Stock Market Anomalies Every Investor Should Know
The Efficient Market Hypothesis (EMH) suggests that investment markets and stock prices are rational and fully reflect all available information. However, there are times when markets may deviate from EMH due to market anomalies.
An anomaly is defined as a strange or unusual occurrence. With respect to stock markets, the continuous release and quick dissemination of new information and ongoing speculation can mean that markets are not always so efficient.
Many of these market anomalies come and go quickly. Others occur just frequently enough that investors may be tempted to use them as the basis for a trading strategy.
Here we list several stock market anomalies (calendar and trade driven), including some that occur on a semi-regular basis. But do they occur with enough regularity that investors can profit from them?
Calendar anomalies are those that are associated with certain dates or events in a year.
Super Bowl Indicator
When a team from the original American Football Conference wins the Super Bowl, the year will be a bear market. When a team from the original National Football League wins the Super Bowl, there is a bull market for the year. Although data shows this to be true for almost 75% of the time, there can be no basis in cause and effect for this anomaly and therefore it should not be allowed to inform an investment strategy.
Weekend Effect (Days of the Week Effect)
This is the tendency for stock prices to rise on Fridays and decrease on Mondays. Statistically, this has been shown to be true going back to 1950. However, it does not occur often enough to be the basis of a dependable trading strategy.
Santa Claus Rally
This is a rise in the stock market during the last five trading days of the year and the first two trading days of the following year. It is thought to be driven by tax-loss selling prior to the holidays (followed by year-end purchasing of these stocks at lower prices) and overall investor optimism related to the holiday season. Trying to profit from this anomaly can be counterproductive as the rally is not predictable.
Stocks that underperformed in the fourth quarter tend to outperform the market in January of the following year. Reasons may be a combination of tax-loss selling at year-end and other investors waiting to make stock purchases in the new year so as not to be affected by tax-loss sellers. However, December losers do not turn often enough into January winners to make this a profitable investment strategy.
Sell in May and Go Away
This is driven by the belief that stock prices are depressed in the summer months due to lower trading volumes. A common trading strategy for believers has been to invest in stocks from November until the end of April and then invest in a fixed-income portfolio for the rest of the year. Costs of trading and being totally out of equity markets often negate any gains that may have been achieved by this strategy.
Trade Driven Anomalies
Merger Arbitrage Effect
When a company merger or acquisition is announced, the value of the company being acquired tends to increase, while the value of the purchasing company tends to decline. This is usually a result of mispricing driven by the acquisition announcement and subsequent investor trading and often quickly corrects itself.
Research suggests that stocks at either end of the performance spectrum tend to reverse their direction over periods of time. Yesterday’s outperformers become tomorrow’s underperformers. Outperformers become expensive and underperformers eventually become cheap. This anomaly becomes somewhat self-fulfilling as investors act on the perceived mispricing. Trying to time the reversal often proves difficult.
Anomalies are anomalies because there is no conclusive basis for either their occurrence or their persistence, or both. They are noticed because they do occur with some regularity, but they do not always occur. It is very difficult to consistently profit from exploiting market anomalies. It represents a more extreme version of market timing and studies have repeatedly shown that “time in the market beats timing the market”.
This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.