‘The Efficient Market Hypothesis’ (EMH) is a landmark in modern financial theory. It states that it is impossible to beat the market at any given point of time. The existing stock prices are incorporated to reflect upon the markets. This hypothesis is revered and disputed at the same time. It states that markets always reflect the fair value of stocks making it impossible to buy undervalued stocks or sell at an inflated value. This is contested as Warren Buffet challenged the market trends by investing in undervalued stocks and earning billions. He has constantly outperformed the markets and contested the EMH. Hence, this point towards a common phenomenon, that is, no theory is absolute and every rule has it exceptions and assumptions.
It is the exceptions and assumptions that stems from an ideal theory that is discussed and analyzed by experts and researchers. It becomes what is commonly phrased as the ‘talk of the town’. The deviation from the EMH is what led to the formulation of the market anomalies.
What are Market Anomalies
Anomalies are considered to be unusual occurrences or exceptional occurrences that are not expected to occur in the course of daily life. Market Anomalies also known as market distortion is a situation when the price and/or rate of return contradicts the EMH. The structural reasons that cause market anomalies are:
- Unfair Competition: Competition is a state where all organization in the stock market competes on the same terms and bound by the same regulation. The terms of competition or violation of regulation will be termed as unfair competition. In such a situation, the profit of an organization is at the cause of the loss of others. This unnaturally affects the stock prices and reflects differently than the consistent performing stocks. For example, if an organization is declaring their own schemes and collects money from clients, which does not adhere to Government regulations. This is called creating a sense of unfair competition in the market.
- Lack of Transparency: Transparency is a factor that is incidental to free markets. The Market Efficiency theory states that the changes in the economy due to political, social or economic reasons are always reflected in the prices of the stock and the corresponding changes in the stock market. However, if there is the sudden change in prices of a certain stock and the same is not reflected in the stock of their peer groups. This is the cause of lack of transparency.
- Regulatory Factors: Regulations are supposed to be deterrent that dictates behaviour and incentives. However, when the above two factors have been carried out, there is a violation of regulatory factors. An unnatural depiction of stock prices displays that there regulation has not acted as a deterrent.
Let us look at the some commonly existing market anomalies:
- Days of the Week Anomaly: This is a surprisingly persistent anomaly. The stocks prices tend to behave in a certain manner depending on whether it is the weekend or weekday. The change of the year is also supposed to indicate a rise in the stock market
- Weekend Effect: The stock prices are the lowest on the first day of the week, which is Monday. The stock market closes normally on a high on Friday and the opening on Monday is always lower than the prices on Friday. It is often noted that some Mondays may also reflect a negative rate of return.
- Turn of the Month Effect: This states that markets have the tendency to rise on the last trading day of the month. The inflated prices stay for the first three days of the month.
- Turn of the Year Effect: This states that stock prices start to rise at the last week of December. The stock prices remain on a high for at least two week of January.
- The January Effect: There is a sudden rise in the stock markets in the month of January and it stays so for at least two week. The reason being the small cap funds consistently outperform all other categories in this month. They are often known to outperform the markets and the other asset classes. The reason for this often cited to as January marks the last few months of the financial year and there is a rush on the part of the investors to invest. So investors start a new year by making investments for tax purposes.
- Stock Spilt Effect: Companies tend to increase the number of available shares and decrease the share prices to allow average investors to invest without changing the market capitalization of the company. However, it is often seen that when prices are reduced to split stocks the prices of the stocks rise. This is taken as an indication that the prices will keep rising.
- Short Term Price Drift: Stocks in the market are supposed to reflect the on goings in the economy. Hence, a positive occurrence or speculation or announcement pushes the stock prices higher. It is usually taken as an indication that prices keep moving higher even after the announcement has been made. However, an anomaly occurs when the stock prices do not react to the speculations or announcements and the prices neither increase nor not decrease in the short term.
- Merger Arbitrage: This refers to a situation when there are rumours of an acquisition or merger in the market. The firm that is being acquired sees a rise in the stock prices and the firm that is acquiring sees a fall in their stocks prices. It is often said that the valuation presented by the bidding firm does not reflect the intrinsic value of the firm. Hence, a rise in the rise stock prices allows the firm that is being acquired to get a premium price from the bidder.
Market Anomalies are exceptions that rule the market. For a lot of anomalies there are no concrete reasons that could justify its occurrences. Anomalies, are surrounded by speculations and guesses but lacks concrete reasoning. They could occur on a regular basis or not occur at all. There is no accounting for when an anomaly will be next cited in the stock markets. It is often stated that investors are biased towards anomalies and that is the reason why anomalies persistently occur. While anomalies are shrouded in myths and realities but can be sure that these are occurrences that will keep persisting and will co-exist along with the stock markets.