Econometics Calender Effect

Assignment 2 Write Up: Calendar Effects

Statement of the Problem

In the first assignment we tested Wells Fargo’s daily stock returns to determine if there was a normal distribution. We hypothesized that if returns were normal, it would further substantiate the Efficient Market Hypothesis, an ideology that states that markets are efficient and there is no potential to earn outsized returns (alpha). However, it was noted that if returns were not normally distributed at the 95% confidence level, then more research would need to be conducted to try to understand EMH. This is our attempt to try to understand EMH from another angle.

        It is a primary assumption in finance that markets are efficient and that the price of any security fully reflects all the available information. Implicitly, the only things that should change stock prices is new information coming into the market. This would mean that trading rules are unreliable and mean-reverting (e.g. they will not generate long-term profits), technical trading is a waste of time, and that a passive buy and hold (of the entire market) is the most profitable venture. Investors therefore, are only rewarded for taking systematic risk.

        This belief has become increasingly prevalent in the market, as witnessed by the recent trend in capital flows from actively managed funds to passively managed funds. Flows from active to passive funds increased to nearly $500 billion in the first half of 2017 (Graham, Luke 2017). According to Barron’s, a Credit Suisse analyst estimates that passive investments could make up half of all U.S. equity retail flows in 2018 and 2019 (Rivas, Teresa, 2017). With a mass exodus in active management occurring, the situation begets questions about whether active management should even exist. Therein (theoretically) lies a paradox. If enough people believe that the market is efficient then no one will engage in active management, thereby decreasing the overall efficacy of the now not-so-efficient market by slowing the diffusion of information into market prices. Therefore, if enough people actually believe that the market is efficient then that belief actually ensures the falsity of the theory itself, ergo, a paradox forms.

        The following conclusion can be made that active management is not valuable when everyone is doing it, and vice versa for passive management. There must be a balance in order for active managers to ensure market efficiency and for passive investors to collect their free rides.  Fees aside, there should be a number of market anomalies for active managers to capitalize on in order to justify their existence, and to increase market efficiency. This assignment is focused on testing for one of those documented market anomalies.

Context

“Calendar Effect” is a collection of assorted theories that certain days, months or times of year are subject to above-average price changes in market indexes and can therefore represent good or bad times to invest (Staff, Investopedia, 2017). Some theories that fall under the calendar effect include the January Effect, the Monday Effect and the Weekend Effect. Robert Ariel, in 1987, first documented these effects, noting that, based on 19 years of data, the mean return for stocks is positive for days immediately before and during the first half of the month (Ariel, Robert, 2017). In contrast, Ariel noted that the mean return for days during the second half of the month was indistinguishable from 0.