5 Stock Market Anomalies that you should know about as an Individual Investor
- May 5, 2018
- 8 min read
The money market is a thorough mix of logic, meticulous calculations, predictive modelling, sheer luck, optimism, pessimism and human emotions. There is absolutely no other man made structure in human history that has empowered, enticed, impressed, elated, enslaved and ruined man as much as the money markets from the world over have. From the rise of capitalism and the tall skyscrapers, the luxury cars to pinnacles of human innovation, and the fall of countries, jobless populations, ruined economies to dying cities, the money markets have made everything happen over the last 30 centuries or so. It is what economists call the rise and decline of economies, as one outdoes the other, time and again, again and again.
Armed with this knowledge of money market behaviour, and documented market microstructure, financial stalwarts have tried to model the market and explain how such events take place, so as to evade the next disaster when it arrives. And some of these models are so intricate that they explain a plethora of market events, investor behaviour, pricing of assets and even financial disasters!
But still, there exists a glut of incidents and repeating events that most of our robust models feel inadequate to explain. These are what have been defining the forefront of market microstructure modelling in modern finance.
These inexplicable repeating occurrences are called anomalies. And there exists a ton of anomalies that can make or break an investor’s fortunes depending on the reaction it gets.
As an informed trader you should be aware about the most common and notorious among these anomalies, so that you do not fall prey to these events start when they start cropping up. Most of the modern stock market is heavily dominated by asset pricing theories, most notably, the efficient market hypothesis and the capital asset pricing model, popularly referred to as EMH and CAPM.
I am sure even the most inchoate of investors have seen the Greek letter β in all its glory, scurrying around stock descriptions. That, my dear friend is the dominance of CAPM!
Now, institutional investors know about these anomalies and how they behave. So, they are better armed to keep their investment strategies immune to these anomalies or make profits from them. It is the individual investor, who ventures to the stock market and falls prey to such gusts of anomalous winds. It is time you equip yourself with some of these fragments of knowledge to be better protected against the market anomalies, or make the best of the situation and earn profits from them!
Small Firm Market Anomaly
We have often heard seasoned individual investors say that it is a better bet to invest in giant well established firms than small firms. And it seems reasonable as well, as most investors consider industrial giants to be blue-chip investments.
But statistical analysis has something else to say!
Analysis of the stock market has shown repeatedly that small firm stocks seem to out-do the large firm stocks. Take a look at the following snapshot. It is surprising but true- the NIFTY Small Cap has outperformed the NIFTY 50, which is arguably the most tracked index in India, throughout the most of 2017.
Courtesy: Stockcharts.com
A two-fold explanation is usually given for this. First, analysts say that small firms have relatively higher flexibility which renders them to be more adaptive to customer demands, which in turn becomes the harbinger for good news and positive sentiment. Secondly, the explanation is that of diminishing rate of returns- a Rs. 100 worth of sales company will register a 10% growth in sales if the sale of its product increases by Rs.10, while a Rs. 1,000,000,000 (Rs.1 Billion) worth of sales company will have to show an increase in sales worth Rs. 1,000,000,00 (Rs.100 Million) to register the same growth. The Rs. 100 million worth of increase in sales is definitely more challenging than Rs. 10 worth of increase in sales!
On the flip side, it is also true that small firms are hit harder than large firms when the market decides to go for a dip.
This anomaly gives you some new ideas about the portfolio you should be carrying in a bull run! You should look forwards to dips in the prices of small firms during bull runs, and load your portfolio with them to earn a better return than the tracking index in most cases.
2. Neglected Firm Anomaly
If you follow most financial news channels or the infinite number of apps that have cropped up these days, you find most of the focus in on a certain set of stocks and their performances. The analysts hardly talk about companies whose balance sheet valuation is below a certain threshold. It is these stocks with low liquidity that are classified as neglected stocks. These stocks have very little analyst support and are usually not discovered by ordinary investors.
The neglected stocks come to life when some institutional level investor discovers the value proposition in it. The discovery leads to information dissemination, which in turn pushes more buy pressure on these stock, which eventually leads to the outstanding performance of the neglected stocks.
The following graph puts the anomaly into perspective.
Courtesy: SlideServe
Now this anomaly is akin to the former anomaly we discussed above. But if you are an individual investor with a humble amount of capital, I’ll suggest you to steer clear of the neglected firm anomaly. Honestly, you need to have access to the market audience to make this anomaly work in your favour. And that is only possible if you are already an investment mogul. Even then, this anomaly can lead to a disaster!
3. The Calendar Effect
The Calendar effect is the most popular among all market anomalies. The anomaly says that stocks see higher returns on an average during certain months, days or years when compared against other months, days or year, respectively.
In the US, the most common example of this is the month of January where this effect can be seen to be very pronounced. Many leading journals have published research quantifying the same, and proving it to be true, statistically!
