Financial Market Anomaly - Essay Example

?A Survey of One Financial Market Anomaly (e.g. The Momentum Effect and Market Efficiency) Table of Contents Introduction 3 Definition of Turn-of-the-Year Anomaly 3 Pattern of Turn-of-the-Year Anomaly 4 Discovery of Turn-of-the-Year Anomaly 5 Influence of Turn-of-the-Year Anomaly on Market Efficiency 5 Reasons behind Turn-of-the-Year Anomaly 6 Why Turn-of-the-Year Anomaly Matters for both Academics and Practitioners 7 Persistence of Turn-of-the-Year Anomaly 7 Conclusion 8 References 9 Introduction Anomaly defines such occurrences in the market when actual outcome under a certain set of norms is dissimilar from the estimated outcome. An anomaly provides the indication that a given theory or model does not imply in real life practices. Hence, anomalies often happen against the assumption of Capital Asset Pricing Model (CAPM). According to Schwert (2002), “anomalies are empirical results which seem to be inconsistent with maintained theories of asset-pricing behaviour”. Anomalies specify either market ineffectiveness or insufficiencies in the fundamental asset-pricing model. Contextually, market anomaly is regarded as a price and return miscalculation on financial market which appears to oppose ‘efficient market hypotheses’ (Schwert, 2002). This report is based on the survey of one financial market anomaly named ‘turn-of-the-year’ effect. The objective of the report is thus to recognise and describe the reasons for the occurrence of turn-of-the-year anomaly. Furthermore, the report also aims to understand how this anomaly influences the aspect of market efficiency. Definition of Turn-of-the-Year Anomaly The turn-of-the-year effect defines an outline of increased trading quantity and higher stock prices in the year end (i.e. last week of December) and in the beginning of year (i.e. the first two weeks of January). According to Keim (1983) & Reinganum (1983), majority of irregular revenues generated by small organisations happens during the first two weeks of January. This anomaly is recognised as turn-of-the-year effect. In this context, Roll (1983) had theorised that higher unpredictability of little capitalisation stocks cause substantial short term capital losses. Most of the investors hence desire to realise income tax before year end. This stress leads to more sales of stock in the end of year, resulting in substantial minimisation of prices of small capitalisation stocks (Schwert, 2002). Pattern of Turn-of-the-Year Anomaly The study of the Return on Investment (ROI) of US along with other key financial markets constantly discovered robust dissimilarities in stock yielding behaviour across the year. The following figure hereby illustrates the average ROI on monthly basis from 1927 to 2001 in the US: Source: (Stern School of Business, 2012) From the above figure, it can be observed that the returns on investment in January from 1927 to 2001 were considerably higher in the US in comparison to the return of other months. This pattern of returns can be observed in the first two weeks of January. To be stated, the turn of the year effect was much more noticeable for small organisations in comparison with big organisations (Stern School of Business, 2012). However, the turn-of-the-year anomaly was learnt to b only existing in those markets where individual income taxes are active. In the similar context, the pattern of the stock markets of Hong Kong did reveal a turn-of-the-year effect owing to the fact that there were no capital gains from taxes. Similarly, in China the capital gains on taxes are considered as uniform which does not offer any kind of inducement for investors during year ends. Thus, turn-of-the-year anomaly is hardly observed in China as well as in Hong Kong (Ji, 2008). Discovery of Turn-of-the-Year Anomaly The seasonal anomaly had been first identified by Sidney B. Watchel in the year 1942. Chronologically, in the year 1976, Rozeff & Kinney had documented the turn-of-the-year effect in New York Stock Exchange (NYSE) for the first time. They had found that the average yield of stock in NYSE in January was comparatively more than other months which indicated the existence of turn-of-the-year effect. Keim (1983) had also studied turn-of-the-year anomaly and found its influence in stock return explaining that the return of small organisations were considerably higher than big organisations in the month of January. Similar outcome was found by the study of Reinganum in the 1983. Gultekin & Gultekin (1983) had also found evidences about the existence of turn-of-the-year in several industrial nations (Sah, n.d.). Influence of Turn-of-the-Year Anomaly on Market Efficiency In efficient market, stock prices should follow an arbitrary system. Several researchers provided different descriptions on the influence of turn-of-the-year anomaly on market efficiency. One of the most significant descriptions regarding the influence of this anomaly on market efficiency can be identified with relation to the ‘tax-loss-selling’ theory. This theory states that stocks are commonly sold by the investors during the month of December so that if they incur losses, they can counterbalance the gain accumulated throughout the year. As a result, by incurring losses, investors tend to save money on taxes. Based on this concept, the ‘tax-loss-selling’ theory proclaims that in the last month of a year, investors tend to sell the stocks with low prices so that they can minimise the amount of tax paid. Hence, they put a downward stress on the stock prices and as soon as the year ends, the selling stress is relieved and stock prices recover to the equilibrium level resulting in unusually high ROI rates (Raj & Thurston, 1994). According to turn-of-the-year anomaly, there are certain months such as January or April which can provide high return on investment then other months of the year. Keim (1983) had depicted that almost half of the ‘annual size premium’ in the US is focused in the month of January, especially in the first week of a year. This finding has been reproduced by several equity markets in the world (The Wharton School, 2006). Reasons behind Turn-of-the-Year Anomaly Ligon (1997) stated that the reason behind this turn-of-the year anomaly is fundamentally caused due to huge market liquidity in the beginning of the year. It is in this context that the high liquidity in market correlates with