Despite insider dealing is prohibited and legally restricted, investor still dreams to have massive return from their investment. Based on the market efficiency, the markets are rational and the price of securities reflects according to all available information. Therefore, investors take actions timely and price of securities quickly adjusted, based on latest information. However, it is predicated that many stock markets are not following the rule of market efficiency hypothesis, because investors often shows irrational investment activities and suffer the limited arbitrage. Thus, people seek for abnormal return and it results anomalies. This paper explains what market anomaly is and how financial market anomalies can affects to market efficiency. Furthermore, this paper specifically investigated momentum effect which is kind of market anomalies and its impact.
Financial Market Anomalies
In earlier level, anomalies can only be defined relative to a model of normal return behaviour. The normal return behaviour based Fama (1970)'s the efficient market hypothesis based on the empirical studies such as stock price behaviour or investment managers' performance. Later on many academic journals conclude a market anomaly by underlying asset-pricing model is inadequate. George & Elton (2001) defined market anomaly as "irregularities and deviation from an exceptional condition, a surprise or unexpected phenomenon with respect to the market theory such as efficiency of market and Capital Asset Pricing Model (CAPM)". Simply, market anomalies are unusual occurrences in financial market, also those events hard to explain by the efficient market theory are called anomalies. (Silver 2011)
Furthermore, there is a number of information about anomalies' pattern, but this paper focused on calendar / seasonal patterns in financial market. Gultekin and Gultekin (1983) said calendar or seasonal patterns in financial market has been repeated over past years and shown USA and other stock market. The pattern normally effects in the beginning of the week, the month and the year. It is very hard to define how this pattern is often repeated; however, there are few hints in the patterns, for example of the year end effect, companies may suffer tax loss at the end of year, having a problem with profitability or other issues. Just like Nasdaq's Yahoo in 2006, the earlier times of the year the stock price of Yahoo was $40, however the stock price was fallen at the year end to $25. Surprisingly, when new year begins and the company released fourth quarter's result, the stock price was gone up to $30 per share.
Effect on market efficiency
The stock market anomalies may affect the market efficiency, because, the market anomalies against market efficiency theory. The market efficiency separated into three different forms. In a weak form, all information is already reflected in the current prices of stocks or stock prices moves randomly. Thus, in the weak form, no investor can beat the price of securities and can get abnormal return. In the semi strong form of market efficiency, investors cannot make abnormal profit on the basis of fundamental analysis. In the strong form of market efficiency, the stock prices are fully reflected by the all information available thus, no one can beat the prices even by insider trading.
However, some evidences of market anomalies are as under the momentum effect. It is directly related to the weak form market efficiency. According to weak form market efficiency, analysing past earnings is useless to get profit now. However, according to momentum effect, investor can analyze past earnings, choose the stock that has performed well recently and earn profit from that stock, because the winner stock is expected to do well in a near future. Making profit by analyzing past earnings contradict with the weak form market efficiency.
The Momentum Effect
According to the study of momentum effect, the investors can gain abnormal return by using the strategy of momentum effect. They sell the past loser stocks and buy the past gainer stocks (Hons & Tonks 2001). Hons and Tonks observed that past gainer stocks' returns are higher than the past loser's stocks, because the past gainer stocks are more risky than past loser stocks, so investors demand higher return to compensate for bearing higher risk. It is a positive correlative strategy only for a short-period of time. The momentum effects can be seen especially in January because of buying pressers by the investors so that stocks' momentum is hurt in the month of January. Momentum strategy earned a negative return of -1.55% in January and positive return in other months rather than January. The past history shows a position return of 1.48% per month through the momentum strategy in the months outside of January.
The table shows momentum effect through the following formula:
The UMD is the return of portfolio with higher performing long stocks (past winners) and short stocks with low returns in the recent months (2months - 13 months). The market risk premium is difference in return between CRSP portfolios of the New York Stock Exchange, Nasdaq, Amex stocks and one month treasury bill. SMB is the difference between the portfolios of small and large capitalization firms that are holding constant book to market ratios. HML is the difference between the returns of portfolios with high and low book to market ratios. The Standard errors are used to calculate the t-test.
The momentum effect strategies are presented through the year 1977-1996. Following table shows the momentum effect according to CAPM and based on the three factors Fama & French benchmark.
The past winner stocks are continued to outperform over the past loser stocks over the period from 1965 to 1989. According to Jagadeesh & Titman (2001), "the momentum strategies are continued to be outperform the stocks listed at NYSE over the period from 1990 to 1998. The stocks with buy recommendation from the analysts showed high price momentum and stocks with sell recommendation showed low price momentum (Womack 1996). The trading restrictions and trading costs should be considered in order to investigate the profitability through the momentum strategies. Trading with momentum strategies may get high return. The study shows that a large part of profit came through the short positions in small cap and liquid stocks that are leading to transaction costs (Grinblatt & Moskowitz, 2004). It is also documented that momentum return is likely to be high from the stocks with high transaction costs. There are several methods to make momentum trading less expensive with regard to the transaction costs (Chan et al, 1990). The analysts restricted their samples to large capitalization's stocks and they excluded stocks with a price below $5.
