## There Exist Two Different Accruals Anomalies Monday, 23 April, 2018

**A new financial research paper related to:**

**Authors:** Detzel, Schaberl, Strauss

**Title: **There are Two Very Different Accruals Anomalies

**Link:** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3069688

**Abstract:**

We document that several well known asset-pricing implications of accruals differ for investment and non-investment-related components. Exposure to an investment-accruals factor explains the cross-section of returns better than the accruals themselves, and this factor’s returns are negatively predicted by sentiment. The opposite results hold for non-investment accruals. Further tests show cash profitability only subsumes long-term non-investment accruals in the cross-section of returns and economy-wide investment accruals negatively predict stock-market returns while other accruals do not. These results challenge existing accruals-anomaly theories and help resolve mixed evidence by showing that the anomaly is two separate phenomena: a risk-based investment accruals premium and a mispricing of non-investment accruals.

**Notable quotations from the academic research paper:**

"To measure current-period performance with earnings, accountants add accruals to free cash flow that adjust for long-term investment expenditures and differences in timing between the earning and receipt of cash flows. The evidence in this paper shows that the asset-pricing implications of investment and non-investment components are fundamentally different. These findings challenge existing theories of the accruals anomaly and demonstrate that there are not one, but two, accruals anomalies to explain: a risk-based premium for accruals that capture real investment, and a short-lived mispricing of accruals that capture transitory adjustments to profitability.

Characteristics-vs-covariances tests show that an investment-accruals factor better explains the cross-section of returns than the investment accruals themselves. This result is evidence against earnings fixation and profitability-related mispricing explanations of the investment-accruals premium, which do not predict a factor structure of returns. In contrast, the opposite pattern holds for non-investment accruals, consistent with mispricing in the form of a violation of the law of one price. These results are corroborated by evidence that investment accruals predict the cross-section of returns for more than two years (consistent with persistent risk) while non-investment accruals only predict returns for one to eight months (consistent with short-lived mispricing).

While the investment-accruals premium is explained by a risk factor and is therefore not an arbitrage opportunity, the underlying factor is at least partially driven by sentiment as opposed to entirely rational demand. The negative investment-accruals premium is most significant in times of high sentiment, which is consistent with firms responding to sentiment-induced overvaluation with high levels of real investment. In contrast, the negative non-investment-accruals premium is significant only when sentiment is in its bottom quartile. This finding challenges existing mispricing explanations of accruals that do not predict that overvaluation of high-accruals firms should be

concentrated in low-sentiment periods. Moreover, the profitability of non-investment accruals in low-sentiment times challenges the theory that anomaly returns should increase with sentiment because of the relative difficulty in arbitraging over-valuation.

Following Lewellen and Resutek (2016), we decompose total accruals into three components: working-capital accruals (WC), long-term investment accruals (IA), and long-term non-investment or "nontransaction" accruals (NTA). The IA component includes items such as new PP&E that represent expenditures in real investment. The WC and NTA include items such as accounts payable and receivable as well as depreciation that do not represent new long-term investment expenditures, but only transitory accounting adjustments to cash flows. Hence we refer to WC and NTA collectively as "non-investment accruals".

The Fama-Macbeth framework can provide additional evidence of risk versus mispricing. Ball et al. (2016) argue that risk should be more persistent than mispricing and investigate whether longer lags of OA and COP continue to predict returns in Fama-Macbeth regressions. Based on the same motivation, Figure 2 presents Fama-Macbeth regression slopes and their corresponding 95% confidence intervals from regressions of monthly stock returns on control variables and lagged values of the three accruals measures (WC, IA, and NTA). Figure 2 demonstrates NTA and WC have the least persistent predictive power for returns. In contrast, IA is a more persistent predictor of

returns and remains significant for up to 28 additional months. Overall, the evidence from Figure 2 is consistent with the IA premium arising from risk, whereas WC and NTA premia appear to be consistent with mispricing that is arbitraged away after several months.