greater ROI in January. Rozeff & Kinney (1976) observed in this regard that in January the average return of stock in NYSE was almost 3.5% higher than other months of the year. The most apparent reason for this anomaly can be identified with reference to the ‘tax-loss-selling’ theory described above. In December, enormous sell of stocks occur as investors want to avoid their capital gains on taxes; however, in January the cost of stock increases as those investors try to repurchase the stocks that had been sold in previous months. Conversely, Keong & et. al. (2010) had established the fact that majority of Asian stock markets demonstrate positive yield in December except stock market of China, Hong Kong, Japan and Korea as there are low level of capital gains from taxes. Few nations also demonstrate positive stock effects in the month of April and May owing to the fact that in many nations, April is considered as turn-of-the-year month. The most possible reason for turn-of-the-year anomaly can be identified as the investors’ interest to gain saving on tax liabilities at the end of year, rebalancing investment portfolios and executing amendment of inventories (Latif & et. al., 2011). The other reason in relation to the occurrence of anomaly can be identified as the high level of bonuses gained in January which at times is capitalised in the stock market and thus helps to increase the stock price. Furthermore, in the beginning of a year, investors are observed to decipher an optimistic vision about the performance of the stock market. On the basis of this assumption, investors intend to take a strong position as soon as possible by purchasing stocks. In fact the robustness of this anomaly for a long period of time suggests that turn-of-the-year effect is an occurrence which is dependable on equilibrium pricing (Kim, 2006). Why Turn-of-the-Year Anomaly Matters for both Academics and Practitioners The turn-of-the-year effect or sometimes termed as January effect has been of special courtesy for researchers as it tends to contradict and challenge the market efficiency theory. This anomaly has remained as a subject of interest for research since long. Hence, studying this anomaly can help to understand the unpredictable behaviours deciphered by investors in the end of a fiscal year and the beginning of a fiscal year. The study of turn-of-the-year market anomaly is vital for both academics and practitioner as it can help to document the return on stock with more accurate assumptions. The turn-of-the-year effect matter for practitioners principally as it helps to evaluate the risk premium patterns at certain timings of a year. By studying the investment pattern, practitioners can obtain sufficient knowledge and experiences on stock performances which in turn shall help to take the advantage of market anomaly and earn higher revenue through stock purchases. The turn-of-the-year anomaly also helps to determine the approach for a profitable trading. Understanding the patterns of this anomaly can thus help both academics and practitioners to take the opportunity of abnormal profits in the share market (Thaler, 1987). Persistence of Turn-of-the-Year Anomaly Unlike other anomalies, turn-of-the-year effect has not vanished fully since it was first recognised. Several empirical tests provide evidences on unusually high trading quantity in December and remarkably high return in January (Sias & Starks, 1997). Keim & Reinganum (1983) had stated that although the impact of turn-of-the-year has become meagre than before, it is still consistently positive in several nations (Schwert, 2002). Several researchers also indicated that there are certain months such as January and April which can provide high level of return in comparison with other months. For instance, in the year 2006, Asteriou & Kovetsos had investigated 8 Central and Eastern European (CEE) economies during the period of 1991 to 2003 and found strong statistical evidences for turn-of-the-year effect in nations such as Slovakia, Romania, Poland and Hungary. The assessment of Heininen & Puttonen also revealed that in several nations, December provides relatively large yields than the amount gained in other months (Heininen & Puttonen, n.d.). The study of Maxwell during the period of 1987 to 1997 also documented statistically significant turn-of-the-year-effect in investment bonds (Rossi, 2007). Conclusion The existence of turn-of-the-year anomaly indicates that investors can gain abnormal returns by investing on particular durations of the year. However, in future, turn-of-the-year anomaly might disappear as more and more investors will attempt to exploit this anomaly. For instance, investors who foresee the stock price to increase in January will attempt to obtain more stocks before January, which can gradually increase the stock price before January, resulting in the decline of turn-of-the-year effect. Presence of financial anomaly can thus make a market inefficient due to unpredictable outcomes. To be precise, turn-of-the-year anomaly mainly exists due to non-conformity of usual activities performed by investors with respect to time periods. With the improvement in information technology, information sharing and communication has become significantly advanced which can render better market knowledge and experiences to the investors with respect to this anomaly. As a result, it will help to make market more efficient by reducing the influences of turn-of-the-year anomaly (Wong & et. al., 2006). References Gultekin, M. N. & Gultekin, N. B., 1983. Stock Market Seasonality: International Evidence. Journal of Financial Economics, Vol. 12, pp. 469-481. Heininen, P. & Puttonen, V., No Date. Stock Market Efficiency in the Transition Economies through the Lens of Calendar Anomalies. Higher School of Economics. [Online] Available at: http://www.hse.ru/data/090/182/1235/Heininen_Puttonen_paper.pdf [Accessed November 08, 2012]. Ji, X., 2008. Understanding the Turn-of-the-year Effect. The Journal of International Management Studies, Vol. 3, No. 2, pp. 37-40. Kim, D., 2006. On the Information Uncertainty Risk and the January Effect. Journal of Business, Vol. 79, No. 4, pp. 2127-2162. Keim, D. B., 1983. Size-Related Anomalies and Stock Return Seasonality: Further Empirical Evidence. Journal of Financial Economics, Vol. 12, pp. 13-32. Keong, L. 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