Chapter 4: Market Anomalies

• Market anomalies - types

• Market efficiency and arbitrage
• Behavioral explanations for anomalies
• Stock market puzzles

1
 Market efficiency
Watch Video: 43 minutes
https://www.youtube.com/watch?v=bM9bYOBuKF4

• A discussion on market efficiency by Nobel laureate Eugene F.

Fama and Richard H. Thaler, the father of behavioral
economics
– They discuss how markets behave/misbehave, value stocks vs. growth
stocks, the existence of economic bubbles etc.
 Market Anomalies

Watch video: 51 minutes

https://www.youtube.com/watch?v=z5hWd2Zoies

Robert J. Shiller, Nobel Laureate in Economic Sciences and Professor

of Economics at Yale University, European Finance Association (EFA)
Annual Meeting, Università della Svizzera italiana
 Market Efficiency - Recap

• Watch video (9 minutes)

• https://www.youtube.com/watch?v=UTHvfI9a
wBk

4
Efficient Markets Hypothesis - Recap

5
 Market efficiency and arbitrage

Theoretical requirements for market efficiency

• Market efficiency requires that only one of
the following three conditions holds:
1. Universal rationality
2. Uncorrelated errors
3. Unlimited arbitrage

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 Market efficiency and arbitrage

Theoretical requirements for market efficiency

1. Universal rationality
• all investors are always rational
• does this hold?
• false because some investors at least some of the time
execute trades on less than fully rational grounds.

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 Market efficiency and arbitrage

Theoretical requirements for market efficiency

2. Uncorrelated errors
• If the behavior of traders in the market were random,
there would be no cause for concern about the
efficiency of markets because their trades would
cancel out.
• Is the behaviour of traders random?
• Evidence provided by psychologists indicates that
people are subject to the same kinds of judgment
errors, thus their errors are correlated.
– Social influences also play a role.
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 Market efficiency and arbitrage

Theoretical requirements for market efficiency

2. Uncorrelated errors (cont’d)
• Sentiment drives prices when large numbers of
investors (noise traders) simultaneously and
erroneously value some or all securities in the same
way due to psychological and/or social forces
• This drives prices further away from the fundamental
value.

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 Market efficiency and arbitrage

Theoretical requirements for market efficiency

3. Unlimited arbitrage
• Even if some investors (noise-traders) sometimes act
irrationally and their errors are correlated, provided
smart-money investors are able to act in such a way as to
arbitrage away incorrect prices, market efficiency will
remain intact.
• Is unlimited arbitrage possible?

10
 Example of arbitrage opportunity:
Triangular arbitrage
• March 27/2019
Currency pair Rate
US$ per C$ 1.1426
€ per US$ 1.1855
€ per C$ ?

• What must € per C$ rate be to nullify arbitrage?

1.1426 * 1.1855 = 1.3546
Were this not so, arbitrage would be profitable.
• What if, counterfactually, the € per C$ rate were
11 1.25?
 Market efficiency and arbitrage

Theoretical requirements for market efficiency

3. Unlimited arbitrage (cont’d)

• What hampers arbitrage exploitation?
• Unfortunately, arbitrage is limited by three main
potential problems:
i. fundamental risk,
ii. noise- trader risk, and
iii. implementation costs.
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 1. Fundamental risk
• Exists because of the potential for rational
revaluation as new information arrives
• If you think a stock is underpriced you can buy it,
but:
– there is idiosyncratic (unsystematic) risk
• The possibility that the price of an asset may decline due to an event that
could specifically affect that asset but not the market as a whole
• For example, if a company suffers a major plant closure due to a disaster,
its stock price may be affected while the rest of the market is not.
• Idiosyncratic risk can be reduced through proper diversification.