"

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## The Day of the Week Effect in the Crypto Currency Market Monday, 16 April, 2018

**An interesting paper, an analysis of a day of the week effect in the crypto currency market ... :**

**Authors:** Caporale, Plastun

**Title: **The Day of the Week Effect in the Crypto Currency Market

**Link:** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3082117

**Abstract:**

This paper examines the day of the week effect in the crypto currency market using a variety of statistical techniques (average analysis, Student's t-test, ANOVA, the Kruskal-Wallis test, and regression analysis with dummy variables) as well as a trading simulation approach. Most crypto currencies (LiteCoin, Ripple, Dash) are found not to exhibit this anomaly. The only exception is BitCoin, for which returns on Mondays are significantly higher than those on the other days of the week. In this case the trading simulation analysis shows that there exist exploitable profit opportunities that can be interpreted as evidence against efficiency of the crypto currency market.

**Notable quotations from the academic research paper:**

"There exists a vast literature analysing calendar anomalies (the Day of the Week Effect , theTurn of the Month Effect, the Month of the Year Effect, the January Effect, the HolidayEffect, the Halloween Effect etc.), and whether or not these can be seen as evidence againstthe Efficient Market Hypothesis. However, with one exception (Kurihara and Fukushima, 2017) to date no study has analysed such issues in the context of the crypto currency market – this being a newly developed market, it might still be relatively inefficient and it might offer more opportunities for making abnormal profits by adopting trading strategies exploiting calendar anomalies. We focus in particular on the day of the week effect, and for robustness purposes apply a variety of statistical methods (average analysis, Student's ttest, ANOVA, the Kruskal-Wallis test, and regression analysis with dummy variables) as well as a trading robot approach that replicates the actions of traders to examine whether or not such an anomaly gives rise to exploitable profit opportunities.

We examine daily data for 4 crypto currencies, choosing those with the highest market capitalisation and the longest data span (2013-2017), namely BitCoin, LiteCoin, Ripple and Dash. The data source is CoinMarketCap (https://coinmarketcap.com/coins/).

The complete set of results can be found in Appendix B. The results of the parametric and non-parametric tests are reported in Appendices C, D, E and F) and summarised in Table 3 and 4. There is clear evidence of an anomaly only in the case of BitCoin.

Since the anomaly occurs on Mondays (when returns are much higher than on the other days of the week) the trading strategy will be the following: open long positions on Monday and close them at the end of this day. The trading simulation results are reported in Table 5. In general this strategy is profitable, both for the full sample and for individual years, but in most cases the results are not statistically different from the random trading case, and therefore they do not represent evidence of market inefficiency.

"

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## Problems with a Long Horizon Predictability Tuesday, 10 April, 2018

**There are a lot of media articles showing how "expensive" the current stock market (or some equity factor) is. However, these articles can be based on a weak statistical analysis:**

**Authors:** Boudoukh, Israel, Richardson

**Title: **Long Horizon Predictability: A Cautionary Tale

**Link:** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3142575

**Abstract:**

Long-horizon return regressions have effectively small sample sizes. Using overlapping long-horizon returns provides only marginal benefit. Adjustments for overlapping observations have greatly overstated t-statistics. The evidence from regressions at multiple horizons is often misinterpreted. As a result, there is much less statistical evidence of long-horizon return predictability than implied by existing research, casting doubt over claims about forecasts based on stock market valuations and factor timing.

**Notable quotations from the academic research paper:**

"Pronouncements in the media about how “cheap” or “rich” the stock market or aggregate factor portfolios have become are quite common. These views also creep into the practitioner/academic finance literature.

Empirical support for these types of statements originates from seemingly “impressive” evidence of long-horizon predictability of stock returns based on valuation measures. Further, practitioners often document strong levels of statistical significance using overlapping long-horizon returns based on standard errors that they believe correct for overlapping data.

The issue is there are few independent long-horizon periods in the short samples used to study markets. Using overlapping returns in the hope of increasing the sample size offers little help. Intuitively, no matter how the data is broken down, you can’t get around the issue of short sample sizes. Therefore, findings of long-horizon predictability are illusory and reported statistical significance levels are way off. A quarter-century of statistical theory and analysis of long-horizon return regressions strongly makes this case. The bottom line is that practitioners need to be aware of these issues when performing long-horizon return forecasts and need to appropriately adjust long-horizon statistical metrics.

