More on Market (In)efficiency

Wednesday, May 2nd, 2007
By Inya Ivkovic, MA for Profit Confidential

In my last PROFIT CONFIDENTIAL article, I touched on the vast subject of market efficiency. Here are a few more salient points that investors could use when buying and selling stocks.

As I mentioned last time, there are three forms of market efficiency: weak, semi-strong, and strong. The semi-strong form of efficient market hypothesis argues that whenever new fundamental or technical information is released to the general public, it is quickly absorbed by the market and reflected in securities’ prices.

In essence, what the semi-strong form implies is that neither fundamental nor technical analysis works because the market is inherently self-sufficient and does not need direction from analysts. Or, it could also say that I should be out of a job, if it weren’t for a few anomalies refuting those very assumptions.

One such anomaly is that companies with high dividend yields have had their stock prices historically perform better than expected. The same applies to companies that have had surprisingly good quarterly earnings.

Then there are so-called “January,” “Weekend,” and “Year-end” anomalies. Historically speaking, the month of January tends to offer more buying opportunities than any other month of the year. Why? One explanation offered originates from small-caps, which typically exploit the month of December tax selloffs to buff their financial statements, only to spawn oftentimes intense buying in January.

The Weekend anomaly is a bit ambiguous, arguing that markets typically fall on Fridays and gain on Mondays. But, then again, I don’t think there has ever been a Black Friday. In contrast, there have been quite a few Black Mondays, Tuesdays, and a few Gray Wednesdays, too. Go figure this one!

Year-end rallies are something most investors are familiar with. After the month of October passes, which is psychologically

associated with some of the worst market crashes in history, the holiday spirit typically ensues before investors can retire all the turkey from Thanksgiving, often creating additional buying pressures.

Furthermore, there is something called the Price/Earnings anomaly. Disputing the semi-strong form of efficient market hypothesis from the fundamental point of view, stocks with low P/E ratios have historically outperformed stocks with high P/Es. One of the tools in valuing stocks is to determine their intrinsic value by multiplying their P/E ratio with their earnings per share (EPS). Stocks with lower multiples may indicate that the full impact of a company’s EPS could not be fully reflected in market prices. So, if your valuation model tells you that your stock is worth more than it is currently priced by the market, of course you are going to buy it (you and quite a few other people out there).

Finally, there is Lombardi Financial’s favorite: the Small-cap anomaly. Again, historically speaking, small-caps tend to outperform large-caps. One of the reasons is their inherently huge growth potential. But, there is also the fact that small-caps hardly ever make it to the radar screen of large brokerage houses’ analysts. For example, a huge British oil company, BP PLC, is followed by no less than 108 analysts worldwide. In contrast, a micro-cap player, Patch International Inc. (our Payload Stocks readers should be familiar with this pick), has no smart money following. Yet, since we placed Patch on our radar screen, the stock has more than doubled in value, while BP PLC has gained barely over 30% in the past 52 weeks.

So, there you have it. Theories are fine and good, but they can be refuted by numerous anomalies that have historically earned investors large chunks of money. This could also be your window of opportunity to pocket some of that money for yourself.

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Tags: stock market, Stock Market Analysis