Question

What are the five anomalies (from the efficient markets chapter, semi-strong section) that we discussed in the synchronous class session? Which three of the five help to explain the synchronous session discussion(s) of the best performing style-capitalization equity returns over longer periods of time?

Explain how asset bubbles may (or may not) support the efficient market hypothesis.

Answer 1

5 MARKET ANOMALIES ARE -

1.SMALL FIRMS TEND TO OUTPERFORM

2.JANUARY EFFECT

3.LOW BOOK VALUE

4.NEGLECTED STOCKS

5.REVERSALS

three of the five help to explain the synchronous session discussion(s) of the best performing style-capitalization equity returns over longer periods of time are -

1. Small Firms Tend to Outperform

Smaller firms (that is, smaller capitalization) tend to outperform larger companies. As anomalies go, the small-firm effect makes sense. A company's economic growth is ultimately the driving force behind its stock performance, and smaller companies have much longer runways for growth than larger companies.

A company like Microsoft (MSFT) might need to find an extra $6 billion in sales to grow 10%, while a smaller company might need only an extra $70 million in sales for the same growth rate. Accordingly, smaller firms typically are able to grow much faster than larger companies.

2. Low Book Value

Extensive academic research has shown that stocks with below-average price-to-book ratios tend to outperform the market. Numerous test portfolios have shown that buying a collection of stocks with low price/book ratios will deliver market-beating performance.

Although this anomaly makes sense to a point—unusually cheap stocks should attract buyers' attention and revert to the mean—this is, unfortunately, a relatively weak anomaly. Though it is true that low price-to-book stocks outperform as a group, individual performance is idiosyncratic, and it takes very large portfolios of low price-to-book stocks to see the benefits.

3. Reversals

Some evidence suggests that stocks at either end of the performance spectrum, over periods of time (generally a year), do tend to reverse course in the following period—yesterday's top performers become tomorrow's underperformers, and vice versa.

Not only does statistical evidence back this up, but the anomaly also makes sense according to investment fundamentals. If a stock is a top performer in the market, odds are that its performance has made it expensive; likewise, the reverse is true for underperformers. It would seem like common sense, then, to expect that the over-priced stocks would underperform (bringing their valuation back in line) while the under-priced stocks outperform.

Reversals also likely work in part because people expect them to work. If enough investors habitually sell last year's winners and buy last year's losers, that will help move the stocks in exactly the expected directions, making it something of a self-fulfilling anomaly.

how asset bubbles may (or may not) support the efficient market hypothesis.

The efficient market hypothesis (EMH) cannot explain economic bubbles because, strictly speaking, the EMH would argue that economic bubbles don't really exist. The hypothesis's reliance on assumptions about information and pricing is fundamentally at odds with the mispricing that drives economic bubbles.

Economic bubbles occur when asset prices rise far above their true economic value and then fall rapidly. The EMH states that asset prices reflect true economic value because information is shared among market participants and rapidly incorporated into the stock price.

Efficient Market Hypothesis and Bubbles

Whether bubbles are predictable is subject to debate. Behavioral finance, a field that attempts to identify and examine financial decision making, has uncovered several biases in investment decision making, both on an individual and market level. There are several reasons why a market and investors could act inefficiently and as a result, misinterpret a bubble as a bull market.

Market Information

All investors review information differently and could, therefore, apply different stock valuations. Also, some investors might exhibit inattentiveness to certain kinds of information. For example, stock prices take time to respond to new information and the investors who act quickly on the information could earn more profit than those who act on the information later.

Human Emotions

Stock prices can be affected by human error and emotional decision making. Herding behavior is when all market participants act in the same way to the information available. The herd instinct could be applied to the correction in the S&P 500 following information about the 2020 coronavirus outbreak. Although the fear could be justified, the fear of losing money prompted many traders and investors to sell equities leading to widespread declines in markets across the globe.

Human Bias

Confirmation bias can occur when investors only accept and research information that supports their view of the investment. If an investor is bullish on a stock, only articles and research that support the bullish view would be considered. As a result, the investor might miss or avoid pertinent information that might cause the stock's price to decline. These biases have been shown to exist, but determining the incidence and level of a particular bias at a particular time has its challenges.