Anomalies that occur in the Stock Market

A market anomaly is a price action that contradicts the expected behaviour of the stock market.

Days of the week: Research and past history has shown us that stocks tend to move more on Fridays more than mondays and that there is generally a bias toward positive market performance on Fridays. On a logical level, there is no particular reason that this should be true. Some psychological factors could be at work. Perhaps an end-of-week optimism permeates the market as traders and investors look forward to the weekend. Alternatively, perhaps the weekend gives investors a chance to catch up on their analysis on the market, and develop pessimism going into Monday.

Small firms: Firms with a smaller capital amount often outperform larger companies. A company’s economic growth is the driving force behind its stock performance, and smaller companies have much longer runways for growth than larger companies. A company like Google may need to earn an extra $3 billion in revenue to grow by 10% whereas a smaller company may need only an extra $10 million in revenue to grow the same amount. This is why smaller firms tend to perform better.

The January effect: What happens is that stocks that underperformed in the fourth quarter of the prior year tend to outperform the markets in January. Investors will often look to drop underperforming stocks late in the year so that they can use their losses to offset capital gains taxes. This “tax selling” can push these stocks to levels where they become attractive to buyers in January. Likewise, investors will often avoid buying underperforming stocks in the fourth quarter and wait until January to avoid getting caught up in the tax-loss selling. As a result, there is excess selling pressure before January and excess buying pressure after January 1st, which causes this effect.

Reversals: Stocks that either perform extremely well or extremely poorly in a fiscal year usually do a complete 180 and follow a reverse course in the next period. If a stock is a top performer in the market, odds are that its performance has made it expensive. Likewise, the opposite is true for underperformers. It is then expected that the over-priced stocks would underperform (bringing their valuation back in line) while the under-priced stocks outperform. If enough investors habitually sell last year’s winners and buy last year’s losers, that will help move the stocks in exactly the expected directions.

Low book value: Extensive research has shown that stocks with below-average price-to-book ratios tend to outperform the market. Numerous test portfolios have shown that buying a collection of stocks with low price/book ratios will deliver market-beating performance. Cheap stocks should attract buyers’ attention and revert to the mean. This is a relatively weak anomaly. It takes very large portfolios of low price-to-book stocks to see the benefits.

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