Anomalies in the Markets

Anomalies in the Markets

While it is clear that evidence in favor of the efficiency of markets remains extremely strong, two other studies published in the late 1980s are disturbing because they cast doubt on some of the key assumptions of the efficient-market hypothesis.

The first, authored by Kenneth French and Richard Roll, examined the key presumption of the efficient-market hypothesis that market moves are precipitated by the receipt of new information. If the major cause of market movements is the receipt of news, then market prices should not fluctuate more over periods when the market is open than when it is closed. French and Roll demonstrated that this is not the case and the asset prices are much more volatile during exchange trading hours. For example, the variability (statistically, the variance) of prices from the opening to the close of trading on an average day is over six times as large as the price variances from Friday’s close to Monday’s opening even though the weekend is eleven times longer.

One possible explanation for this phenomenon is that new public information (new economic data, merger announcements, judicial decisions, new contracts, and so forth) is most likely to arrive during normal business hours. Alternatively, the greater price volatility during periods when the market is open could be caused by the provision of private information (the predictions of market gurus, the recommendations of fundamental security analysts, and so forth), which typically gets incorporated into market prices when the exchange is open.

Security analysts are more likely to work at this time, and the benefits of producing such information are larger when the information can be acted upon quickly and conveniently.

You are never too old to set another goal or to dream a new dream (C. S. Lewis). Photo by Elena

In order to distinguish between these two explanations, French and Roll examined the volatility of prices around regular business days when the exchanges were closed. During the second half of 1968, the major stock exchanges were closed on Wednesdays because of a paperwork backlog. This gave these two men a wonderful research opportunity. Public information could be expected to be generated without interruption on those Wednesdays while the flow of private information would be sharply reduced. Thus, we should expect the volatility of prices from Tuesday’s close to Thursday’s opening (when the market was closed on Wednesday) to be considerably larger than the variability of prices from Tuesday’s close to Wednesday’s opening (during Wednesdays when the exchange was open) if new public information is the major cause of stock price changes. On the other hand, if the production of private information is an important cause of stock price change, the Tuesday-Thursday volatility would be far less when the exchange was closed on Wednesday. It turned out that the two-day volatility numbers were, in fact, quite small. They were only a little larger than the one-day numbers, suggesting that the generation of private information is a principal cause of price variances in the market.

The point is that the market makes its own news. Just as the discovery of an important new source of petroleum can affect the price of an oil stock, so can the publication of a bullish report on the stock from a major brokerage firm. Although this is not necessarily inconsistent with markets being efficient, it does open the possibility of there being additional influences in the market besides the receipt of new public information. Surely the sentiment of the professional investment community is not irrelevant.

Roll has also shown in another study that even with hind-sight, the ability to explain stock price changes is relatively modest. Less than 40 percent of the volatility in stock prices is explained by news events concerning the economy, industry developments, and specific news about the individual companies It appears that security valuations and their changes over time are quite complex and that private information and the sentiments of professional and other investors can play an important role in the valuation process.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.