The Efficient Market Hypothesis represented the conventional wisdom among academics
during the 1970s and early 1980s. The Efficient Market Hypothesis states that an investor cannot
expect to outperform the market averages.
However, during the 1980s and early 1990s, an astonishing number of anomalies became
evident. An anomaly is an exception to the rule, a deviation from what is
expected. A market anomaly, therefore, is an exception to the Efficient Market
Hypothesis. Market anomalies have become too numerous and too well-documented to
ignore. In fact, they have become so well documented that they threaten the
credibility of the Efficient Market Hypothesis.
The anomalies listed below have all become well documented during the past few years.
Although the returns earned by anomalies are not constant over time (i.e., each
anomaly may vary in importance over time), they are all associated with above-average
returns over a long period of time. There is no guarantee that these items will
continue to be anomalies in the future; in fact, it is almost certain that the most
popular ones will not be. Nevertheless, these anomalies have become the basis
for the quantitative style of investing, which attempts to identify and exploit
Proven Market Anomalies
- Low Price/Book Value Ratio -- Stocks with low price-to-book
value ratios tend to outperform the market averages. This effect appears to be
concentrated largely in the month of January.
- Low Price/Earnings Ratios -- Stocks with low price/earnings
ratios tend to outperform the market averages. This is true of all markets: bull,
bear, and neutral.
- Low Price/Sales Ratio -- Stocks with low price/sales ratios
tend to outperform the market averages. This technique states that a company may
experience earnings difficulties causing a drop in price (and creating an attractive price
for a potential buyer). The underlying premise is that a decline in sales is more
serious than a decline in earnings. If sales hold up, the management can eventually
solve the earnings problem, causing a rise in the price of the stock. If sales
decline as well as the price, however, it could be indicative of several serious problems
(increased competition, loss of the company's reputation, poorly defined need for the
company's products, etc.). These are much more difficult to solve and the stock
should be avoided.
- High Yield -- Stocks with high dividend yields (dividend
per share divided by the stock price) tend to outperform the averages. This is
especially true in down markets, indicating that high yield stocks are defensive in nature
(i.e. particularly attractive in bear markets). The effect is especially strong in
January as well.
- Net-Net Current Assets -- Benjamin Grahams method of
ranking stocks has been proven to be highly effective. The net-net current asset
method considers stocks that meet the following criteria to be attractively priced:
- Value Line Rankings -- Stocks which are ranked number 1
(out of 5 ranking values) by Value Line Investment Survey tend to outperform the
market averages, both on an absolute and a risk-adjusted basis. Value Lines
ranking system tends to favor stocks with low price/earnings ratios, high earnings
momentum, and high price momentum.
- Small Stock Effect (Size) -- Over a long period of time,
small capitalization stocks (i.e., smaller companies) have earned a higher rate of return
than the S&P 500 Average, both on an absolute basis and a risk-adjusted basis.
Half of the effect has occurred in January.
- Neglected Firm Effect -- Stocks which are not widely
followed by securities analysts tend to outperform the averages. The ideal situation
occurs where a stock begins to be covered by analysts.
- Low Price Stocks -- Low price stocks tend to perform better
than high priced stocks. This does not include "penny stocks", which are often
very poor investments.
- Earnings Surprise -- Stocks which
report earnings considerably different from the consensus earnings forecasts
tend to move by exceptional amounts. Stocks which report earnings
higher than expected (i.e., a positive earnings surprise) have a large
increase in price while stocks reporting earnings which are less than
expected (a negative earnings surprise) experience a corresponding
fall. This price movement continues for up to several
weeks after the announcement, meaning that an investor can still profit from
the information, even though it has been made public.
- Relative Strength -- Stocks which have been outperforming
the market tend to outperform over a intermediate period of time (3-5 years).
However, stock prices tend to reverse over long cycles, e.g., the biggest losers over the
past three to five years tend to be the biggest gainers over the next three to five years.
- Reversion to the Mean (also called the Residual Reversal
Effect) -- Stocks which outperform one month tend to underperform the next month (and vice
versa). (However, this is true only if the performance is not caused by an earnings
surprise. If the change in price is due to an earnings surprise, it is more likely that
the performance will persist.) Stocks which have experienced a recent reduction
in their P/E ratios tend to have higher rates of return than other stocks. Although
a weaker effect, it is also true that stocks with recent large increases in their P/E
ratio tend to perform worse than other stocks.
- Earnings Torpedo -- Stocks whose earnings plummet suddenly
are disasters. These companies often possess high P/E ratios as a result of a
consensus that earnings growth is expected to be spectacular. As such, they are
under pressure to keep earnings up, even when the fundamental operations begin to
deteriorate. Companies whose earnings "fall off a cliff" often have used
creative accounting (accounting gimmicks) to keep earnings up until it was no longer to do
so. Earnings torpedoes should be avoided at all costs and often can be identified
beforehand by evaluating the "quality of earnings" (the conservatism of the
firms accounting practices).
- Late Earnings Reporters -- Firms who report their earnings
later than others in the industry often have poor results to announce. Therefore,
companies which have not announced earnings by their usual date should be avoided.
- Trends in Analysts Earnings Estimates -- Stocks
whose earnings estimates have been recently upgraded by analysts tend to produce abnormal
returns. As one would expect, the longer you wait before acting on the change, the
less the additional profit you can earn. However, the effect lasts as long as three
months, meaning that you can wait as long as three months after the change in estimates
and still be able to earn an abnormal profit.
Time-Related or Calendar Anomalies
- January Effect (turn of the year) -- The rate of return on
common stocks has been unusually high during the month of January. The effect may
be attributable to tax-related selling in December and consequent buying in January.
(The buying is concentrated in the first five days of January and occurs largely in
- Week of the Month -- The 1st two weeks of the month have a
considerably higher rate of return than the last two weeks of the month.
- Monday Effect (also called the Turn of the Week or the
Weekend Effect) -- Weekends are often bad for stocks, possibly because companies and
governments tend to release bad news on the weekends. Monday is the worst performing
day of the week by far, when measured over a long period of time (i.e., from Fridays
close to Mondays close). In fact, historically, Monday is the only day of the
week that averages a negative rate of return.
- End of the Day Effect (turn of the day) -- During the last
15 minutes of the days trading, prices tend to rise dramatically.