• Pure arbitrage seeks to eliminate this

– Problem: you need to find perfect substitutes.
• two assets with identical cash flows and different market prices
– Identical assets are not common in the real world
14
• makes pure arbitrage difficult to find in financial markets
 Pure arbitrage - example
• Say KCB stock is underpriced.
• You buy KCB.
– But market may drop.
– Or banking industry may drop.
• So, you buy KCB stock and short Equity Bank
stock
– But KCB itself may falter without industry or market dropping
(unsystematic risk).
• Even if you totally manage fundamental risk,
there is still noise-trader risk:
– spread may widen as investors get it even more wrong.
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 1. Fundamental risk
• Arbitrageurs may identify a mispricing of a security
that has a close substitute that enables pure
(riskless) arbitrage.

• However, if a piece of bad news affects the substitute

security involved in hedging, the arbitrageur may be
subject to unanticipated losses.

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 2. Noise trader risk
• Sentiment and noise
– Noise is opinion on value unrelated to fundamental
information (i.e., based on misinformation)
– Sentiment is correlated noise and has the potential
power to move markets.
– This implies that price movements can be driven by
misinformation rather than information.

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 2. Noise-trader risk
• This is the risk that mispricing being exploited by the
arbitrageur might worsen.
• It has been shown that noise-trader risk is
systematic, which means that it cannot be diversified
away.
• Real world arbitrageurs cannot wait it out because as
professional money managers they do not have long
horizons – they are usually evaluated at least at once
per year.

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 3. Implementation costs
• Aside from fundamental risk and noise-trader risk,
transaction costs can potentially obstruct arbitrage
• In some cases, horizon is short but short-selling is:
– Expensive (commissions, spreads & fees for shorting stock)
– Difficult or even impossible (lack of availability regardless of
fees; legal factors: many institutions cannot short)
• Plus, there is cost of finding these arbitrage
opportunities.
• Case study: Royal Dutch/Shell
• Watch video
– https://www.youtube.com/watch?v=twBHZyhzPLE
19
 CASE: Royal Dutch Shell
• Rosenthal & Young (1990) ruled out fundamental risk
and implementation costs as convincing explanations
for the existence of such large and variable price
differences between these twins.
• Contractually, the ratio of cash flows is set, so it is
not easy to see how fundamental risk could matter.
• Moreover, both securities trade in very liquid
markets at high volume and low transactions costs,
which rules out implementation costs.

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 CASE: Royal Dutch Shell
• This leaves noise-trader risk
– While the level of the premium/discount is difficult to
explain, Dabora & Froot (1999) showed that changes in the
price difference appear to be driven by trade location.
– Specifically, the return of each “twin” appears to be
correlated with the market on which it is most actively
traded

21
 CASE: Royal Dutch Shell
• Noise trader risk
– For example, when the U.S. market rises relative to
the U.K. market, the price of Royal Dutch (which
traded relatively more in New York) increased
compared to the price of Shell (which traded relatively
more in London)
– Similarly, when the dollar appreciated against the
pound, the price of Royal Dutch tended to increase
relative to that of Shell.
– In short, country-specific sentiment seems to be the
leading factor.

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 Market anomalies
• Market anomalies are empirical results that appear,
until adequately explained, to run counter to
efficient market hypothesis (EMH), which states that
financial markets are efficient and reflect all available
information.
• Market anomalies are patterns or behaviors that
cannot be explained by rational economic theories
and suggest the presence of systematic mispricing or
inefficiencies in the market.
 Market anomalies
• Efficiency tests are joint hypothesis tests
– which means that market efficiency and a particular risk-
adjustment technique (e.g., CAPM) together constitute the
maintained hypothesis
– rejection implies either market inefficiency or an
inappropriate risk-adjustment method (or perhaps both)
– because one cannot say which, it is virtually impossible to
categorically reject efficiency

• Behavioral explanations for market anomalies

emphasize the role of psychological biases and
investor behavior.
 Market Anomalies
1. Lagged reactions to earnings announcements
2. Small firm effect
3. Value effect
4. Predictable serial correlation
– Momentum and reversals
5. Calendar anomalies

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 Market Anomalies
1. Lagged reactions to earnings announcements:
– Reaction to extreme announcements is slow!
– This phenomenon describes a significant post-
earnings announcement price drift in the direction
of the earnings surprise, also called earnings
momentum.
– In perfectly efficient markets, new information
(such as surprisingly high or low earnings during an
earnings announcement) should cause a one-off
instant price shift in the direction of the surprise.

