In the fascinating realm of economics and finance, an anomaly occurs when actual outcomes defy the predictions set by particular models under specific assumptions. Anomalies serve as compelling evidence that certain assumptions or models may falter when faced with real-world scenarios. These irregularities may stem either from recent or long-established models.
Key Takeaways
- Anomalies challenge the core assumptions of economic and financial models by presenting results that diverge from expected predictions.
- Patterns that counter the efficient market hypothesis, like calendar effects, typify market anomalies.
- Psychological drivers often underpin many market anomalies.
- Once anomalies are widely recognized, they typically dissipate as market participants correct the inefficiencies.
Understanding Anomalies
In finance, anomalies often categorized into market anomalies and pricing anomalies. Market anomalies are return distortions that contravene the efficient market hypothesis (EMH). In contrast, pricing anomalies occur when an asset is valued differently from a predicted model price.
Prominent instances of market anomalies feature the small-cap effect and the January effect. The small-cap effect denotes the tendency of smaller companies to outperform larger corporations over time. Alternatively, the January effect highlights how stocks frequently yield higher returns in January compared to other months.
Anomalies also emerge concerning asset pricing models like the capital asset pricing model (CAPM). Although innovative in theory, CAPM often fails to accurately forecast stock returns. Observations of numerous anomalies subsequent to CAPM’s development have fueled debates regarding the model’s validity. Nevertheless, despite empirical and practical shortcomings, CAPM retains some utility.
Notably, anomalies are rare, ceasing quickly as public awareness leads to arbitrage actions that nullify these opportunities.
Types of Market Anomalies
In financial markets, any potential to achieve excessive profits undermines the principle of market efficiency, which asserts that prices already encapsulate all pertinent information, rendering them non-arbitrageable.
The Compelling January Effect
The January effect is identified by the enhanced performance of stocks previously underperforming in the fourth quarter, now outperforming markets in January. This phenomenon implies that end-of-year tax-loss harvesting leads to temporarily depressed stock prices, making them attractive buys in January.
The surge in buying pressure post-January 1 counterbalances the intense selling provoked by tax actions in December, generating this effect.
The Historical September Effect
Known for subpar stock market returns, the September effect is partially supported by statistical data and mainly anecdotal theories. Speculations include investors returning from summer vacations ready to lock in gains or liquidate stocks to plan for end-of-year tax considerations—although subject to scrutiny, this remains a noted anomaly.
Intriguing Days of the Week Anomalies
Proponents of efficient markets are troubled by the “Days of the Week” anomaly, showcasing inconsistences like elevated Friday market activity over Mondays and regular positive performances on Fridays. Despite the absence of a fundamental rationale, this pattern highlights persisted behavioral trends.
The Monday effect posits that Monday returns tend to follow the trend from the preceding Friday, primarily driven by speculated psychological factors over rational fundamental foundations.
Superstitious Market Indicators
Beyond calendar-related anomalies, several non-market-centric indicators intriguingly claim to forecast market directions:
- The Super Bowl Indicator suggests market trends based on the outcome of a football game, yet lacks empirical rationale despite a notable historical track record.
- The Hemline Indicator correlates market movements with skirt length trends, sometimes humorously predicting crashes with the arrival of longer skirts.
- The Aspirin Indicator inversely associates stock prices with aspirin sales, implying fewer headaches (and thus less need for aspirin) during rising markets.
Related Terms: efficient market hypothesis, capital asset pricing model, tax-loss harvesting.
References
- Schwert, G. William. “Anomalies and Market Efficiency”. The Bradley Policy Research Center, Working Paper No. FR 02-13, October 2002, pp. 1. Download PDF.
- Schwert, G. William. “Anomalies and Market Efficiency”. The Bradley Policy Research Center, Working Paper No. FR 02-13, October 2002, pp. 4-5. Download PDF.
- Daily FX. “The January Effect: Potential Impact on Stocks”.
- Avramov, Doron and Chordia, Tarun. “Asset Pricing Models and Financial Market Anomalies”. March 2005, pp. 1-54. Download PDF.
- Fang, Lily; Lin, Chunmei; and Shao, Yuping. “School Holidays and Stock Market Seasonality”. Financial Management, vol. 47, no. 1, Spring 2018, pp. 131-157.
- Schwert, G. William. “Anomalies and Market Efficiency”. *The Bradley Policy Research Center,*Working Paper No. FR 02-13, October 2002, pp. 8-9. Download PDF.
- CME Group. “What to Make of the Super Bowl Indicator”.
- InStyle. “Is the Hemline Index Actually Real?”
- Chen, Hao; Dong, Yinghong; and Lai, Kaisheng. “Revisit Hemline Index Theory: Forecasting Daily Trading of Short Skirts by Stock Market in China”. International Conference on Behavioral, Economic and Socio-cultural Computing (BESC), November 2016, pp. 1-6.
