Market Anomalies

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 these anomalies.

Proven Market Anomalies

1. 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.
2. 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.
3. 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.
4. 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.

5. Net-Net Current Assets -- Benjamin Graham’s 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:

6. 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 Line’s ranking system tends to favor stocks with low price/earnings ratios, high earnings momentum, and high price momentum.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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 firm’s accounting practices).

14. 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.

15. 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.

16. 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 small stocks.)

17. 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.

18. 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 Friday’s close to Monday’s close).  In fact, historically, Monday is the only day of the week that averages a negative rate of return.

19. End of the Day Effect (turn of the day) -- During the last 15 minutes of the day’s trading, prices tend to rise dramatically.