We show theoretically and demonstrate via simulations that there is only a marginal benefit to overlapping data for the types of return forecasting problems faced in finance. For example, in forecasting 5-year stock returns using 50 years of data, the effective number of observations, from nonoverlapping (10 periods) to monthly overlapping (600 overlapping periods), increases from 10 to just 12 observations. Statistical significance emerges only because reported standard errors (and t-statistics) are both noisy and severely biased. For example, at the 5-year stock return horizon with 50 years of data, the range of possible standard error estimates is so wide to make inference nonsensical, with the expected t-statistics effectively double their “true” value. Applying the appropriate statistics to data on long horizon stock returns and valuation ratios drastically reduces the statistical significance of these tests.

__Background for Why Long-Horizon Return Regressions Are Unreliable:__

To gain intuition and for illustrative purposes, the left-hand side of Figure 1 shows the scatter plot of the inverse of cyclically adjusted price earnings ratio (1/πΆπ΄ππΈ) and subsequent 5-year stock returns post 1968 and 10-year stock returns post 1883. Note that the number of nonoverlapping observations is 8 and 12, respectively. The point estimates of the correlations are quite large and positive, 0.26 and 0.38. However, there is very little data to back up these estimates. For example, suppose one were to take away the most outlier point in the plot; the correlations respectively become 0.04 and 0.28. Of course, this finding should not be a surprise. Under the null of no predictability, and putting aside any bias adjustment, the standard error of the correlation coefficient is 1/SQRT(T), which is 0.35 and 0.29 for 8 and 12 observations, respectively. In other words, it is quite possible the true correlation is zero or negative, especially for 5-year stock returns used in the late subsample.

In an attempt to combat this issue, practitioners will often sample long horizon stock returns more frequently using overlapping observations, believing they are increasing their sample sizes significantly. Consistent with this observation, the overlapping scatter plots on the right-hand side of Figure 1 are instark contrast to those on the left-hand side and appear to show overwhelming evidence of a strong positive relation.

For example, in referring to 1/CAPE’s ability to forecast 10-year returns relative to his previous work, Shiller writes in chapter 11 of the latest edition of his book, Irrational Exuberance, “We now have data from 17 more years, 1987 through 2003 (end-points 1997 through 2013), and so 17 new points have been added to the 106 (from 1883)". As such, in describing this estimated positive relation between 1/CAPE and future long-term returns, Shiller (2015) writes “…the swarm of points in the scatter shows a definite tilt.”

__This is fallacy.__

In Shiller’s above example, because 1/CAPE (measured as a 10-year moving average of earnings) is highly persistent, only 2, not 17, nonoverlapping observations have been truly added. To see this, note that standing in January 2003 versus in January 2004, looking ahead 10 years in both cases, the future 10-year returns have 9-years in common. So even if stock returns are serially independent through time, the 10-year return in adjacent years will be 0.90 correlated by construction. Moreover, 1/CAPE itself has barely changed due to its 10-year moving average of earnings and fundamental persistence of stock prices during the period between January 2003 and January 2004. It is these facts that create, by construction, Shiller’s “swarm” effect, visible in the figures. In reality, there is just a smattering of independent data points, 12 to be precise.”"

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## What is Bitcoin's Fair Value ? Wednesday, 4 April, 2018

**Nice academic paper uses Metcalfe’s law to estimate Bitcoin's fundamental value. A really recommended read ... :**

**Authors:** Wheatley, Sornette, Huber, Reppen, Gantner

**Title: **Are Bitcoin Bubbles Predictable? Combining a Generalized Metcalfe's Law and the LPPLS Model

**Link:** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3141050

**Abstract:**

We develop a strong diagnostic for bubbles and crashes in bitcoin, by analyzing the coincidence (and its absence) of fundamental and technical indicators. Using a generalized Metcalfe’s law based on network properties, a fundamental value is quantified and shown to be heavily exceeded, on at least four occasions, by bubbles that grow and burst. In these bubbles, we detect a universal super-exponential unsustainable growth. We model this universal pattern with the Log-Periodic Power Law Singularity (LPPLS) model, which parsimoniously captures diverse positive feedback phenomena, such as herding and imitation. The LPPLS model is shown to provide an ex-ante warning of market instabilities, quantifying a high crash hazard and probabilistic bracket of the crash time consistent with the actual corrections; although, as always, the precise time and trigger (which straw breaks the camel’s back) being exogenous and unpredictable. Looking forward, our analysis identifies a substantial but not unprecedented overvaluation in the price of bitcoin, suggesting many months of volatile sideways bitcoin prices ahead (from the time of writing, March 2018).

