What is an anomaly?
In economics and finance, an anomaly occurs when the actual result according to a given set of hypotheses is different from the expected result predicted by a model. An anomaly provides proof that a given hypothesis or model does not hold up in practice. The model can be a relatively new or older model. In finance, two common types of anomalies are market anomalies and price anomalies.
Market anomalies are yield distortions that contradict the efficient market hypothesis (EMH). Price anomalies occur when something, such as a stock, is valued differently from how a model predicts that it will be valued.
Key points to remember
- Anomalies are events that deviate from the forecasts of economic or financial models that undermine the basic assumptions of these models.
- In markets, models that contradict the assumption of an efficient market, such as calendar effects, are good examples of anomalies.
- Most market anomalies are of psychological origin.
- However, anomalies tend to disappear quickly once their knowledge is made public.
Understanding the anomalies
Anomaly is a term describing an event where actual results differ from expected or predicted results based on models. Two common types of anomalies in finance are market anomalies and price anomalies. Common market anomalies include the small cap effect and the January effect. Anomalies often occur with respect to asset pricing models, particularly the fixed asset pricing model (CAPM). Although CAPM was derived using innovative theories and theories, it often does a poor job of predicting stock returns. The numerous market anomalies observed after the formation of CAPM have made it possible to found those who wish to refute the model.
Although the model does not stand up to empirical and practical tests, this does not mean that it has no utility.
Anomalies tend to be rare. In fact, once the anomalies are known to the public, they tend to disappear quickly as the arbitrators seek and eliminate such a possibility of recurring.
Examples of market anomalies
In the financial markets, any opportunity to make excess profits undermines market efficiency assumptions – which states that prices already reflect all the relevant information and therefore cannot be arbitrated.
The January effect is a fairly well-known anomaly. The idea here is that stocks that underperformed in the fourth quarter of the previous year tend to outperform the markets in January. The reason for the January effect is so logical that it is almost difficult to speak of an anomaly. Investors will often look to dump underperforming stocks at the end of the year so they can use their losses to offset taxes on capital gains (or to take the small deduction that the IRS allows if there is a net capital loss for the year). Many people call this event “harvest of tax losses”.
As the sales pressure is sometimes independent of the fundamentals or the real valuation of the company, this “tax sale” can push these actions to levels where they become attractive to buyers in January. Likewise, investors will often avoid buying underperforming stocks in the fourth quarter and will wait until January to avoid being drawn into the sale of tax losses. As a result, there is excessive selling pressure before January and excessive buying pressure after January 1, causing this effect.
The September effect refers to historically low stock market returns for the month of September. There is a statistical case for the September effect depending on the period analyzed, but much of the theory is anecdotal. Investors are generally thought to be coming back from their summer vacation in September, ready to freeze their gains and tax losses before the end of the year. There is also a belief that individual investors liquidate stocks from September onwards to offset children’s school fees. As with many other calendar effects, the September effect is viewed as a historical quirk in the data rather than an effect with a causal relationship.
Like the previous October effect, the September effect is a market anomaly rather than an event with a cause and effect relationship. In fact, the centenary dataset for October is positive despite the month of panic in 1907, Black Tuesday, Thursday and Monday 1929 and Black Monday in 1987. September saw as much turmoil in the market only in October. It was the month that the original Black Friday occurred in 1869, and two substantial one-day drops occurred in the DJIA in 2001 after September 11 and in 2008 as the subprime crisis deepened.
However, according to Market Realist, the effect has dissipated in recent years. Over the past 25 years, for the S&P 500, the average monthly return for September has been around -0.4%, while the median monthly return has been positive. In addition, large and frequent declines did not occur in September as often as before 1990. One explanation is that investors reacted by “prepositioning”, that is, by selling stocks in August.
Days of the week
Effective market supporters hate the “weekday” anomaly because not only does it seem to be true, but it also makes no sense. Research has shown that stocks tend to move more on Friday than on Monday and that there is a bias towards positive market performance on Friday. It’s not a huge gap, but it’s persistent. The Monday effect is a theory that Monday stock market returns will follow the dominant trend of the previous Friday. Therefore, if the market was up on Friday, it should continue throughout the weekend and, next Monday, resume its rise. The Monday effect is also known as the “weekend effect”.
Fundamentally, there is no particular reason why this should be true. Certain psychological factors could be at work. Perhaps weekend optimism permeates the market as traders and investors look forward to the weekend. Alternatively, maybe the weekend gives investors a chance to catch up, stew and worry in the market and develop pessimism by Monday.
Aside from timing anomalies, there are certain non-market signals that some believe will accurately indicate the direction of the market. Here is a short list of superstitious market indicators:
- The Super Bowl indicator: When a team from the former American Football League wins the match, the market will close lower for the year. When a former National Football League team wins, the market will end the year higher. As stupid as it sounds, the Super Bowl indicator was correct more than 80% of the time over a 40-year period ending in 2008. However, the indicator has one limitation: it does not contain any allowance for a win of the extension team.
- The Hemline indicator: The market goes up and down with the length of the skirts. Sometimes this indicator is called the “bare knees, bull market” theory. To its credit, the hem indicator was accurate in 1987, when designers went from miniskirts to floor skirts just before the market collapsed. A similar change also took place in 1929, but many wonder what happened first, the crash or the hem changes.
- The aspirin indicator: Equity prices and aspirin production are inversely related. This indicator suggests that when the market increases, fewer people need aspirin to cure market-induced headaches. The drop in aspirin sales should indicate an increase in the market. (See more superstitious anomalies on Wackest stock market indicators in the world.)