What is Anomalies? If Efficient Market Hypothesis holds, all - - PowerPoint PPT Presentation

Lecture 2: Anomalies and Market Efficiency

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Nattawut Jenwittayaroje, Ph.D, CFA NIDA Business School Master of Arts program in Applied Finance

9.2

What is Anomalies?

• If Efficient Market Hypothesis holds, all securities should have the

same risk-adjusted returns.

• Therefore, observable stock characteristics such as size, PE ratio, or

price-book value ratios will be useless in finding undervalued (i.e., positive abnormal return) stocks or overvalued (i.e., negative abnormal return) stocks.

• Anomalies are empirical results that seem to be inconsistent with

maintained theories (e.g., CAPM) of asset-pricing behavior.

• Fama (1970): Joint test of market efficiency and asset pricing theory
• Jensen (1978): economic relevance
• After anomalies are documented and analyzed, they often seem to

disappear, reverse, or attenuate.

• Arbitrage strategy vs Statistical aberration

9.3

Data Snooping

• The process of examining data and models affect the

likelihood of finding anomalies.

• Authors in search of an interesting research paper are

likely to focus attention on ‘surprising’ results.

• Solution:
• Test the anomaly on an independent sample: other

countries, prior time periods, and/or subsequent data

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Market Anomalies: Size Effect

• Size Effect was first documented by Banz (1981) in the US

markets.

• Based on the sample period from 1926 to 1975, Banz (1981)

divided the stocks on the NYSE into quintiles based on their market capitalization, and found that smaller firms earn higher returns than larger firms of equivalent risk.

• Reinganum (1981) also documented that smaller firms had higher

average risk-adjusted returns than larger firms in the US stock market prior to 1980.

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Market Anomalies: Size Effect

• Fama and French (1992) using data for the period 1963 to 1990,

group all stocks on the NYSE, AMEX, and NASDAQ into 10 groups based on their market capitalization.

• Their results show that the average return of the smallest stock

group is 0.74% per month higher than the average return of the largest stock group.

• Dimson and Marsh (1986) and Chan et al. (1991) also find a small

firm premium for markets outside the U.S. (i.e., UK and Japan respectively).

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Market Anomalies: Size Effect

• From Table 1 below, however, small-firm anomaly has

disappeared since the initial publications of the papers that discovered it, Banz (1981) and Reinganum (1981)

www.dfafunds.com Size effects

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Market Anomalies: Turn-of-the-year (January) effect

• Roll (1983) and Haugen and Lokonishok (1988) show strong

differences in return behavior across the months of the year.

• Specifically, they found that returns in January are significantly

higher than returns in any other months of the year.

• Keim (1983) and Reinganum (1983) showed that much of the

abnormal return to small firms occurs during the first two weeks in January  “turn of the year effect” or “January effect”.

• Roll (1983): higher volatility of small stocks caused substantial

short-term capital losses that investors might want to realize for income tax purposes before the end of the year.

• Selling pressure in December and rebound in early January.

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Market Anomalies: Turn-of-the-year (January) effect

Average Return by Month of the Year

January Effect: SET50 of the SET

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Market Anomalies: Turn-of-the-year effect

• Schwert (2003): from Table 2, it seems that the turn-of-the-

year anomaly has NOT disappeared since it was originally documented.

Whole period Sub-period

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Market Anomalies: Weekend Effect

• The weekend effect refers to the differences in returns

between Mondays and other days of the week, where the returns on Mondays are significantly negative, while the returns on every day of the week are not.

• The weekend effect is another return phenomenon that has

persisted over long periods and over several international stock markets.

• In the US market, French (1980) observed another calendar

anomaly, by showing that the average return to the S&P portfolio was reliably negative over weekends (i.e., Friday to Monday) in the period 1953-1977.

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Market Anomalies: Weekend Effect

• Weekend Effect – Gibbons and Hess (1981) study returns by days
• f the week during 1962-1978.

