Market Anomalies

Market Anomalies

Market anomalies are something that shouldn’t be, but still are. An unexplained phenomena. An occurrence with no story to back it up. A glitch in the matrix. In the stock market, they show up in countless ways: sudden dips and jumps, patterns that stick around impossibly long, companies that defy the odds year after year.

They’re popular with traders because, since they can’t be explained, anyone can try to explain them. There’s an endless amount to be said about them. Anyone can sell their own snake oil, and many do. So, before you end up accidentally stocking up on snake oil, do yourself a favor and acquaint yourself with market anomalies.

A Major Market Anomaly: Momentum

This anomaly is so ingrained in our culture, it will hardly come as a surprise to anyone, trader or not: winners keep winning. The rich get richer. When it rains, it pours. This kind of common-sense knowledge shows up in the stock markets in countless ways.

When traders talk about momentum – “this still has room to run”, “it’s all downhill from here” – they’re falling prey to one of the most basic, almost childish assumptions: what’s been happening will keep happening. That’s all it is: monkey see, monkey do. But, as predictable as it is, this anomaly persists because stock prices are set by – you guessed it – monkeys traders. And, if enough traders join in, you end up with momentum, which can build and build until it suddenly, disastrously turns.

What about fundamental market anomalies?

Momentum is an example of a technical anomaly, rooted in patterns in market data. Fundamental anomalies are based in data that isn’t in the charts, like the ratio of a company’s stock price to revenue or total assets or other balance sheet figure. A few typical examples:

Small firms outperform big ones. There will always be “evidence” that small companies will produce better returns than big ones: penny stocks. Sometimes, they explode for 1000% returns in days – something that’s inconceivable for the S&P 500. Sometimes, there are gains to be had, but over the long term, following small companies devolves into a game of sheer chance.

– Low price to book value means opportunity. If a company has a low stock price, but relatively high book value (total assets minus total liabilities), some take that as a sign that the market is undervaluing its stock. But, in today’s blitzscaling climate, a company’s choice to take on debt (and thus lower its book price) may mean it’s poised for quick growth.

– Neglected stocks are bound to turn around. You know how sometimes you set expectations low so that you can blow someone away? This anomaly is what happens when traders apply that logic to the market. If a stock is popular and getting lots of attention, all those traders’ high expectations are priced in, making it overpriced. Which means that unpopular stocks that no one cares about are bound to do better than expected – except this isn’t often the case. Bad stocks can just be bad. It happens all the time.

Fundamental anomalies might seem more sensible because they’re grounded in actual facts about companies, but they’re still based on ho-hum logic that can convince you of a pattern that isn’t there.

So, if they’re not true, where do market anomalies come from?

The stock market is not a barometer of how companies are doing, like hospital patient’s vitals. It’s a reflection of companies’ past performance and future expectations as well as plenty of other loosely related variables, like how competitors are doing, how the sector is doing, geopolitics, who the new CEO is, and on and on.

The stock market operates on a nebulous, unprovable assumption that all information is priced in: the efficient market hypothesis. If this hypothesis were true, then every stock’s price would perfectly reflect 100% of the available information about it. Trading would be about as exciting as stamp collecting. And you’d probably be reading a book instead of this.

But, like age, a stock price is just a number. You can’t pin an exact value to a stock, even for a moment, because time is part of a stock’s value. The data in a given moment has priced in certain assumptions about the future and certain patterns from the past. The market takes in an entire world of information to make decisions about individual stocks, contracts and commodities, assigning it a value.

Anomalies remind us that the rules that seem to govern the market are always being tested. When an anomaly comes around, it’s not that the market is crazy. It’s a sign that we, individually and collectively, haven’t framed the market correctly. We’re leaving something out, or assuming something.

So, because we keep being human, market anomalies keep happening. That’s just how random chance works. The billions of interactions every day on the market mean that just about anything will happen eventually – even the impossible. We have to constantly challenge our assumptions and admit when our judgment gets the best of us.

Fortunately, machine learning can now help us see past our human nature. While traders have used the term “anomaly” since around 1970, Fractalerts’ market data goes back to 1930 – literally since before anomalies were anomalies.

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