26
 Market Anomalies
1. Lagged reactions to earnings announcements:
– Rendleman et al (1982) examined daily return data around
the quarterly earnings announcements of about 1,000 US
firms during 1972–1980.
– Their procedure was to divide earnings announcements
into 10 deciles, ranging from extremely positive (in decile
10) surprises to extremely negative (in decile 1) surprises.
!""#$"%&' &!(")"*+,&-.&%/&' &!(")"*+
– 𝑆𝑢𝑟𝑝𝑟𝑖𝑠𝑒𝑠 =
0#1!/)1)/2
– Next, cumulative average excess returns (CAR) paths were
calculated over the relevant quarter for each of the deciles

27
Post-earnings announcement drift

Rendleman, R. J., C. P. Jones, and H. A. Latane (1982) “Empirical anomalies based on

unexpected earnings and the importance of risk adjustments,” 28
.
 Market Anomalies
2. Small Firm/Size Effect
– Small cap portfolios vs. large cap portfolios?
• Small cap wins out!
– The small-firm effect is the tendency for firms with
low levels of market capitalization to earn excess
returns after accounting for market risk
– Fundamental anomaly
• violation of semi-strong form efficiency
– This anomaly is not usually attributed to
behavioral factors
• However, it plays a central role in the Fama and French three
factor model of risk adjustment
29
 Market Anomalies
3. Small Firm/Size Effect (cont’d)
– The stability of the small-firm effect has been
questioned.
• The small-firm effect has declined dramatically in the
last 20 years or so.
– One possibility is that published research has
revealed to arbitrageurs profitable opportunities
that they have then systematically exploited.
– Anecdotal evidence in support of this is the fact
that small-cap investing became a recognized
strategy employed by specialists shortly after the
publication of relevant research
30
 Market Anomalies
4. Value Effect
– Value stocks: are stocks with prices that are low relative
to earnings, cash flows, and book value.
– Growth stocks (or glamour stocks): are stocks with prices
that are high relative to earnings, cash flows and book
value, at least in part because the market anticipates high
future growth.
– Value investing is the tendency to overweight value stocks
(relative to growth stocks) in one’s portfolio.
– The main difference between growth and value stocks is
that
• value stocks are companies that investors think are undervalued
by the market, and
• growth stocks are companies that investors think will deliver
better-than-average returns. 31
 Market Anomalies
4. Value Effect (cont’d)
– Value stocks (high B/P ratio) vs. growth stocks
(low B/P) portfolios?
• Go for value stocks!
– Value stocks tend to outperform the market.
– Portfolios formed based on P/Es:
• Low P/Es do better!
– Fundamental anomaly
• violation of semi-strong form efficiency

32
Value vs. growth portfolios:
International evidence

33
 Market Anomalies
5. Predictable serial correlation:
– Weak form efficiency stipulates that returns
should not be predictable by conditioning merely
on lagged returns
– There is abundant evidence that this does not
always hold in practice.
– Momentum exists when returns are positively
correlated with past returns, while reversal exists
when returns are negatively correlated with past
returns.

34
 Market Anomalies
5. Predictable serial correlation:
– The sign of the correlation is horizon-dependent.
• For short-term (one-month), there is reliable reversal
• Medium-term (about 3–12 months) - there is well-
documented momentum!
• Long-term (about 3–5 years) reversal is typical!
– Technical anomaly
• violation of weak form of efficiency

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 Momentum evidence

36
 Reversal evidence

Source: Figure 3 from De Bondt, W. F. M., and R. Thaler, 1985, “Does the stock market overreact?” Journal of
Finance 40, 793–807. © 1985 Wiley Publishing, Inc. this material is used by permission of John Wiley & Sons, Inc.

