November Effect: Buy beaten - down Micro-caps

Advances in Behavioural Finance over the last several decades appeared to have shifted the paradigm away from the theory of  Efficient Market Hypothesis as proposed by Fama (1970).

According to this hypothesis, securities are priced efficiently hence, they fully reflect all the relevant information. This implies that, the future path of asset prices in stock markets around the world is merely a series of random numbers, i.e. prices follow the random walk hypothesis. This normative statement came increasingly under fire with the discovery of a series of persistent anomalies that seem to defy rational, logical thinking. 

Anomalies has always been challenge to the dominating efficient market theory which suggest that nobody can outperform in market as the market follows a random walk and is unpredictable. Anomalies, on the other hand, are systematic patterns recognized in the movements of the asset prices, which can be exploited by smart investors to earn profit. Existence of anomalies is an indicator of either market inefficiency or inadequacies in the underlying asset-pricing model. The theory of random walk hypothesis was first postulated by Bachelier (1900).

After all, we are human, and we are not always rational in the way equilibrium models would like us to be…. Financial markets are a real game. They are the arena of fear and greed. Our apprehensions and aspirations are acted out every day in the marketplace…. So, perhaps prices are not always rational and efficiency may be a textbook hoax. (Wood 1995, p. 1).

Numerous researchers have challenged the EMH in the US securities market as well as in many international securities market. There are a large number of anomalies documented by researchers as size effect, calendar effect, low beta firm effect, neglected firm effect, the value effect, and momentum effect etc. However, this essay mainly takes into the account the calendar anomalies, experienced by Indian stock markets.

In the context of financial markets, calendar effects, that contradict the Efficient Market Hypothesis (EMH), have been documented over several years. These calendar effects are trends seen in stock returns, where the returns tend to rise or fall on a particular day or month as compared to the mean. 

They are called anomalies because they cannot be explained by traditional asset pricing models and they violate the weak-form of market efficiency (i.e. asset prices fully reflect all past information). Examples of such patterns include the Month-of-the-year effect, Day-of-the-week effect, Intra-month effect, Turn-of-the-month effect, Holiday effect, Halloween effect, and Daylight savings effect.

 As the name suggests, the month-of-the-year effect is a seasonal phenomenon where exchange traded equities tend to produce abnormal returns during particular months of the year. This effect is sometimes identified as the 'January effect' since most developed countries tend to produce abnormal returns in January. January effect was first introduced by Watchel (1942) and further developed by Rozeff and Kinney (1976). The existence of  a January Effect means that returns for the month of January are statistically significantly greater than those during the remaining months of the year.

The question of efficiency of the Indian stock markets is not a novel undertaking. Sharma and Kennedy (1977) found that the Indian markets obeyed the theory of random walk and concluded that markets were efficient.

Kulkarni (1978) rejected the random walk hypothesis and confirmed the presence of seasonality in monthly prices.

Ignatius (1998) gave evidence for the December Effect. Pandey (2002)confirmed a tax-loss-selling hypothesis in the Indian market explaining the presence of abnormal returns in April only to be contradicted later by various other studies. Chakrabathi and Sen (2007)found evidence of the November Effect at the market level.

The above reflect a somewhat controversial picture of the Indian stock market over the years, maybe

due to statistical misgivings. Or perhaps we could presume the disappearance of these anomalies over

time as in Schwert (2002), on the basis that rational traders exploit the documented anomalous behaviour, hence leading to more efficient markets. In other words, the anomalies are arbitraged away. 

The December Effect was first reported by Ignatius (1998) while studying the Indian market during the period 1979-1990, albeit in a different fashion. Ignatius found that December generated the highest mean returns, and that April and June generated high returns in the Indian stock index.

There are a number of reasons as to why December produces abnormal returns compared to any other

month in the Indian market. A number of festivals fall in the second quarter namely, 'Ganesh Chaturthi', 'Durga Pooja', 'Dussera', 'Kali Pooja', 'Laxmi Pooja' and 'Diwali'. However, of all the festivals, Diwali is the one festival that is celebrated across the country in a significant way. Though the Hindu calendar determines when Diwali is celebrated each year, it usually falls in November (or sometimes at the end of October). The festival is considered to bring with it good luck and is therefore, 'auspicious.' Most people buy new homes, new cars and expensive durables during this period. Also, the festival calls for the old tradition of distributing gifts. Even the poorest people in the country save their meagre earnings all year to celebrate this festival.

