The Abominable Anomalousness of the Anomaly Analogy

(The following is a slightly revised version of an article originally published in November 2017.)

The other night I asked my son, a high school student who knows next to nothing about economics or the stock market, “Which is more likely to grow faster, a small company or a large company?” He answered, “A small company.” Then I asked him, “Which will rise in price faster, a company whose price is cheap compared to what it earns, or a company whose price is expensive?” He answered, “The cheap one.”

An anomaly is a strange or unusual occurrence, a deviation from the rule. Academics talk of the fact that small firms grow faster than large firms as a “size anomaly.” The fact that cheap stocks usually rise in price faster than expensive stocks is a “value anomaly.” But are these really “anomalies”? Or, like my high school student suggested, are they in the very nature of firms?

I don’t want to go into the whole history of the efficient market hypothesis (EMH), the capital asset pricing model, and the application of Thomas Kuhn’s paradigm-shift theory to them, which is why these things are called “anomalies.” Instead, I want to look at the big metaphor (the analogy) behind the term.

Back in 1972, Eugene Fama proposed that we could work with a model of “a capital market that is efficient in the sense that prices at every point in time fully reflect available information.” He had been working on this theory since the 1960s, along with many other economists of the time. Basically, he viewed the stock market as a rather well-oiled machine. An anomaly, then, is analogous to a gear that’s gone slightly out of place.

I’d like to propose a different metaphor. The stock market is a badly oiled contraption, stuck together with cellophane tape and staples, and full of rust spots and leaks and broken parts. Its pricing mechanism is terrible and inefficient, and it runs a crazy, circuitous, and illogical course. Why? Because many of the price movements in stocks are based on the quirks of human behavior rather than on sound financial sense.

In this model, what the academics call an “anomaly” is really a thing in the machine that actually works the way it’s supposed to.

The reason movements in stock prices are so confoundedly difficult to predict is not because they’re efficient and reflect all known information, but because they are the products of thousands of small overreactions, unfulfilled expectations, and misguided second guesses. Rather than cancelling each other out, as the EMH suggested, these behavioral quirks make stock prices far more volatile than they should be, and make them move in entirely unexpected directions.

This is where the savvy investor gets an advantage. By looking at the general principles behind this machine, she can see through all the smoke, hear through all the noise, and figure out approximately what certain stocks are doing and what they’re likely to do in the future.

The EMH view of the stock market is Orwellian. In 1984, war is peace, freedom is slavery, and ignorance is strength. For the EMH, a common sense principle is an anomaly. So let me list, in alphabetical order, four of the many “anomalies,” or common sense principles, that really govern the stock market:

1. The accruals anomaly. Companies with low accruals – whose earnings are backed by real cash transactions in the present – are more likely to do well than companies whose earnings are all predicated on future cash flows.
2. The size anomaly. Small companies generally grow faster than large companies.
3. The stability anomaly. Companies whose sales and earnings grow at a modest but steady rate are more likely to keep growing at a modest but steady rate than companies that are growing or shrinking extremely fast. Similarly, companies with big changes in margin – in other words, that are increasing their sales while decreasing their earnings, or increasing their earnings while decreasing their sales – are more likely to fall in price than companies that keep their margins steady by increasing both their sales and their earnings.
4. The value anomaly. Stocks whose price is low compared to similar companies with similar sales, earnings, and free cash flow are more likely to increase in price than stocks whose price is high.

All of these principles should either be immediately apparent after a few moments’ thought or can be easily explained in a paragraph or two. One doesn’t need elaborate models of stock behavior or decades worth of backtests to come to these conclusions.

So if these are general principles rather than anomalies, what are the real anomalies in stock market behavior? Or are there any?

Let’s go back to my model of the stock market as a huge but terribly inefficient machine held together with matchsticks and glue. What would qualify as a “strange or unusual occurrence” for such a machine? Even a total breakdown, as happened in 1929 and 2008, wouldn’t be an anomaly. Nor would various other inefficiencies, like the overvaluation of “momentum” stocks, the huge jumps in price after earnings reports that showcase unsustainable growth, the huge drops in price when a firm decides to issue a few extra shares, and so on.

No, the only real “anomaly” in today’s stock market is the dominance in popular opinion of the view that the stock market is a well-oiled machine, that stock prices reflect all available information, and that inefficiently priced stocks simply don’t exist.