37
 Market Anomalies
6. Calendar Anomalies

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 Market Anomalies- Summary
1. Small cap portfolios vs. large cap portfolios?
– Small cap wins out!

2. Earnings announcements momentum:

– Reaction to extreme announcements is slow!

3. Value vs. growth portfolios

– Go for value!
– Low P/Es do better!

4. Momentum and reversal

– Medium-term momentum!
– Long-term reversals

5. Calendar anomalies
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 Explanations for anomalies
• Some of these anomalies can be potentially
explained using insights from behavioral
finance.
• This is not without controversy, especially
from strict adherents to EMH.
– These researchers say that most anomalies:
• are attributable to improper risk-adjustments
• Or, because of transaction costs, cannot be capitalized
on

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Explanations of market anomalies
1. Small Firm and Value Effect
•Rational explanation: Risk?
–For example, perhaps stocks with certain characteristics
are riskier, and beta doesn’t reflect this additional risk.
•Fama-French 3-factor model:
– Was developed in 1992 and expands on CAPM by adding size risk and
value risk factors to the market risk factor in CAPM.
– This model considers the fact that value and small-cap stocks
outperform markets on a regular basis.
– By including these two additional factors, the model adjusts for this
outperforming tendency, which is thought to make it a better tool for
evaluating manager performance.

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 Explanations for anomalies

1. Size and Value Effect – cont’d

•Fama-French 3-factor model

where:
– Rit = total return of a stock or portfolio i at time t
– Rft = risk free rate of return at time t
– RMt = total market portfolio return at time t
– Rit−Rft = expected excess return
– RMt−Rft = excess return on the market portfolio (index)
– SMBt = size premium (small cap minus big)
– HMLt = value premium (high B/P minus low)
– β1,2,3 = factor coefficients
42
 Explanations for anomalies
1. Size and Value Effect – cont’d
• Two main reasons why retail investors have favoured growth
over value stocks:
1. Expectational error hypothesis:
• Take a growth stock with a high P/E or P/B.
• Such stocks have a period of anticipated higher-than-normal growth.
• What if market overestimates length of supernormal growth period?
• When it becomes clear that mean reversion is occurring, growth stocks
deteriorate.
• Similar story (in reverse) can be told for value stocks.
2. Representativeness:
• Because of representativeness, investors may assume that good
companies are good investments.

• These two reasons are mistakes of judgment.

43
 Explanations for anomalies
1. Size and Value Effect – cont’d
• From the perspective of growth stocks, the intuition
is that markets have overreacted to good news.
– While prices have logically risen in response to the good
news, they have gone too far (relative to fundamentals),
and thus must fall back down to some extent.
– This leads to weak returns from growth stocks going
forward.
• From the perspective of value stocks that have
witnessed price declines after bad news, prices have
fallen too far, and thus must rise back up.
– This leads to strong returns from value stocks in the future.

44
 Explanations of market anomalies
3. Post earnings announcement drift
• Under-reaction in the S/T
– Investors anchor on recent earnings
– Mainly exhibited by small traders (Battalis and
Mendenhall, 2005)
• Over-reaction in the L/T
– Concurrent with the under-reaction in the S/T
– Studies show that analyst forecasts are too
optimistic
• Most predict high performance
– Overconfidence? Agency conflict?
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 Big market puzzles
• Several big puzzles relate to aggregate stock
market – behavioral finance has partial
explanations for some of these puzzles:
– Equity premium puzzle: stock returns are higher than they
should be given risk borne by investors in stock markets
– Bubbles: why do markets get so far out of line with
fundamentals?
– Excess volatility: It seems that often market movements
are not obviously explained by new information.

