11 Stock Market Oddities — and How to Exploit Them

By Dr Penny Pincher on 3 July 2018 0 comments

It is often said that it's impossible to "beat the market." There's no magic formula for success. If everyone is trading based on the same information, stocks should always sell for a fair price. At least, that's the idea if markets are what economists call "efficient," meaning all relevant information is available to all parties at the same time and that prices respond immediately to that information.

But sometimes the stock market doesn't behave that way. Stock prices may not actually reflect the underlying asset valuation of the company. This phenomenon is known as a stock market anomaly.

Think of anomalies as quirky rules of thumb that don't always hold. For instance, stock prices have been known to rise in the period after Christmas in what's called the Santa Claus rally. Some investors try to take advantage of these trends to pick up extra profit, but of course, the Santa Claus rally doesn't happen every year, so there's risk involved. The same goes for the other types of anomalies.

As we've heard before, past performance is no indication of future success. Likewise, there's no guarantee that anomalies will repeat themselves.

Nevertheless, it's worth informing yourself about market anomalies so you can decide for yourself whether you want to try to take advantage of them. Here are some of the most common stock market anomalies. (See also: Does Skill Really Matter in Stock Market Investing?)

1. Reversal anomaly

What goes down must eventually come up — and vice versa. This anomaly states that stocks that are performing very well tend to reverse course the following period and decrease in value. Stocks that are performing poorly follow a similar course — they tend to increase in value the following period.

There are a couple of logical explanations for this behavior. Perhaps investors anticipate that high performing stocks won't perform at that level indefinitely, and start to price in the expectation that they will come down.

From a statistical perspective, this anomaly could be an example of regression to the mean, meaning you'll get a more representative average price by examining the data over a longer interval than by looking at the price over a shorter interval in which performance happens to be above or below average.

2. Dogs of the Dow

The Dogs of the Dow theory states that by picking the right subset of stocks in the Dow Jones industrial average, you can beat the market. Investors who try this approach do so by picking the 10 Dow stocks with the highest dividend-to-price ratio. A further refinement is to take the five stocks on that list of 10 that have the lowest stock price, and hold them for a year.

Whether the Dogs of the Dow is a consistent phenomenon or not is debatable, but picking underperformers may be an extension of the reversal anomaly; stocks that are performing relatively poorly tend to improve eventually.

3. January effect

The January effect is when stocks that underperformed from October through December suddenly perform better than average come January. A possible explanation for this anomaly is that investors are motivated to sell underperforming stocks at the end of the year to claim a loss to lower capital gains taxes. Once they're done selling, the price rebounds.

This is a case where stock price can be affected by factors other than their expected return and risk. The savings on taxes can cause investors to sell underperforming stocks at prices below a logical asset valuation.

4. Santa Claus rally

It is said that the 12 consecutive days starting on Christmas (Dec. 25) produce the best returns of any 12-day period in the market. Investors can try to take advantage of this anomaly by waiting until Christmas to invest, just in time to reap the best returns of the year.

However, the Santa Claus rally is not very consistent from year-to-year. It's not clear whether there is a fundamental basis for this anomaly, or whether it's just a coincidence that has happened a few times by chance.

5. Small firm effect

This stock market anomaly states that smaller companies tend to outperform larger ones because their underlying growth rates look better than those of bigger firms. It takes fewer dollars in sales for a small company to generate the same percentage of growth as a larger business. For instance, a small company can grow 10 percent by boosting sales just a few million dollars, but a large company might need to increase sales by billions of dollars to grow the same percentage.

6. Value effect

The value effect says that stocks of companies with below-average price-to-book ratios tend to perform better than other stocks. A company's price-to-book ratio is its share price divided by the value of the company's assets as shown on its balance sheet. The concept behind this anomaly makes intuitive sense — buying stock at a price that is a good value relative to other stocks should make a better investment.

But going too low on a price-to-book ratio can get you stock in a company that is in financial distress. A very low price-to-book ratio indicates that the market knows a business has significant hurdles to overcome to achieve strong profits. You could get much lower than average returns or even lose all of your investment in case of bankruptcy.

7. Days of the week

According to this anomaly, stocks tend to perform better on Fridays than on Mondays. Maybe investors get some enthusiasm and optimism heading into a weekend and are more eager to buy. But on Monday, the trend is reversed after investors have had time to reconsider their investments over the weekend.

Does this anomaly mean that you should buy stocks on Friday and sell on Monday to maximize returns? Because this anomaly is not very consistent, you could come out ahead — or you could lose money, depending your timing.

8. Election-year rally

A few years ago, my investment adviser encouraged me to ramp up my investment contributions during the run-up to the 2004 presidential election. The logic he presented was that elected officials pull out all the stops to try to get the economy fired up in time for an election. If the markets are up, voters are more likely to put their support behind a candidate, so election years generally produce better returns than other years.

I took my adviser's advice and boosted my investment contributions, but the market actually went down a little over the three months leading up to the election. Fortunately, I kept my money in the stock market, and there was a rally after President George W. Bush was re-elected. In the recent election of 2016, the market also trended down in the months leading up to the election, but rallied after the election. Based on these two elections, I would say the election-year rally is really that the market goes up right after the election — instead of in the run up to the election, as my adviser predicted.

9. Turn of the month effect

The turn of the month effect results in stock prices going up on the last day of the month and on the first four days of the following month. The explanation for this is that during this time period, large institutional investors tend to reallocate investments within their funds, liquidating cash assets and using them to buy stocks. That, in turn, drives up stock prices.

10. Momentum effect

The momentum effect occurs when stocks that have recently performed well continue to outperform others for some time. One cause may be that the market doesn't immediately apply updated pricing information into its stock valuations. Another cause may be that some investors are making investment decisions based on past performance rather than current information. If investors keep buying high-performing stocks, the price will keep going up for a while until the market has time to react and apply current information to the stock valuation.

11. Post-earnings announcement momentum

This anomaly refers to the fact that markets sometimes have a delayed response to surprising information revealed in a company's earnings announcement. For example, if a company announces that its earnings surpassed expectations greatly, the price might gradually ramp up rather than jump instantly.

An explanation for this anomaly is that the market is not perfectly efficient. It takes investors time to process the new information and react to it, resulting for a time in stock prices that are an anomaly until the market catches up.

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