Anomaly: Definition and Types in Economics and Finance
An anomaly in economics and finance is when the actual outcome under a certain set of assumptions differs from the anticipated outcome predicted by a model. An anomaly shows that a certain premise or model is untrue. The model may be either quite recent or older.
Market anomalies and price anomalies are two forms of abnormalities that frequently occur in finance. Market anomalies are return distortions that defy the EMH or efficient market hypothesis. When something is valued differently from how a model predicts it would be priced, such as a stock, this is known as a pricing anomaly.
The small-cap impact and the January effect are typical market abnormalities. The term “small-cap effect” describes the tendency of smaller businesses to outperform bigger ones over time. The January effect is the propensity of equities to return much higher in January than in other months.
Anomalies frequently arise in asset pricing models, particularly the capital asset pricing model (CAPM). Although the CAPM was developed utilizing novel premises and ideas, it frequently performs poorly at forecasting stock returns. Those seeking to refute the CAPM used the various market abnormalities discovered after its creation as a starting point. Even if it might not hold up in empirical and practical tests, the model is still used.
Rare anomalies are more common than not. Anomalies tend to vanish rapidly once made public because arbitragers look for and take away any chance for them to happen again.
Market anomalies by kind
Any chance to make excessive profits on financial markets calls into question the idea that prices accurately reflect all relevant information and cannot be arbitraged.
It’s a very well-known phenomenon called the January effect. Stocks that underperformed in the previous year’s fourth quarter tend to outperform the markets in January, according to the January effect. It is almost difficult to call the January impact an oddity because its cause is obvious. Investors sometimes try to sell off failing stocks around the end of the year, so they may deduct a modest amount from their taxes if they have a net capital loss for the year or utilize their losses to offset capital gains taxes. This activity is sometimes referred to as tax-loss harvesting.
This “tax selling” might drive these stocks to levels where they become appealing to purchasers in January since selling pressure can sometimes be independent of the company’s real fundamentals or valuation.
Similarly, investors sometimes postpone purchasing poor equities until January to avoid being affected by tax-loss selling. This impact is brought about due to excessive selling pressure before January and excessive purchasing demand following January 1.
The September impact describes September’s unusually low stock market results. There is statistical support for the September effect depending on the period examined. However, the notion is largely based on anecdotes. Investors often return from summer vacation in September, keen to lock in profits and tax losses before the year ends.
Another common misconception is that stockholders sell their holdings before school starts in September to help pay for their kids’ tuition. The September effect is seen as a historical anomaly in the data, similar to many other calendar effects, rather than an effect with any causal connection.
Day of the Week Inconsistencies
The “Days of the Week” phenomenon irks proponents of efficient markets since it seems to be true and defies logic. According to research, there is a bias toward better market performance on Fridays, and equities tend to move more on Fridays than on Mondays. Although it is not a significant difference, it is a recurring one.
According to the Monday effect idea, stock market returns on Mondays will often mirror the trend from the previous Friday. So, if the market was up on Friday, it should stay up through the weekend and rise again on Monday. Another name for the Monday impact is the “weekend effect.”
Fundamentally, there is no specific reason why this should be the case. There may be some psychological elements at play. The market may be characterized by a week’s end optimism as traders and investors eagerly anticipate the weekend. Alternately, perhaps investors use the weekend to catch up on reading, stew over the state of the market, and grow pessimistic ahead of Monday.
Superstitions as Signs
In addition to calendar irregularities, there are also non-market indications that some individuals think will properly predict the market’s direction. A concise collection of superstitious market indicators is provided below:
The Super Bowl Indicator predicts that the market will end the year lower when a club from the former American Football League wins the game. The market will conclude the year more positively when an old National Football League team triumphs. Despite how absurd it may appear, over 53 years ending in 2021, the Super Bowl indicator was accurate about three-quarters of the time.1 The indicator does, however, have one drawback: it does not account for a victory by an expansion club.
The market fluctuates with skirt length, according to the hemline indicator. This signal is also known as the “bare knees, bull market” idea. In 1987, when designers moved from miniskirts to floor-length skirts right before the market fell, the hemline indication proved reliable. A comparable transition also occurred in 1929. However, there is debate about whether the hemline adjustments or the crash occurred first.
The aspirin indicator shows an inverse relationship between stock prices and aspirin output. This measure implies fewer people use aspirin to treat market-related headaches when the market is rising. Fewer aspirin sales should show a declining market.
- Anomalies are occurrences that differ from the forecasts of economic or financial models and call into question the fundamental tenets of those models.
- Calendar effects are a prominent example of a trend in the market that defies the efficient market theory.
- The majority of market abnormalities have psychological roots.
- However, anomalies frequently vanish shortly after being made public once their existence is known.