Most analysts consider this to be caused by the fact that the fiscal year in the US is from January to December. So, people register their losses in December to reduce tax burdens for that year, and in the following month of January the market gets fresh investment at lower prices because of the dip in stock prices in the prior month of December, causing the prices to soar up and result in higher returns.
But investors in India have been skeptical of this effect as our financial year runs from April to March. So, we dug up some research on the same to comment on this anomaly.
The majority of the research says that the Calendar effect is also present in India, i.e. investors may expect for better returns in the months of December. The following research papers can be consulted for more details:
https://www.nseindia.com/content/press/NS_jan2009_1.pdf
https://www.researchgate.net/publication/242762716_Calendar_Effects_In_The_Indian_Stock_Market
Chakrabarti, G., and C. Sen (2007), "November Effect: An Example of Calender Anomaly in Indian Stock Market." West Bengal University of Technology, Kolkata, India. Online at: http://ssrn.com/abstract=1121606
Consider the following dataset, it lists the monthly returns of Nifty for the last 25 years:
Courtesy: StableInvestor
Out of the 25 years, the number of times each month has provided a positive return is as follows:
January- 14/25
February- 18/25
March- 10/25
April- 12/25
May- 15/25
June- 18/25
July- 18/25
August- 16/25
September- 17/25
October- 11/24
November- 13/24
December- 19/24
I guess December is the season to be jolly indeed! You can surely try this to lock in some profits.
4. Low book value anomaly
This anomaly is one of the weaker anomalies on this list. Though it has some research backing it up with statistical tests, the market seems to act on it weakly. This anomaly states that stocks with lower price-to-book-value ratio perform better. The same is also true in the case of lower price-to-earnings stocks.
Now, this is logical and follows straight from the core principle of value investing. A lower PB ratio or PE ratio leaves more headspace for the stock to revert to the mean market PB/PE performance. Adding this to a lower price, increments in market value of the stock will register greater percentage return. Hence, the outstanding performance!
This is a great idea on paper, but in reality we feel this is not fool-proof, as a lower PB or PE ratio might be because of a plethora of reasons- general bad perception of the market, bad balance sheet figures, improper management or any other reason. Now this evolved PE or PB ratio is the result of market sentiments and time. It simply cannot be outdone by saying that a lower PB/ PE ratio will give better returns, as the market has already invested time, thought about it and assigned the lower value in consensus. So, before jumping onto this bandwagon, assess the reason for the lower PB/ PE ratio.
5. Reversals
“Today was your day, tomorrow will be mine.”
This is a common dialogue in movies. The funny thing is, given a time span of 12 months or so, the stocks seems to be threatening other stocks with the very same dialogue!
Yes, research has shown that today’s top earning stocks become the top losers, usually, in the next 12 months, while today’s losers place themselves as the top earners.
The explanation for this is along the line of dynamic mean reversion non-equilibrium. It says that as a stock starts performing, investors rally behind it, creating momentum. This momentum in turn siphons in more money from investors looking to make profits from a performing stock. This causes the price of the stock to rise. Eventually the price rises so much that the value proposition of the stock ceases to exist, i.e. the stock is costlier than what its value should be, either in fundamental valuation sense or what the market is willing to pay for it. Now, the reverse pressure becomes dominant, and investors pull out from this stock. This leads to a momentum on the sell side, which in turn results in the falling price of the stock. And thus a cycle gets completed, and the next cycle begins.
This anomaly should tell you that there is a pattern in price movements. The trick is to identify the frequency, which is where the juggernauts of quantitative finance step in, which is a topic for another day, another blog!
A bonus tip for the investors is the anomaly of value investing against growth investing.
Research has shown that value stocks have repeatedly outperformed growth stocks. This sure tells you that value stocks should form a core component of your portfolio. So instead of just hunting for the next multi-bagger, ensure that your portfolio has the survivor set of stocks, based on sound valuation.
So before we close this article on market anomalies, we would advise the following to any investor looking to take advantage of the anomalies, to lock in profits. It is praiseworthy if you can take advantage of the anomalies to earn more but be aware:
As the market micro-structure evolves, new anomalies will come through and the old ones might disappear, so do not go seeking the anomaly, blindly.
Anomaly based profit locking is stressful, so do not attempt to pursue them unless you have the cool for it.
Always invest a part of your savings in fixed income instruments, and long term investment related stocks that can survive all weathers, without considerable harm under, normal economic discourse.
And with that we conclude this list of the 5 anomalies that you should know about as an individual investor. For any query or feedback please write to us at insigniainvestments@gmail.com or head over to https://insigniainvestment.wixsite.com/home
Have a nice day.
And remember, the objective is not attaining supernormal profits, but profits that meet your financial goals with minimal exposure to risk. That is the trait of successful investing.
Stay invested.
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