Anomaly Sensitivity to Business Conditions

By Krueger, Thomas M.; Johnson, Keith H. | Akron Business and Economic Review, Spring 1990 | Go to article overview

Anomaly Sensitivity to Business Conditions


Krueger, Thomas M., Johnson, Keith H., Akron Business and Economic Review


Anomaly Sensitivity To Business Conditions

In a recent edition of this journal, Erickson, Fredman, and Stickels[14] documented the greater importance of the price/earnings ratio relative to the price/sales ratio. They concluded that the price/sales ratio should be used only with great caution and only by experienced analysts. The caution with which investment analysts should use the price/earnings ratio, firm size, and Timeliness rankings criteria, in light of concurrent business conditions, is addressed in this article.

A variable may have explanatory power only in the presence of certain business conditions. Small firms may do extremely well in an expanding economy but show lackluster performance during business contractions. Alternatively, Value Line may find the few start performers easier to identify in a recession than the best of the advancing crowd during periods of economic growth. If the market's condition has no impact on anomaly explanatory power, then the significance of chosen anomaly characteristics would remain unchanged.

Specifically, this paper reports results of an empirical analysis of the relationship between firm size, price/earnings ratios, and Value Line Timeliness rankings under alternative business conditions. Firms continually followed by Value Line over the 1975 through 1984 period form the sample set. This set was chosen because it consists of corporations for which information was widely disseminated. Therefore, it would tend not to be sensitive to the firm neglect/informational deficiency hypotheses put forth by Arbel and Strebel[3] and Arbel[2].

The next section gives a brief overview of the investments literature related to the anomalies under consideration. A more detailed listing of anomaly research is available in Table 1 of Jacobs and Levy[19]. The third section will provide the research methodology. Results are then presented and a conclusion is derived.

OVERVIEW OF THE RELEVANT ANOMALY LITERATURE

The Firm Size Effect

Among the most commonly studied anomalies have been the firm size, price/earnings ratio, and Value Line's Timeliness rankings. A continuous line of research dating back to Banz[4] suggests that small firms, on average, earn higher risk-adjusted returns than do larger firms. The size term was found to have roughly the same statistical significance in explaining returns as did beta. The primary payoff came from holding the smallest twenty percent of New York Stock Exchange stocks. Furthermore, over the 1936-1975 period, the average annual return differential from buying very small firms versus large firms was 19.8 percent.

Reinganum[26, 27] demonstrated that differences in trading frequency, tax-loss selling, or differences in the bid-ask spread between large and small firms did not fully explain the January effect. Price/earnings ratios, dividend yield, standard deviation of return, and coskewness were unable to explain the negative relationship between firm size and subsequent returns[13].

The Price/Earnings Ratio Effect

According to Elton and Gruber[13], Wall Street folklore advocated buying firms with low price/earnings ratios long before Basu[5] rigorously tested the P/E anomaly. Exaggerated optimism was believed to be associated with high P/Es and exaggerated pessimism supposedly led to low P/E figures. Subsequent price adjustments, as investor perception becomes more moderate, supposedly produces an inverse relationship between P/E and security returns.

Abnormal returns of the two lowest P/E quintile portfolios were positive in at least fourteen of eighteen months following portfolio formation in Basu's[5] original sample. Basu's[6] sensitivity analysis indicated that the abnormally good performance of low P/E stocks was insensitive to the choice of either the Sharpe-Lintner version or Black's zero-beta version of the Capital Asset Pricing Model. After controlling for differences in firm size, Basu[7] provided evidence that the common stock of low P/E ratio firms earn, on average, higher risk-adjusted returns than the common stock of high earnings capitalization firms. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Anomaly Sensitivity to Business Conditions
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.