A financial economist’s calendar

Calendar Anomaly Day

On this day, we celebrate calendar effects in asset markets, including end-of-quarter and end-of-year patterns.

January 1 is the day most impacted by deceptive practices historically pursued by some fund managers, including window-dressing and price manipulation. Examples of window-dressing are discussed in Musto (1999), such as money market funds holding government securities around quarter-end reporting dates in order to appear safe. Stock price manipulation occurs around December 31 as mutual funds seek to inflate the value of their holdings, as shown in Carhart, Kaniel, Musto, and Reed (2002). So, if you invest in a mutual fund with inexplicably high returns on the last trading day of December and inexplicably low returns on the first trading day of January, you might be participating in Calendar Anomaly Day whether you want to or not.

On a macro level, Du, Tepper, and Verdelhan (2018) show striking end-of-quarter violations of covered-interest rate parity, probably reflecting regulations that assess financial risk based on quarter-end holdings. Once upon a time, economists thought that covered interest rate parity always held, but following the GFC, this version of the Law of One Price (LOOP) became regularly and flagrantly violated at the end of every quarter.

Another type of seasonality is firm-specific scheduled events, such as earnings announcements and dividend payments. These events seem to temporarily raise firm prices for a few days or weeks, and operate through diverse channels including attention-grabbing (previously discussed by me) and reinvestment of dividends (see Hartzmark and Solomon (2018)).

Palm/3Com Sunday

On this day we celebrate violations of LOOP in financial markets, as exemplified in the Palm/3Com mispricing occurring in March 2000. Here’s the abstract from Lamont and Thaler (2003):

Recent equity carve-outs in U.S. technology stocks appear to violate a basic premise of financial theory: identical assets have identical prices. In our 1998–2000 sample, holders of a share of company A are expected to receive x shares of company B, but the price of A is less than x times the price of B. A prominent example involves 3Com and Palm. Arbitrage does not eliminate this blatant mispricing due to short-sale constraints, so that B is overpriced but expensive or impossible to sell short. Evidence from options prices shows that shorting costs are extremely high, eliminating exploitable arbitrage opportunities.

I’ve previously discussed several aspects of the Palm/3Com case:

• High shorting costs allow high mispricing.
• Low float, high price.
• LOOP violations often occur during bubbles.

Passive Investing Day

On this day we celebrate passive investing, an innovation which has benefited millions of investors, giving them low fees and diversified portfolios.

As I’ve previously argued, the market can’t be 100% passive, and active investors are a necessary ingredient to well-functioning markets. But the rise of passive has surely benefited ordinary investors.

Arbitrage Day

On this day we celebrate arbitrage, a powerful force that was once believed to bind together the financial universe.

Ross (1987) said that “to make a parrot into a learned financial economist, he only needs to learn the single word ‘arbitrage.’” While that’s an overstatement, it’s true that arbitrage is a central concept both in theory and in practice. While LOOP violations are important to study, the big picture is that arbitrage usually causes LOOP to hold across different domains.

A large literature, including Shleifer and Vishny (1997), explores the many forces that sometimes prevent arbitrage from operating. Sadly, these limits to arbitrage seem to be growing over time, especially after the GFC, which was the high-water mark of arbitrage capital.

Independent and Identically Distributed Normal Day

On this day we celebrate the IID normal distribution, a helpful base case for thinking about properties of returns.

Of course, IID normal is just an abstraction, a statistical assumption that is useful in some settings and not others. Don’t listen to the cranks and charlatans who claim that all academic finance is fatally flawed because it is based on the false assumption that returns are normally distributed. Financial economists are well aware that the normality assumption is just a simplification; we’ve been studying non-IID and non-normal distributions for many decades.

Quant Memorial Day

On this day, we commemorate all that we lost between August 3 and August 10, 2007, a horrific week for anyone involved in quant equities. This week has many names: quant quake, quant meltdown, quant crisis, quant bloodbath, quant extinction, quantocide, and quantocalypse.