**Notable quotations from the academic research paper:**

"The explosive growth of bitcoin intensified debates about the cryptocurrency’s intrinsic or fundamental value. While many pundits have claimed that bitcoin is a scam and its value will eventually fall to zero, others believe that further enormous growth and adoption await, often comparing to the market capitalization of monetary assets, or stores of value. By comparing bitcoin to gold, an analogy that is based on the digital scarcity that is built into the bitcoin protocol, some markets analysts predicted bitcoin prices as a high as 10 million per bitcoin.

There is an emerging academic literature on cryptocurrency valuations and their growth mechanisms. Many of these studies attribute some technical feature of the bitcoin protocol, such as the “proof-of-work” system on which the bitcoin cryptocurrency is based, as a source of value. However, as has been proposed by former Wall Street analyst Tom Lee, an early academic proposal, by now widely discussed within cryptocurrency communities, is that an alternative valuation of bitcoin can be based on its network of users. In the 1980s, Metcalfe proposed that the value of a network is proportional to the square of the number of nodes. This may also be called the network effect, and has been found to hold for many networked systems. If Metcalfe’s law holds here, fundamental valuation of bitcoin may in fact be far easier than valuation of equities—which relies on various multiples, such as price-to-earnings, price-to-book, or price-to-cash-flow ratios—and will therefore admit an indication of bubbles.

Here, we combine—as a fundamental measure—a generalized Metcalfe’s law and—as a technical measure—the LPPLS model, in order to diagnose bubbles in bitcoin. When both measures coincide, this provides a convincing indication of a bubble and impending correction. If, in hindsight, such signals are followed by a correction similar to that suggested, they provide compelling evidence that a bubble and crash did indeed take place.

Given the number of active users, and calibrations of the generalized Metcalfe’s law, which maps to market cap, we can now compare the predicted market cap with the true one, as in Figure 2. Also, using smoothed active users, the local endogeneities—where price drives active users—are assumed to be averaged out. The OLS estimated regression, by definition, fits the conditional mean, as is apparent in Figure 2. Therefore, if bitcoin has evolved based on fundamental user growth with transient overvaluations on top, then the OLS estimate will give an estimate in-between and thus above the fundamental value. For this reason, support lines are also given, and—although their parameters are chosen visually—they may give a sounder indication of fundamental value. In any case, the predicted values for the market cap indicate a current over-valuation of at least four times. In particular, the OLS fit with parameters (1.51,1.69), the support line with (0,1.75), and the Metcalfe support line (-3,2) suggest current values around 44, 22, and 33 billion USD, respectively, in contrast to the actual current market cap of 170 billion USD. Further, assuming continued user growth in line with the regression of active users starting in 2012, the end of 2018 Metcalfe predictions for the market cap are 77, 39, and 64 billion USD respectively, which is still less than half of the current market cap. These results are found to be robust with regards to the chosen fitting window.

"

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## How Algo Trading Reacts to Market Stress Tuesday, 27 March, 2018

**A recent academic research looks at effects of algorithmic trading during turbulent times:**

**Authors:** Breedon, Chen, Ranaldo, Vause

**Title: **Judgement Day: Algorithmic Trading Around the Swiss Franc Cap Removal

**Link:** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3126136

**Abstract:**

A key issue raised by the rapid growth of computerised algorithmic trading is how it responds in extreme situations. Using data on foreign exchange orders and transactions that includes identification of algorithmic trading, we find that this type of trading contributed to the deterioration of market quality following the removal of the cap on the Swiss franc on 15 January 2015, which was an event that came as a complete surprise to market participants. In particular, we find that algorithmic traders withdrew liquidity and generated uninformative volatility in Swiss franc currency pairs, while human traders did the opposite. However, we find no evidence that algorithmic trading propagated these adverse effects on market quality to other currency pairs.

**Notable quotations from the academic research paper:**

"We analyse the role of AT in foreign exchange (FX) markets in a period containing the 15 January 2015 announcement by the Swiss National Bank that it had discontinued its policy of capping the value of the Swiss franc against the euro. This ‘Swiss franc event’ represents a natural experiment as one of the largest shocks to the FX market in recent years and probably the most significant ‘black swan’ event in the period in which AT has been a prominent force in FX markets. In particular, we study the contribution of AT and human traders to two important dimensions of market quality, namely liquidity and price efficiency. Our analysis is based on a unique dataset with a detailed identification of AT obtained from EBS Market, which is the leading platform for electronic spot FX trading in many of the major currencies.