Another point to mention here is that all jobs in India pay a 'bonus' to employees in the months of November or December depending on the company. These jobs include government jobs, company jobs, and even domestic or labour intensive jobs. This means that consumers have extra cash in hand during this period.

Due to high cash in hand and the festive season, buying by consumers shoots up in a significant way. As the selling of consumer durables increases, it gives impetus to the industry production after clearing out the backlogs from the previous period. Thus, the entire economy is reinvigorated. By December the markets look interesting again, and investors are bullish about the next period returns, making the stock market the right place to invest in during December.

Another possible interpretation for the December Effect in the Indian market could be found in the optimism of the Indian stock market in the recent years. The significant growth rate in the country has probably increased optimism in anticipation of the Government's announcement of its budget with the expectation of good news that will further accelerate the country's economy. Therefore, the investors tend to indulge themselves in the pre-budget rally. Information leakages about the budget begin in the months of December and January which tend to fuel trading of a speculative nature.

Lastly, the growth of foreign mutual funds in the country also supports the December effect. There has been a significant growth in the foreign mutual funds in India during the last few decades. Foreign Fund Managers are paid a performance bonus before they leave for their Christmas holidays that is evaluated on the basis of their portfolios. Therefore, they tend to aggressively trade in December, 'window dressing' their portfolios before the end of the year. This reduces the chances of redemption and also, makes their portfolios look profitable, helping fund managers cash in on a good performance bonus. 

In case of November-December Effect the mean returns for November and December are significantly greater than those of the other ten months. There is also March-to-May effect in which mean returns for the months March to May are significantly less than those during the other nine months. These are two distinct effects, which are independent of each other.

Published studies  that have examined  calendar  effects in the  Indian  stock market appear to be limited.  Kaur (2004) reports  that  few studies  have examined the  day-of-the-week effect in the Indian stock market, and further notes the absence of studies that examine monthly seasonality in the Indian stock market.  Kaur utilized two Indian stock indexes, the Bombay Stock Exchange (BSE) 30 index and the National Stock Exchange (NSE) S&P CNX Nifty stock index, to examine the day-of-the-week effect and the monthly effect.

Yakob,  Beal  and  Delpachitra  (2005)  examined  seasonal  effects  in  ten  Asian  Pacific  stock  markets, including the Indian stock market, for the period January 2000 to March 2005.  They state that this is a period of stability and is therefore ideal for examining seasonality as it was not influenced by the Asian financial crisis of the late nineties.

Yakob, et al., concluded that the Indian stock market exhibited a month-of-the-year effect  in that statistically significant  negative  returns  were  found  in March and  April  whereas  statistically significant positive returns  were  found  in  May,  November  and  December. Of  these  five  statistically  significant  monthly  returns, November generated the highest positive returns whereas April generated the lowest negative return.

Kaur did not find a January Effect in the Indian stock market, but  did find that March and September  generated substantially lower returns, whereas February and December generated substantial positive returns.  

Calendar effect thus connotes the changes in security prices in stock market following certain trends based on seasonal effects. Such trends or consistent patterns occur at a regular interval or at a specific time in a calendar year. Presence of such anomalies in any stock market is the biggest threat to the concept of market efficiency as these anomalies may enable stock market participants beat the market by observing these patterns. Existence of these anomalies in Bombay Stock Exchange National Stock Exchange is against the principle of market efficiency as it may offer abnormal economic rewards to the investors tracking these anomalies.

I myself have observed a phenomenal rally in the small and micro-cap counters during the mid-November to end December period. Therefore, the investors and traders are suggested to accumulate the stocks of this space, from next week.

Bibliography: 

i) The December Phenomenon: Month-of-year-effect by Anokhi Parikh.

ii) Calendar Effects  In The Indian Stock Market  by Jayen B. Patel, (Email: jpatel@adelphi.edu), Adelphi University.
iii) The thesis entitled “Calendar Anomalies in Indian Stock Market” by Neha Bankoti.

iv) Stock Market Anomalies: A Survey of Calendar Effect in BSE-Sensex by Abhijeet Chandra, IIT Kharagpur, West Bengal.