7 Market Anomalies Investors Should Know
by Stephen Simpson|
Filed under: ACTIVE TRADING
FINANCIAL THEORY
It is generally a given that there are no free rides or free lunches on Wall Street. With hundreds of investors constantly on the hunt for even a fraction of a percent of extra performance, there should be no easy ways to beat the market. Nevertheless, there are certain tradable anomalies that seem to persist in the stock market, and those understandably tend to fascinate many investors.
While these anomalies are worth exploration, investors should keep this warning in mind – anomalies can appear, disappear, and re-appear with almost no warning. Consequently, mechanically following any sort of trading strategy can be very risky. (Find out why little companies have the greatest potential for growth in Small Caps Boast Big Advantages. For another article identifying the same principles, read Why Warren Buffett Envies You.)
TUTORIAL: Detecting Market Strength
Small Firms Outperform
The first stock market anomaly is that smaller firms (that is, smaller capitalization) tend to outperform larger companies. As anomalies go, the small firm effect makes rather a lot of sense. A company's economic growth is ultimately the driving force behind the performance of its stock and smaller companies have much longer runways for growth than larger companies. A company like Microsoft(NYSE:MSFT) might need to find an extra $6 billion in sales to grow 10%, while a smaller company might needs only an extra $70 million in sales for the same growth rate. Accordingly, smaller firms typically are able to grow much faster than larger companies and the stocks reflect this.
January Effect
The January Effect is a rather well-known anomaly. Here, the idea is that stocks that underperformed in the fourth quarter of the prior year tend to outperform the markets in the month of January. The reason for the January Effect is so logical that it is almost hard to call it an anomaly. Investors will often look to jettison underperforming stocks late in the year if they have a loss in them so that they can use those losses to offset capital gains taxes (or to take the small deduction that the IRS allows if there is a net capital loss for the year). (Check out January Effect Revives Battered Stocks.)
As this selling pressure is sometimes independent of the actual fundamentals or valuation of the company, this "tax selling" can push these stocks to levels where the stocks become attractive to buyers in January. Likewise, investors will often avoid buying underperforming stocks in the fourth quarter and wait until January, so as to avoid getting caught up in this tax-loss selling. As a result, there is excess selling pressure before January and excess buying pressure after January 1, leading to this effect.
Low Book Value
Extensive academic research has shown that stocks with below-average price-to-book ratios tend to outperform the market. Numerous test portfolios have shown that buying a collection of stocks with low price/book ratios will deliver market-beating performance. Although this anomaly makes sense to a point (unusually cheap stocks should attract buyers' attention and revert to the mean), this is unfortunately a relatively weak anomaly. Though it is true that low price-to-book stocks outperform as a group, the individual performance is very idiosyncratic and it takes very large portfolios of low price-to-book stocks to see the benefits. (For more insight read How Buybacks Warp The Price-To-Book Ratio.)
Neglected Stocks
A close cousin of the "small firm anomaly", so-called neglected stocks are also thought to outperform the broad market averages. The neglected firm effect occurs on stocks that are less liquid (lower trading volume) and tend to have minimal analyst support. The idea here is that as these companies are "discovered" by investors the stocks will outperform.
Research suggests that this anomaly actually is not true – once the effects of the difference in market capitalization are removed, there is no real outperformance. Consequently, companies that are neglected and small tend to outperform (because they are small), but larger neglected stocks do not appear to perform any better than would otherwise be expected. With that said, there is one slight benefit to this anomaly – though the performance appears to be correlated with size, neglected stocks do appear to have lower volatility. (Wall Street tends to focus on large cap stocks, leaving other stocks under-followed and undervalued, check out Finding Undiscovered Stocks.)
Reversals
There is some evidence that stocks at either end of the performance spectrum over periods of time (generally a year) do tend to reverse course in the following period – yesterday's top performers become tomorrow's underperformers, and vice versa.
Not only is there statistical evidence to back this up, the anomaly also makes some sense according to investment fundamentals. If a stock is a top performer in the market, the odds are that the stock's performance has made it expensive; likewise in reverse for the under-performers. It would seem like common sense, then, to expect that the over-priced stocks then underperform (bringing their valuation back more in line) while the under-priced stocks outperform.
Reversals also likely work in part because people expect them to work. If enough investors habitually sell last year's winners and buy last year's losers, that will help to move the stocks in exactly the expected directions, making it something of a self-fulfilling anomaly. (Learn to distinguish between a temporary price change and a long-term trend, read Retracement Or Reversal: Know The Difference.)
Days of the Week
Efficient market supporters hate the Days of the Week anomaly because it not only appears to be true, but it makes no sense. Research has shown that stocks tend to move more on Fridays than Mondays and that there is a bias towards positive market performance on Fridays. It is not a huge discrepancy, but it is a persistent one.
On a fundamental level, there is no particular reason that this should be true. Some psychological factors could be at work here, though. Perhaps there is an end-of-week optimism that permeates the market as traders and investors look forward to the weekend. Alternatively, perhaps the weekend gives investors a chance to catch up on their reading, stew and fret about the market, and develop pessimism going into Monday. (For more read Capitalizing On Seasonal Effects.)
Dogs of the Dow
The Dogs of the Dow is included as an example of the dangers of trading anomalies. The idea behind this theory was basically that investors could beat the market by selecting stocks in theDow Jones Industrial Average that had certain value attributes. There were different versions of the approach, but the two most common were to select the 10 highest-yielding Dow stocks or go a step further and take the five stocks from that list that had the lowest absolute stock price and hold them for a year.
It is unclear whether there was ever any basis in fact for this approach, as some have suggested that it was a product of data mining. Even if it had once worked, the effect would have been arbitraged away - say, for instance, by those picking a day or week ahead of the first of the year. Moreover, to some extent this is simply a modified version of the reversal anomaly; the Dow stocks with the highest yields probably were relative underperformers and would be expected to outperform.
Conclusions
Attempting to trade anomalies is a risky way to invest. Not only are many anomalies not even real in the first place, they are very unpredictable. What's more, they are often a product of large-scale data analysis that looks at portfolios made up of hundreds of stocks that deliver just a fractional performance advantage. Since these analyses often exclude real-world effects like commissions, taxes and bid-ask spreads, the supposed benefits often disappear in the hands of real-world individual investors.
With that said, they can still be useful, to a certain extent. It seems unwise to actively trade against the Day of the Week effect, for instance, and investors are probably better off trying to do more selling on Friday and more buying on Monday. Likewise, it would seem to make sense to try to sell losing investments before tax-loss selling really picks up and to hold off buying underperformers until at least well into December.
All in all, though, it is probably no coincidence that many of the anomalies that seem to work hearken back to basic principles of investing. Small companies do better because they grow faster, and undervalued companies tend to outperform because investors scour the markets for them and push the stocks back up to more reasonable levels. Ultimately, then, there is nothing really anomalous about that at all – the notion of buying good companies at below-market valuations is a tried and true investment philosophy that has held up for generations. (Check out our Stock Picking Strategies Tutorial.)
by Stephen Simpson, CFA
Stephen Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare.
Simpson operates the Kratisto Investing blog, and can be reached there.
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