A detailed understanding of AT in distressed situations is important for at least two reasons. First, a better comprehension of whether AT is beneficial or detrimental for market quality in extreme situations would help inform the ongoing reform of trading venues. Second, the resilience of an exchange system depends on the behaviour of different types of market participant and their reciprocal influence on each other. For instance, a tendency of AT to offer liquidity in calm markets and withdraw it in distressed situations could lead less sophisticated agents to become reliant on high levels of market liquidity only to find it in short supply when they most needed it. If these adverse consequences of AT were predominant or not offset by other traders, then AT could represent a systemic threat to the whole trading system. To shed light on this key issue for financial stability, we analyse whether human traders and AT substitute for or complement each other in supplying and consuming liquidity.

We proceed in three steps. First, we describe the EBS Market platform and our sample of data from it. Second, we perform an in-depth analysis of market liquidity and price movements by decomposing order flow, effective spreads and intraday volatility by type of trader. This enables us to highlight the contribution of AT and human traders to liquidity provision and consumption, transaction costs and realised volatility. Third, we study the contribution to efficient pricing of AT and human traders.

Our study delivers two important findings. __ First, in reaction to the Swiss franc event, we find that AT tended to consume liquidity and reinforce the price disruption. Opposite and offsetting patterns apply for human traders, who supported market quality by providing liquidity and aiding price discovery.__ Second, we find that this market quality degradation coming from AT was concentrated in the shocked FX rate (EUR/CHF) and, to a lesser extent, USD/CHF. Non-CHF currency pairs (USD/JPY, EUR/JPY and EUR/USD in our sample) were essentially unaffected.3 This suggests that AT models were somewhat compartmentalised, which, along with human trading, helped to sustain market quality beyond the CHF currency pairs.

Figure 4 shows the prices at which different types of trader exchanged euros for Swiss francs in the 30 minutes following the SNB announcement depending on whether their trades were consuming liquidity (top panel) or providing it (bottom panel). Trades that consume liquidity result from IOC orders, while those that provide it result from GTC orders. The top panel shows that bank AIs consumed liquidity at extreme prices (prices significantly different to those of immediately preceding trades) on a number of occasions, notably between 9.31 and 9.36. Thus, over 75% of the cumulative appreciation of the franc in the 20 minutes to 9.50 was attributable to bank AIs, which accounted for 61% of the volume of liquidity-consuming trades. Indeed, we show below that bank AIs accounted for an even larger share of the realised variance of the EUR/CHF rate at this time. The lower panel shows that bank AIs also provided liquidity for some of the extreme-price trades. That bank AIs both consumed and provided liquidity at extreme prices may reflect the diverse set of traders from whom these trades may originate. This includes not only the different banks but also their various clients. In addition, a roughly equal number of extreme-price trades were accommodated by human traders. Indeed, human traders accounted for a significantly higher share of liquidity-providing trades (50%) than they did for liquidity-consuming trades (19%) during the 20 minutes to 9.50 when the Swiss franc appreciated sharply.

Figure 5 gives an overview of the reaction of both the EUR/CHF and USD/CHF markets to the SNB announcement over the whole trading day of 15 January 2015. The first row shows that the Swiss franc appreciated extremely sharply against both ‘base’ currencies in the first 20 minutes following the announcement, but that sizeable portions of these gains were reversed in the subsequent hour. After that the two spot rates were much more stable, with the Swiss franc worth about 10% more than at the start of the day. The second row shows that algorithmic traders were net purchasers of Swiss francs over the day, particular bank AIs against the euro and PTC AIs against the US dollar, while human traders were net purchasers of the base currencies. Thus, computers traded ‘with the wind’, buying the franc as it appreciated, while humans ‘leaned against the wind’. Note, however, that human traders did not make net purchases of the base currencies in the key 20-minute period immediately after the announcement. Finally, the third row shows that human traders were consistently net suppliers of liquidity over the day, while PTC AI trades consumed it. However, as we shall see below, net liquidity consumption by PTC AIs is not unusual in these two currency-pairs.

"

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