What Are Market Anomalies?

In the stock market, an anomaly is a price action that completely contradicts the expected behaviour of the stock market.

An anomaly is something that deviates from what is known, what is standard, what is normal, or what is expected in any given scenario. In Nigeria, an anomaly is the sun shining by 9pm. Another one is snow falling in the summer.

However, when anomalies become recurring, even at wide ranges, they reveal a pattern. In the stock market, an anomaly is a price action that completely contradicts the expected behaviour of the stock market.

While there are certain market anomalies that happen at certain periods or seasons (consistently throughout historical chart analysis), there are others that are one off.

Even though it might be generally hard to predict market movements even for the most experienced investor and after a myriad of fundamental or technical analysis, there are anomalies that the investor can be conscious of it so as to exploit them or avoid their impact.

In the stock market, anomalies are said to contradict with the efficient market hypothesis (EMH). The EMH theory simply states that all asset prices fully reflect all the available information and this means that when all stocks are properly priced, abnormal returns cannot be earned.

In other words, an individual cannot attempt to beat the market as the market is always right. Efficiency implies normal and in the market, nothing really changes unless with the availability of new information.

Since future stock prices follow a very random walk pattern, they simply cannot be predicted. What this means is that the idea that there are certain predictable anomalies in the stock market, contradicts the EMH.

This is especially where a semi-strong form EMH is available (That is a market where current stock prices adjust rapidly to the release of all new public information,) making fundamental analysis not such a bad idea for the investor after all.

Market anomalies are not just some market patterns that seemingly lead to abnormal returns. What makes them more interesting is that they can be predicted not by new information but by the information available to the general public like a company’s historical financial reports.

For context, an example of this is how some sales companies are known to sell much less than usual in January.

But this doesn’t mean anomalies have become gospel. While certain anomalies happen frequently, they do not always occur. It is thus important that anomalies should not be used to dictate a trading decision, it can only provide context or influence the process to an extent.

It is said that most market anomalies are psychologically driven say by emotional or cognitive bias. An example of this in behavioral finance is that people are averse to new information and still rely on their old beliefs.

There are also anomalies that are caused by structural factors like lack of market transparency or regulatory actions. The final set of anomalies are calendar related and these kinds are naturally easier to predict using technical analysis.

While it is important to understand that anomalies can appear, disappear, and re-appear at any point in time, it is also good that we know what these anomalies are and how we can work around them.

In the next few articles, we would visit some specific types of market anomalies and define if they are worth monitoring or not.

Written by Lawretta Egba.