78
 1. Equity premium puzzle: Historical
(realized) equity premium in U.S.
• Historically, a well-diversified portfolio of
stocks has substantially outperformed fixed
income securities.
• Important to look at real returns which control
for inflation effects.
• Difference between expected equity return
and fixed-income return is known as equity
premium.
– This is return for bearing additional risk of stocks
relative to bonds or bills
79
 Total nominal return indexes: 1802-1997

Siegel, J.J.. From "The Future Value of an 1802 Dollar Invested in Different Asset Classes (in nominal terms)," in Stocks for the
Long Run 2nd Edition (McGraw Hill, New York, New York), 1998. ©1998 by McGraw-Hill, Inc. All rights reserved. Reproduced by
permission. 80
 Total real return indexes: 1802-1997

Siegel, J.J.. From "The Future Value of an 1802 Dollar Invested in Different Asset Classes (in real terms)," in Stocks for the
Long Run 2nd Edition (McGraw Hill, New York, New York), 1998. © 1998 by McGraw-Hill, Inc. All rights reserved. Reproduced
by permission. 81
 Average historical real returns for
stocks, bonds and bills

Siegel, J. J.. From "Average Real Returns (in %) on Stocks, Bonds and Bills," in Stocks for the Long Run,
2nd Edition, 1998 (McGraw Hill, New York, New York). © 1998 by McGraw-Hill, Inc. All rights reserved.
Reproduced by permission.

82
 Equity premium seems too high
• Theorists have shown that realized equity
premium implies an improbably large degree
of risk aversion.
• In an economy with reasonable parameters,
average return on stock market would be just
0.1% higher than risk-free rate, not 3.9% (or
higher) observed in most studies.

83
 Myopic loss aversion and equity
premium puzzle
• Researchers have linked prospect theory to equity
premium puzzle.
– Key is to remember loss aversion (investors hate losing
money) and to consider how often investors evaluate their
portfolios
– Intuitively, if you evaluate your position every day, there is
a very good chance that by day’s end you will have lost
money, so you find stocks very risky
– But if you evaluate stocks once per decade there is a much
smaller chance that you will lose money, so you will find
stocks not so risky

84
 Myopic loss aversion and equity
premium puzzle cont.
• QUESTION: Given prospect theory approach, what
evaluation period is consistent with historically
observed market risk premium?
• ANSWER: About a year – which is logically how often
a typical investor gives his portfolio a careful look.
• Reasons:
– Tax is paid annually
– Portfolio assessment and adjustments are often annual

85
 Equity premium & MLA - Illustration
• Individual has 2 choices:
– Invest $100 in a savings account (assume zero return)
– Or buy stock with 50/50 distribution for net earnings of
$200 or -$100
• If we assume loss aversion and linearity, value
function is:
v(z)=z for z≥0 and v(z)=λz for z<0 (λ>1)
• If λ = 2.5, investor will not invest in stock (assuming
she looks at portfolio once per year).
• What if investor only looks at portfolio every 2 years?

86
 Equity premium & MLA –
Illustration cont.
ü Now she will invest in stocks because:
0.25(400)+0.5(100)+0.25(-200*2.5)>0
ü Note: we have assumed for simplicity that returns
are additive ($200 for 2 years is $400).
ü Less frequent evaluation leads to:
ü higher demand for stock
ü higher price of stock
ü lower equity premium

87
 2. Market bubbles
• A bubble is said to exist when high prices
seem to be generated more by traders’
enthusiasm than by economic fundamentals.
• Notice that a bubble must be defined ex post
– at some point the bubble bursts and prices adjust
downward, sometimes very quickly
• Extreme prices that seem to be at odds with
rational explanations have occurred
repeatedly throughout history

88
 2. Market bubbles
Examples

• Tulip mania, of the 1630s

• Tech/Internet bubble of 2000

89
 What explains real-world bubbles?
• Irrational Exuberance by Robert Shiller first
came out in 2000 when Dow was approaching
12,000.
• Main argument of book was that market at
end of 1999 was in grip of a major bubble!
• Events proved to be on Shiller’s side.

