Market Anomalies

Market anomalies are exceptions to the notion of market efficiency. They may be present if a change in the price of an asset or security cannot directly be linked to current relevant information known in the market. Market anomalies are only valid if they are consistent over long periods of time and not the result of data mining or examining data with the intent of developing a hypothesis. There is much debate regarding whether market anomalies truly exist after making appropriate adjustments for risk, transaction costs, sampling errors, and other factors. Market anomalies can be categorized as time-series anomalies, cross-sectional anomalies, or other anomalies.

Time Series Anomalies

• Calendar anomalies: Significant differences in returns on different days, months, or years. The most commonly known calendar anomaly is the January effect, in which stocks tend to outperform in the month of January. Part of this effect may be explainable by individual investors or fund managers selling off during the previous December either for tax reasons or to show off impressive end-of-year results.
• Momentum/overreaction: The momentum anomaly occurs when the prices of assets that have been rising tend to keep rising, and falling prices tend to continue falling. Stocks that have shown strong past performance tend to outperform those with weak historical performance in the next period. This is considered an anomaly because, in financial theory, an increase in an asset’s price shouldn’t naturally lead to further price increases unless there’s new information or shifts in supply and demand. According to the momentum anomaly, it’s advisable for investors to purchase stocks that have previously performed well and sell those that have underperformed. The existence of this anomaly is often linked to cognitive biases, which are part of behavioral economics. On the other hand, the overreaction anomaly relates to the tendency of stocks to exhibit long-term reversals in returns. Stocks that have performed poorly in the past three to five years tend to perform better over the next three to five years compared to stocks that have previously done well. The overreaction anomaly suggests buying stocks that were losers in the past while selling those that were winners.

Cross-Sectional Anomalies

Two of the most researched of these anomalies in financial markets are the size effect and value effect. The Fama and French three-factor model (seen in the Portfolio Management section) attempts to adjust for these anomalies.

• Size effect: Small companies tend to outperform larger companies. This argument has indeed been validated through historical analysis, at least until the 1980s. However, some empirical studies have declared the size effect “dead” after the early 1980s.
• Value effect: Value stocks are typically characterized by having below-average price-to-earnings and market-to-book ratios, and they offer higher dividend yields. Historically, these value stocks consistently outperformed growth stocks. However, the strength of this trend has diminished or even disappeared over time, particularly after the publication of research papers that originally highlighted this phenomenon.

Other Anomalies

• Closed-end fund discounts: Closed-end funds sometimes sell at a discount to their net asset value or the price that the fund’s holdings could theoretically be sold for if fully liquidated. Tax inefficiency and expectations of manager underperformance may partially explain this anomaly.
• Earnings surprise: Stock prices commonly tend to react slowly to new information, which can create a window of opportunity for a momentum strategy. In a momentum strategy, the aim is to purchase stocks that have experienced recent positive developments and sell stocks that have recently shown negative developments. This approach can potentially yield profits for investors.
• Initial public offerings (IPOs): Investors can purchase a stock at its initial offering price to earn excess returns. This is somewhat understandable as investment banks arranging the IPOs are often incentivized to set a low price.
• Prior information: Some researchers have found that equity returns relate to prior information like interest rates, inflation rates, stock volatility, and dividend yields. However, this is not evidence of a market anomaly, as abnormal returns cannot be earned using such information.

Question

What characteristic used for stock screening is the least likely to result in any abnormal profits due to market anomalies?

1. P/E ratio.
2. Earnings per share.
3. Market capitalization.

The correct answer is B.

Looking for stocks with significant market capitalizations and favorable price-to-earnings (P/E) ratios can provide investors with the potential to earn abnormal returns, often due to cross-sectional anomalies in the market. However, concentrating only on earnings per share (EPS) without factoring in the share price hasn’t been shown to yield similar abnormal returns. To put it simply, considering both market capitalization and the P/E ratio is more likely to lead to favorable outcomes compared to solely focusing on EPS. This combined approach tends to be more advantageous for investors seeking abnormal returns.