the price effect was most dramatic within the 1^st several days of the announcement. Not only does this study indicate that abnormal returns can be earned by simply watching earnings announcements for surprises and responding quickly to them, but it also shows that price changes are not as fast as EMH would seem to imply.

Small-Firm-in-January Effect

Stocks of small companies tend to outperform large companies, simply because they have a greater potential for growth — the larger the company, the harder it is to grow even larger. However, there appears to be more of an increase in the 1^st 2 weeks of January, even after adjusting for the riskiness of the stocks using the capital asset pricing model (CAPM). Since the stocks of small companies are more volatile, many of the them will have declined in value by the end of the year, and many of these stocks will have been sold to offset profits for the year, or to reduce taxes from other income. It has been hypothesized that the January effect is due to this tax-loss selling in December, thereby depressing the stock prices of small firms more than could be justified by the prospects for the underlying companies. Hence, when the new year begins, investors buy up these stocks, thus raising the stock prices. Some have argued that this hypothesis is not likely to be valid, since, if true, investors would buy the stocks before the end of the year to earn those gains. However, if investors bought before the end of the year, the price may still decline further, since it is impossible to know how much more tax-loss selling there will be — which is why they wait until the beginning of the new year. Of course, to take maximum advantage of this effect, one should buy as early in the new year as possible — then others, especially the technical analysts — will continue the buying by taking advantage of the upward momentum.

Why does the small-firm effect last only 2 weeks? Probably because earnings reports start to become a more important factor and because the new-year buying has brought the stocks to their appropriate price level.

January Barometer

The January Barometer applies to all stocks, most of the time. It is simply stated, "As January goes, so goes the year." It has been reported that there have been only 5 times since 1950 when it has not held true. Presumably, this is because of the passage in 1933 of the 20th "Lame Duck" Amendment to the Constitution, which moved Inauguration Day from March 4 to Jan. 20, when newly elected federal officials take office.

Neglected-Firm Effect

The neglected-firm effect is the observation that small firms that are not covered extensively by analysts tend to outperform the market. But since almost all neglected firms are small firms, this may simply reflect the basic fact that small firms have a greater potential for growth, so the neglected firm effect may not represent an independent effect. This effect may also arise because when small firms become larger, their coverage by analysts increases, and their stock float also increases, which allows more institutional investors to buy the stock. Institutional investors are reluctant to buy stocks with a limited float, since any major buying or selling can have a significant impact on the stock price.

Liquidity Effect

It has also been argued that since stocks of small firms usually have relatively few outstanding shares of stock, few shares trade at any particular time, which makes the stocks relatively illiquid. Illiquidity increases bid/ask spreads, which increases risk, and therefore, such stocks command a higher risk premium as compensation.

Market Anomalies Occur More Often Than Not, But Not Always

Keep in mind that market anomalies, like the stock market, are much like the weather — although there are definitely recurring patterns, you never know what it is going to do on any particular day. Market anomalies occur more frequently than not, which is why they have been noticed, but they don't always occur. So don't risk any more than you can lose in trying to profit from them.