90
 S&P 500 P/E

Shiller, Robert. From "Figure 3: Real S&P 500 Stock Prices and Earnings," in http://www.econ.yale.edu/~shiller/data.htm. © 2008 International
Center for Finance at Yale School of Management.
Reproduced by permission.

91
 Historical P/E ratios
• Market levels out of line with earnings levels.
– Seen by looking at P/E ratio
• Market run-up during this bull market was
unprecedented.
• Three other major peaks in stock market history:
1901; 1929; and 1966.
– From these peaks subsequent performance turned out to
be sub-par

92
 3. Excess volatility puzzle
• It seems that often market movements are not
obviously explained by new information.

• stock returns are more volatile than they should be

given that stock prices are present values of future
expected cashflows

93
 3. Excess volatility puzzle
• Cutler, Poterba & Summers (1989) examined news
events and major stock price movements over a 50-
year period ending in the late 1980s
• First, they looked at major news events (as reported
in the New York Times) and considered whether
market movements resulted from them
• Example 1: Japanese bomb Pearl Harbor (Dec. 8,
1941).
– Market rises dramatically (up by 4.37%)
• Example 2: Johnson defeats Goldwater in
presidential election (Nov. 4, 1964).
– Market hardly moves (down by 0.05%)

94
 Market moves vs. news?
• Secondly, they also looked at the 50 biggest price
moves and tried to relate them to material
information.
• 50 biggest market moves of last 50 years matched against
explanation in New York Times.
• On several days Times actually reported there was no
apparent cause (e.g., Sept. 3, 1946).
• Many other times “cause” doesn't’ seem important
enough – doesn't seem that there is really any new
meaningful information.
• Suggests excess volatility…
– Driven by changes in market sentiment
95
 Shiller’s theory
https://www.nobelprize.org/mediaplayer/?id=1996
• Shiller tackles excess volatility taking a theoretical
approach.
• He showed that it is difficult to explain the historical
volatility of stock returns…
– Assuming investors are rational and discount rates are constant
• Existing volatility implies a great deal of variation in
dividend growth rates – which is fine if these
expectations are realized.
• Using constant growth model, he considered growth rate
forecast changes needed to justify realized changes in
stock prices.
• Given a constant discount rate these would be
unreasonably high.
96
 Prices vs. rational prices

Shiller, Robert J.. From “Do stock prices move too much to be justified by subsequent changes in dividends?,” American Economic Review,
71(3), p. 422. © American Economic Review. Reproduced with the permission of the publisher and the author.

97
 Behavioral explanation
• Consider a stock. Investors think (wrongly) that
dividend growth changes are permanent rather than
transitory.
– For this reason they overreact
– When they figure things out mean reversion sets in
– High returns are followed by low returns -- and vice versa
– Recency plays a role: recent high earnings growth makes
people think that future growth is going to be higher than
it actually turns out to be
• A similar story can be told for overall market.

98
 References
• Dabora, E. M., and K. A. Froot, 1999, “How are stock prices
affected by the location of trade?” Journal of Financial
Economics 53, 189-216.
• Rendleman Jr, R. J., Jones, C. P., & Latane, H. A. (1982).
Empirical anomalies based on unexpected earnings and the
importance of risk adjustments. Journal of Financial
Economics, 10(3), 269-287.
• Rosenthal, L., and C. Young, 1990, “The seemingly anomalous
behavior of Royal Dutch/Shell and Unilever N.V./PLC, journal
of Financial Economics 26, 123-41; and Dabora, E. M., and K.
A. Froot, 1999, “How are stock prices affected by the location
of trade?” Journal of Financial Economics 53, 189-216.

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