August 2007 is shrouded in mystery. What happened that week, what triggered the event, who is to blame, can it happen again; no one can give a definite answer, although Daniel (2009) gives it his best shot. What we do know is that when the week was over, many billions of dollars had been lost and then regained, and eventually many funds shuttered and many people lost their jobs.

August 2007 was a liquidity-driven event where, if you managed to survive the week, you mostly broke even and in this sense the initial losses in early August were not permanent. August 2007, like October 1987, was mostly a daily phenomenon taking place intra-month. If you only had access to month-end data, you might wonder what all the fuss was about.

For those of us who lived through August 2007, the most striking feature was how disconnected the quant world was from the rest of humanity. It was as if Voldemort was terrorizing the magical world but the non-magical muggles were oblivious. Like Harry Potter, we who survived still bear the scars of this trauma.

Capital Day

On this day we celebrate the central role that capital has played in promoting human happiness.

I have nothing against labor, but let’s face it: we are much richer than our ancestors not because we have more labor or because we work harder, but because we have accumulated capital: physical capital in the form of machines and buildings, and intellectual capital in the form of science and technology.

I look forward to the day when humans no longer need to labor, and we sit around discussing philosophy while the robots do all the labor. That’s the power of capitalism and capital.

Socialism is Bad Day

On this day, we recognize an important lesson from American history: socialism is bad.

Americans celebrate Thanksgiving to commemorate a feast held by the Pilgrims in 1621. When they first arrived, the Pilgrims practiced collective farming. They soon discovered that collectivized agriculture is a great way to achieve starvation and poverty. According to William Bradford, first governor of Massachusetts, the Pilgrims switched to private ownership of land and:

This had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content …

The experience that was had in this common course and condition, tried sundry years and that amongst godly and sober men, may well evince the vanity of that conceit of Plato's and other ancients applauded by some of later times; and that the taking away of property and bringing in community into a commonwealth would make them happy and flourishing; as if they were wiser than God. For this community (so far as it was) was found to breed much confusion and discontent and retard much employment that would have been to their benefit and comfort.

Smithmas

On this day we celebrate Adam Smith, founder of economics. Economists gather around the Smithmas tree and refrain from exchanging gifts as per Waldfogel (1993).

Smith was not just the first economist, he was the first behavioral economist, as argued by Ashraf, Camerer, and Loewenstein (2005). Smith had much to say about overconfidence leading to excessive risk-taking.

The spirit of Smithmas is the spirit of free inquiry and free markets. I only wish that every day could be Smithmas.

References

Ashraf, Nava, Colin F. Camerer, and George Loewenstein. "Adam Smith, behavioral economist." Journal of Economic Perspectives 19, no. 3 (2005): 131-145.

Carhart, Mark M., Ron Kaniel, David K. Musto, and Adam V. Reed. "Leaning for the tape: Evidence of gaming behavior in equity mutual funds." The Journal of Finance 57, no. 2 (2002): 661-693.

Daniel, Kent. “Anatomy of a Crisis.” CFA Institute Conference Proceedings Quarterly vol. 26, (January 01, 2009): 11-21.

Du, Wenxin, Alexander Tepper, and Adrien Verdelhan. "Deviations from covered interest rate parity." The Journal of Finance 73, no. 3 (2018): 915-957.

Hartzmark, Samuel M., and David H. Solomon. "Recurring firm events and predictable returns: The within-firm time series." Annual Review of Financial Economics 10, no. 1 (2018): 499-517.

Lamont, Owen A., and Richard H. Thaler. "Can the market add and subtract? Mispricing in tech stock carve-outs." Journal of Political Economy 111, no. 2 (2003): 227-268.

Musto, David K. "Investment decisions depend on portfolio disclosures." The Journal of Finance 54, no. 3 (1999): 935-952.

Ross, Stephen A. "The interrelations of finance and economics: Theoretical perspectives." The American Economic Review 77, no. 2 (1987): 29-34.

Shleifer, Andrei, and Robert W. Vishny. "The limits of arbitrage." The Journal of Finance 52, no. 1 (1997): 35-55.

Waldfogel, Joel. "The deadweight loss of Christmas." The American Economic Review 83, no. 5 (1993): 1328-1336.