Average Daily Returns by Day of the Week: 1962 - 1978

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Market Anomalies: Weekend Effect

• Schwert (1990) shows estimates of the weekend effect from 1885 to 2002,

and shows that (in Table 3) there exists weekend effect in all periods, except the recent period (e.g., 1978-2002).

• Thus, like the size effect, the weekend effect seems to have disappeared
• r at least substantially attenuated, since it was first documented in 1980.

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Market Anomalies: Weekend Effect

• There is evidence of weekend effect in most major international

markets

Monday Rest of the Week

Market Anomalies: Weekend Effect in Thailand

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Market Anomalies: “Value” Effect

• PE Ratio- Studies by Basu (1977) and Basu (1983) investigate the

relationship between PE ratios and abnormal returns.

• Basu (1977, 1983) noted that firms with high earnings-to-price ratios

(i.e., low price-earnings ratios or “value” stocks) earn positive abnormal/excess returns (relative to the CAPM).

PE Ratios and Stock Returns, 1952-2010

Annual Return

Lowest PE Highest PE

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Market Anomalies: “Value” Effect

• There is also evidence of Value effect in other international

markets. Excess Returns on Low PE Ratio Stocks by Countries

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Market Anomalies: “Value” Effect

• Price-Book Value Ratios – Rosenberg et al. (1985), Fama and

French (1992) find that average returns on US stocks are positively related to the ratio of a firm’s book value to market value.

• In other words, low price-to-book stocks (i.e., “value” stocks)

earn higher average returns than high price-to-book stocks.

• Chan et al. (1991) find the same results in Japanese market.
• Fama and French (1998) examine the “Value” (low P/B, low

P/E) vs “Glamour/Growth” (high P/B, high P/E) stocks in international context.

• “Value” outperformed “Glamour/Growth” in all markets under

study.

Market Anomalies: “Value” Effect

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Market Anomalies: “Value” Effect

• Fama and French suggested that low price-book value ratios may
• perate as a measure of risk, since firms with prices well below

book value are likely to be troubled firms. Therefore, investors require additional return for additional risk associated with such firms.

• “Value” (low P/E and/or lowP/B ratios) characteristics represent

a risk factor that are missing from the CAPM.

• Lakonishok et al (1994): Low P/E or low P/B ratio stocks are

generally characterized by low growth, large size, and stable business, all of which should work toward reducing their risk rather than increasing it.

• Therefore, the explanation for this finding is still not justified.

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Market Anomalies: Momentum Effect

• Jegadeesh and Titman (1993) provides an analysis of

relative strength trading strategies over 3 to 12 month horizons.

• They analyse NYSE and AMEX stocks over the period

1965-1989.

• Strategies considered select stocks based on their returns
• ver the past 1, 2, 3 and 4 quarters (i.e., formation periods)

 (J)

• Holding periods considered vary from 1-4 quarters (K).
• So a total of J x K = 4 x 4 = 16 strategies were empirically

examined.

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• For a J/K strategy, at the beginning of each month t, securities are

ranked in ascending order on the basis of returns in the past J months.

• Ten equally weighted decile portfolios are formed. The top decile

is the loser portfolio and the bottom decile is the winner portfolio.

• Strategy adopted in each month t is buy the winner portfolio and

sell the loser portfolio, holding the position for K months.

Market Anomalies: Momentum Effect

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Main Results:

• Returns of all zero-cost (i.e.,

buy minus sell) portfolios are positive and nearly all are significant.

• Most successful zero-cost

strategy is to selects stocks based on their returns over the previous 12 months and then holds them for 3 months

• > 1.31% per month.

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Market Anomalies: Momentum Effect

• Rouwenhorst (1998) used data from12 European countries during

a sample period of 1980-1995.

Main Results:

• For each strategy,

past Winners

• utperformed past

Losers by about 1% per month.

• The returns range

from 0.64% to 1.35% per month, and all excess returns are statistically significant.

