Market Anomalies & how to Profit from them
Updated: Jun 14, 2020
To understand what market anomalies are and how they function, we first have to understand a much wider though simple topic- The Efficient Market Hypothesis (EMH).
Efficient Market Hypothesis (EMH)
As explained by ‘Investopedia.com’
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information, and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments. (At their webpage)
The idea assumes that at all times market prices are adjusted for all information, irrespective of such information’s availability or comprehension to you. However, this leads to the idea of chasing momentum is the only way of generating consistent alpha.
This post details a few major anomalies that occur and lead market price adjustment for such EMH to hold true. This might sound slightly complicated, but I’m sure by the end of it you would understand the topic much better.
What is a Stock Market Anomaly?
An anomaly is defined as something that deviates from the standard, normal, or expected. Similarly, a stock market anomaly is a price action that contradicts the expected behavior. As I write about this, please understand how these are based out of observations in my experience and in no way are supposed to hold but continue to hold.
Corporate Action Anomalies
Merger & Acquisition:
Usually, Mergers and Acquisitions should mean growth of respective companies, however more often than not the stocks of Acquirer and Acquiree in a fixed pattern. viz.- Immediately post-announcement both shares show up move, soon the acquiree's share outperforms the acquirer and post-merger the acquirer's share enters into a long term consolidation.
Most acquisitions are announced post much due diligence (positive buy signal) and it is in effect a surge in demand for the ownership of the company to be acquired (acquiree).
In case of a "stock-for-stock," the shareholders of the acquiree are usually given a premium of the merged entity, the same triggers a switch in ownership - stockholders of the acquirer company sell its stock to buy that of the acquiree company. Acquiree companies are usually smaller in size and such demand tends to skyrocket its share price.
In the case of a "cash-for-stock", a premium to market price has to be offered to the shareholders of the acquiree- high enough to compensate them to forgo future growth of the stock.
Either way, the stock price of the acquirer company "price in" most of their probable synergistic benefits from the announcement of the merger until its conclusion.
Though expansion converts to higher capacity implying higher sales and intern higher profit, it has been interesting to note how most stocks react to it by entering a consolidation phase. Most companies that announce an expansion show a green spike on news and then enter a state of low SD backed consolidation (which is fragile and overreacts to bad news), which is only broken out on the upside when news of the completion of the same expansion comes up. You could cross-reference this with most companies that were in long-duration consolidations or how companies reacted after substantial expansion announcements.
Statistically- It's a wise idea to sell investments in stock on its expansion announcement and buy it back post-completion.
A few probable reasons are:
Most companies decide to enter expansion when they max out on capacity, which usually happens when their respective industry is close to peaking its growth cycle. Hence, there is a high probability the company might finish expansion when the industry has passed its growth phase and they might not have enough orders anymore.
A capacity expansion requires a large cash outflow, most of which is debt-funded. The debt payment obligations make the company's stock very prone to overreacting to any future probable uncertainties.
Either way on completion of the expansion- uncertainties clear up.
Another important factor to consider while assessing the impact of capacity expansion is how the company is raising capital. Companies may use internal accruals or Raise Equity or Debt. While, internal accruals being used are positive, though most companies would prefer debt even if they have enough internal accruals to finance the expansion owing to the tax shield debt brings on. However, raising equity is rarely considered positive.
Raising equity implies the owners of the company prefer to dilute their stake rather than paying interest, which more often than not implies that the return on the company's stock is going to be less than the cost of debt available to the company. This may not be true if the new equity is being brought in from a strategic investor. Equity dilution would also in theory bring down the EPS of the company and in effect directly convert to a lower stock price per share. New equity would also add to the supply of equity in the market.
Rights Issue (/Bonus) vs Buy Back vs Dividend :
While all three are methods for a company to reward its shareholders, each of them gives us insights into the company and its future growth.
Availability of Derivatives:
After a stock’s derivatives are made available, the stock is now available to speculators.
Higher Liquidity- Equity shareholders often get the advantage of higher premium on stocks with low volume, However the same does not exist once derivatives of the stock are listed.
Short Sellers- Shorting a stock with no derivatives always bear the risk of a massive short squeeze. More importantly, it is difficult to find people who would be willing to allow short sellers to borrow their shares, However, once derivatives are available a short seller can easily create positions.
Investors holding large chunks of the stock who would not have usually been able to offload owing to the market impact can now easily hedge their positions in the derivatives segment.
Other Common Anomalies
The Carhart Four- Factor Model:
An extension of an even earlier model- the Fama French Model, the Carhart models highlights a stock’s tendency to outperform if it has:
Size- Smaller Market Capitalisation
Value- High Book to Market (or low PB) Multiple
Momentum- Higher Month on Month Returns*
While the market expects such stocks to not perform, it has been noticed such stocks usually tend to outperform their respective peers.
*Stocks that fall 20% from their highs or rises 20% from their lows usually have been seen to continue the trend.
Similarly, while 200 DMAs are strong support/resistance signals, a breakout of over 7% marks continuation of the trend in their respective direction.
Neglected / Illiquid Stock:
While it's expected that undercovered stocks may not have superior returns, historically that has not been the case. Such stocks have few analysts tracking them, so the probability of a new interested buyer is high and since liquidity is low the demand for stock ownership can skyrocket the stock. But such stocks have higher risk owing to higher information asymmetry and low liquidity.
The Monday Effect- points at a tendency of stocks to open lower on Monday(s) than on their previous Friday. Usually, market participants on the long side close their positions on Friday fearing uncertainty the following weekend could bring.
Turn of the Month- Historically stocks tend to rise in the last two days of a month and the trend continues for the first three days of the following month.
Turn of the Tax Calendar - Stock prices tend to increase along with higher trading volume in the last few weeks of the Financial Year and such trend is continued in the first few weeks of the Financial Year. Usually, such a tendency is notable in smaller market capitalization stocks.
While the market expects FY ending to have a price decrease on account of Capital Gains being realized and the same participants rushing in to buy during the first weeks of the new FY.
There are observations that suggest Institutional buying in low volume stocks to increase Fund’s Return in the last weeks of the Financial Year.
The September/ October Effect- However, many market realists have argued this anomaly does no longer hold. Historically stock market returns have been weak for the month of September while October is usually followed by strong returns, despite being the month of the 1907 Panic, Black Tuesday, Thursday & Monday in 1929, and the second Black Monday in 1987.
Also referred to as the Low- Volatility Anomaly- Beta is the measure of a stock’s volatility. Beta indicates the percentage change in the stock with respect to that of the benchmark (usually an index). A beta of 1.5 means the stock moves up or down by 1.5% for a percent change in the same direction in the respective benchmark. While this means high Beta stocks should have higher returns, empirical evidence suggests this relation has not held true.
These anomalies can appear, disappear and or may reappear with absolutely no warning.