In the domain of finance, we don’t use the word glitches to talk about malfunctions in the stock market. The right term is market anomalies.
As surprising as it may sound the stock market is not perfect. You might say to yourself in the era of powerful computers and sophisticated technology, how could it be possible?
Before going over the issues, we have to understand what I mean when I say “the stock market is not perfect”.
A perfect stock market is one where the stock prices move randomly making it somehow impossible to predict if it’s going to go up or down.
Unfortunately, there is data that suggests otherwise, that there may actually be glitches in the stock market.
Causes of stock market anomalies:
Here you will see the most famous anomalies, but you should know that there are many more.
It seems that in January the returns are higher than any other month. To be even more precise, in the first 5 days.
Moreover, the effect can be seen particularly in small cap firms but there is also evidence for high yield corporate bonds.
The Momentum and Overreaction anomalies:
If you’ve read a psychology book in your life, you know that humans are complex. And it shows in the stock market.
We see that investors tend to overreact to the ups and downs of the stock market.
Shouldn’t we have a reasonable reaction to a decrease in the stock price of 2% compared to an 8% decrease for example?
The overreaction opened the door to opportunity. It appears that stocks that have underperformed in the past 3-5 years tend to perform better afterward, possibly because investors realize that they have overreacted to the drop in stock prices.
It is believed that small firms are a better bet. That is, they perform better than large caps, however since the belief of this study came up there have been studies that deny it.
Meaning that value stocks perform better than growth stocks. Value stocks being those that have a low P/E, M/B, and higher dividend yields. However Fama and French have findings that disprove it.
If we tell ourselves that the market is efficient, when there is an announcement about to be made for a business, there will already be people speculating on whether the announcement will be good or bad. If, for example, a lot of them think the announcement will be positive, the share price will start to rise and when the announcement is made if it is positive, it will jump up again.
But after that, it should stop. Common sense would tell us: “The stock price has reached a level equal to the magnitude of the positive event on the company, so the stock should return to its natural level of volatility.”
However, data suggest otherwise. It seems that stock price goes up, even after the announcement.
Since the newly stocks issues are made by investment bankers, they have a pressure of getting those shares bought.
This pressure brings them to set the stock prices too low, making them an interesting purchase. As attractive as the first day of the increase of stock value could be, it seems that over the longterm they tend to perform below average.
Can you profit from those anomalies?
Some say the transaction costs blow away all the gains and others say that some of these instances are temporary in nature, so that doesn’t mean the market is inefficient.
I think a strategy based solely on market anomalies wouldn’t be a wise decision. But using them as an add-on to your toolkit could be interesting.