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Market Anomalies: Long-Term Price Movement

• Fama and French (1988) examine five-year returns on stocks from 1931-

1986 and present the evidence that serial correlation is more negative in five-year returns than in one-year returns. There is substantial negative correlation in the 5-year return, suggesting that markets reverse themselves

• ver long periods (e.g., 5

years)

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Market Anomalies: Long-Term Price Movement

• DeBondt and Thaler (1985) construct a winner portfolio of 35 stocks, and

a loser portfolio of 35 stocks each year from 1933-1978 and then examine returns on these portfolios for 36 months following the portfolio

• construction. The results find that loser portfolios outperform winner

portfolios.

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Market Anomalies: Market Reaction to Information Events

• Earning announcement- Studies by Aharony and Swary (1980), Joy et
• al. (1977), Rendleman et al. (1982) examine the quarterly earning
• announcement. The results are shown in the figure.
• The results show “post earnings announcement drift” (PEAD)

anomaly.

• PEAD is the tendency for stocks to earn abnormally high returns in the

three quarters following a positive earnings announcement, and to earn abnormally low returns in the three quarters following a negative earnings announcement.

• The most widely accepted explanation for the effect is investor under-

reaction to earnings announcements.

• There is some evidence of a market reaction prior to earning
• announcement. This can be viewed as evidence as insider trading,

information leakage, or getting announcement date wrong.

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Market Anomalies: Market Reaction to Information Events

This figure provides a graph

• f price reactions to

earnings surprise, classified

• n the basis of magnitude

into different classes from “most negative” earnings reports (group 1) to “most positive” earnings reports (group 10).

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Market Anomalies: Market Reaction to Information Events: Index Effect

• Index Effect - The index effect refers to a situation where a

stock that are added to (deleted from) a stock index experiences the significant increase (decrease) in price and trading volume.

• However, index addition/deletion are usually not accompanied

with the announcement of any new fundamental information, related to earnings prospects or risk characteristics, from the added/deleted firms.

• Early study by Harris and Gurel (1986) and Shleifer (1986)

found empirical evidence in the US market that supports the index effect proposition.

• Index effect is also pervasive in several major international

stock markets.

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Nattawut (2014) Index Effects: A Review and Comments, Chulalongkorn Business Review

Market Anomalies: Market Reaction to Information Events: Index effects – US evidence

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Nattawut (2014) Index Effects: A Review and Comments, Chulalongkorn Business Review

Market Anomalies: Market Reaction to Information Events: Index effects – US evidence

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Nattawut (2014) Index Effects: A Review and Comments, Chulalongkorn Business Review

Market Anomalies: Market Reaction to Information Events: Index effects – International evidence

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Evidence on Insiders and Investment Professionals

• There is a belief that insiders must have information advantage over

the average investors, and be able to convert such advantage into excess returns.

• Insider Trading – Jaffe (1974) examines excess returns on two groups
• f stock-buy group and sell group

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Evidence on Insiders and Investment Professionals

• Analyst Recommendation –Womack (1996) documents that the price

effect of buy recommendations tends to be immediate and no drift after announcement, while prices continue to trend down after sell recommendation.

Added to buy Removed from buy Added to sell Removed from sell 3 days around recommendations, 1 month after, 3 months after, 6 months after Market Reaction to Recommendations: 1989-1990

Returns

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Evidence on Insiders and Investment Professionals

• Professional money managers operate as the experts in the

investment field, and are supposed to be better informed, have lower transaction costs, and be better investors overall than smaller investors.

• Money manager – the earliest

study by Jensen (1968) found that the average portfolio manager actually underperformed the market between 1955 and 1964.

• The average alpha (after

expenses) was -0.011, indicating that on average the funds earned less 1.1% per year than the benchmark (adjusted for risk).

Zero alpha

Estimated intercept (alpha) Frequency

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Evidence on Insiders and Investment Professionals

• “Hot Hand” phenomenon – the persistence of mutual fund returns.

 mutual funds that achieved above-average returns continue to enjoy superior performance.

• Malkiel (1995) examines the

predictability of US mutual fund performance from 1980-1990.

• Over the 1980-1990, there

seemed to be no persistence

• f mutual fund performance.
• Overall, 51.7% of the past

winners continued to be the winners in the next period.