Possible Reasons behind the Market Anomalies
In 1970, the stocks returns were measured by using efficient market hypothesis and Capital Asset Pricing Model (CAPM) in case of efficient market. There were chances to earn abnormal profits and in 1978 these techniques were known as market anomalies (Journal of Financial Economics).
The abnormal returns are because of inefficiency of the markets not due to deficiencies of CAPM (Watt). As the market is inefficient, one source of momentum returns is that stocks under-react to the information available. For example, if a company releases good information then, stock price of that company will go up due buying presser and it will generate good profits. However, the stock price does not fully observe the good information; it partly reacts to the good information only. As a result, the stock price continues to rise for a while after the publication of the good news.
Nevertheless the momentum effect lasts for a short period of time only. If a long horizon is considered, it is possible to see the price reversals effect. If investors keep applying the momentum strategies, in the long run the strategies would force the stock price to overreact upon the news. For example, in short run investors are conservative, so they just buy the winner stocks, but in long run they are confident that the winner stock would keep doing well. As a result, they bought too many winners stocks, forcing the stock price to increase above the equilibrium. Therefore, subsequently the stock price must fall back to its equilibrium. This is how short term momentum strategies would lead to long term reversals effects.
Another possible reason behind the momentum effect could be the agency problem. Fund managers usually receive large rewards for their successful strategies and those fund managers also own the most popular shares. They would use the rewards from investors to invest in the shares they own. As a result, this boosts the momentum effect further.
The Behavioral and Risk Based Theories
There are several models explained and they are failed to explain the causes of anomalous behavior of assets. The Fama and French (1993), the three factor model refers to as risk based model but Denial and Titman (1995) criticized that, Fama and French (three factor) model is unable to explain the long-term effects of momentum strategies. However, market behaviour can be linked to momentum effects; especially, price trend can bring about the overreaction of market is due to psychological behavior of the investors. (Wouters 2006) On the other hand, there is underreaction of the market, due to conservative behavior of the investors, because they react to the prior information not at the same time required by the information and investors seek prior information as they expect that the stock will do the same. (Barberis & Sheilfer, 1998)
Moreover, when the Enron scandal revealed in 2001, the US Stock Exchange suffered momentum as Enron and its accounting firm 'Arthur Andersen' brought accounting fraud. Although, other company was not in the problem and had clear management, the markets get into momentum, while many investors left the markets. Furthermore, US Stock Exchange and the world stock market still shows that after relevant information released, stock price kept increasing or decreasing; although, the price of stock already reflected new information. The reason why, the price keeps going upwards or downwards, is investors' overreaction. Therefore, the momentum is hard to predict, but once it is appear; it rewards abnormal return. In long run, the overconfidence of investor causes the stock price to reverse. Hence, the market reacts according to the behavior of investors as they are having different investing styles and they act based upon the past performance.
The importance of the momentum effect to academics and practitioners
Anomaly matters to both academics and practitioners as they both contribute to the literature on price momentum. The financial academics produce a lot of theses and behavioral models that can suggest the possible cases of this anomaly. If academics find that the reason behind the momentum effect is the deficiency of the CAPM, then they can refine the model to incorporate the effect of the momentum effect. In addition, by analyzing the momentum effect, investors would be able to earn abnormal profits. It does not only apply to the stock market, but also the currency and commodities prices. The momentum strategies are used not only by professional funds managers, but also used by the investors who cannot analyze the stock market in details as the professional fund managers. However, such momentum strategies cause investors to lose significantly when there is a sudden reversal in the market. In 2009, "Investors who used a short-term momentum strategy, buying the winners of the previous six months, would have lost 46% in the British market and 53% in America, according to the LBS team" (Economist, 2009). The reversal in stock price had a severe impact on investors, especially those who borrow money to invest in the stock market.
Momentum effect at the present
The market anomaly is still appearing, thus distorting the weak form market efficiency, due to financial and economic aspects. Today's markets are down because of Europe and US debt crises and less number of investors are participating in the financial markets. There is a selling presser more than the buying. Thus, they can't push the price up, that is the US stock market is having a downside momentum effect. This is contradictory to other types of anomalies which disappear after a publication about the anomalies has been released. Once investors knew that anomalies exist, they would adjust their strategies accordingly to benefit from the abnormal return. As a result, the market reacts to the new strategies of investors and the abnormal return disappears. The momentum effect is accompanied by the long term reversal effect enabling the stock price to fluctuate around the equilibrium in long run. Thus, we can observe that short term momentum effect still exist even though the publications about it have been released.
