Literature Review on Day of the Week Effects

Efficient Market Hypothesis (EMH) claims that financial markets are “informationally efficient” Fama (1970). In other words, financial markets reflect all known information and according to stock prices rapidly adjust to any new information (Reilly and Brown, 1997), so the current price already reflects all known information about the stock. Therefore, according to this theory, it would be impossible to earn excess returns and beat the market on a regular basis unless it is through luck.

The EMH was initially expressed by Bachelier (1900) in the form of random walks (Bachelier, 1900 cited in Fama, 1965). The random walk theory is explained by prices that are unpredictable and that future stock prices cannot be forecasted using prior information (Lo & Mackinlay, 1988). Bachelier (1900) concluded that commodity speculation was a “fair game”. This meant that investors could not make abnormal profits as the existing price of a share was a fair estimate of its future price. However this theory was ignored until Samuelson (1965) developed the theoretical framework for the random walk. This theory created by Samuelson (1965), combined with empirical findings from other researchers including Fama (1965) formed the foundation to the development of the EMH. The theory of EMH was finally proposed by Fama (1970).

Fama (1970) states that three different levels of market efficiency exist when based on what is meant as available information. These include the weak-form, which asserts that security prices reflect all historical information, meaning that abnormal profits cannot be gained by using trading strategies based on past information. In other words if the market is set to be weak-form efficient, then it follows a random walk. The second level of efficiency is called semi-strong-form, which asserts that security prices reflect all publicly available information. Therefore prices will immediately adjust for all public announcements. And finally the third level is known as strong-form and states that all information including private and public is reflected in the stock prices. All three forms of efficiency are transparent, meaning that if a stock market is strong-form efficient, it would also mean it is efficient in the weak-form.

However in recent years the EMH has come under scrutiny and many market analysts have argued for market inefficiency, at least in its weak-form (Malkiel, 2003). Since the EMH is based on the assumption that investors are rational, researchers have found that some investors sometimes take irrational approaches to decision making opposed to the conventional rational or logical thinking. In recent years, Behavioural Finance has emerged as one of the key explanations into why and how markets may be inefficient.

Some of the explanations that behavioural finance proposes include feedback mechanisms which describe why short-run serial correlation was not zero found by Lo & Mackinlay (1999). Long-run return reversals has also been established as an explanation as to why markets may not be efficient as DeBondt & Thaler (1985) found that investors were subject to waves of optimism and pessimism which causes stock prices to deviate from their fundamental true value and later to experience a concept known as mean reversion. The concept of mean reversion is a contradiction to the EMH as it follows a trend. This is also consistent with the behavioural decision theory proposed by Kahneman & Tversky (1979) in which they claimed that investors may be overconfident in their ability to forecast future stock prices. The day of the week effect as proposed earlier has been identified as one of the key violations to the EMH and is discussed further in section 2.2.

2.2 – Review of Literature on Day of the Week Effects

The phenomenon of day of the week effects has been extensively researched over the last few decades. Although the literature on this irregularity has been widely documented, only a few have been able to explain these cyclic patterns in stock returns. Also, the explanations that have been proposed by researchers have not been concrete reasons. They have been more like suggestions and some of the more popular ones are as follows. Calendar time hypothesis is a process which operates continuously, so that the return on Monday would represent a three-calendar-day investment, therefore the expected return for Mondays would be three times the expected return for any of the other days of the week (French, 1980). The settlement period hypothesis has been found to explain some calendar effects across different markets in which returns have been higher on pay-in days compared to pay-out days (Kumari & Raj, 2006). Other explanations include Measurement errors in stock prices (Gibbons & Hess, 1981) and spill-over effect which implies that negative Tuesdays returns found in other international markets have been caused by negative Monday returns found in the U.S. & U.K (Jaffe & Westerfield, 1985).

2.3 – Evidence from Developed Markets

Fama (1965) examined the behaviour of stock prices and discovered that there was evidence of abnormality in stock returns. This brought forward the theory of stock prices being influenced by non-trading days. Therefore, Fama (1965) established that anticipation of economical events that occur during non-trading days have a continuous effect on stock prices. He tested the hypothesis that Monday’s variance is three times greater than the other trading days in the week because of the accumulation of variances over the non-trading days. He found that the variance was approximately 20% higher than the other trading days which fell short of his hypothesis. As this was an opening study into this field, there was bound to be limitations and short-comings which may have compromised the accuracy of his results. As the day of the week effect was a secondary focus in his paper only a small sample of stocks were used. In addition, he considered only variances to determine the effect which only describes the spread of the returns, however had he used mean returns in addition, it would have explained the day of the week better as one can confirm by how much the return differs between each day of the week. Nevertheless, this was an introductory study and if it wasn’t for this paper, the issue of day of the week effects may not have been picked up as early as it was.

French (1980) extended Fama’s (1965) contribution in which he examined whether the process of generating stock returns operates continuously or during active trading days only. This was done on S&P 500 stock returns with the following two methods. The Calendar-time hypothesis [1] and the Trading- time hypothesis [2] , in which the returns are only generated during the active trading days of the week. Therefore if the alternative hypothesis was rejected, the returns for each day of the week should be identical since any of the returns represent only one trading day.

French (1980) found that during 1953-1977, the daily returns from the S&P 500 portfolio were inconsistent with both the Trading day model and the Calendar time model. The average returns on the Mondays were negative compared to the other four positive trading day returns. This was an unusual finding which led others to examine this anomaly further.

Gibbons & Hess (1981) investigated further into French’s (1980) research as they examined the S&P 500 index and the equal weighted index from 1962-1978 for the day of the week affect on asset returns. They considered the delay between trading and settlements in stocks and measurement errors as possible explanations for the day of the week effect. They found a similar result to French (1980) however Mondays were not the only day found to give significantly low mean returns. Tuesday appeared to also have low returns, and Wednesday and Friday had higher mean returns than Tuesday and Thursday. In the overall analysis, the annual mean return on a Monday ranged from -33.5% (S&P 500) to 26.8% (equally-weighted index). The hypothesis of the equality of means was rejected in each of the sub-periods run. The inclusion of the sub-periods was very valuable as it gave a different perspective of the market at different time periods.

Following on from Gibbons & Hess (1981), Rogalski (1984) developed his understanding of Monday returns further as he set out to examine the Dow Jones Industrial Average index (DJIA) in terms of trading day and non-trading day returns. This study was different from the previous papers as it distinguished between trading and non-trading day returns, in which the examination from Friday close to Monday close was decomposed into two parts. First one being from Friday close to Monday open; second one was from Monday open to Monday close. He found that all of the average negative returns from Friday close to Monday close occur during non-trading hours and that the actual returns during Monday trading hours are positive.

Smirlock & Starks (1986) proposed a further analysis into the nature and timing of the day of the week effect on the Dow Jones Industrial Average. The use of hourly returns for a 21 year period was justified as a more efficient and thorough manner as the likes of Rogalski (1984) and others had used disparate time periods. For the empirical analysis, the total sample period was divided into three sub-periods. The first sub-period was from 1963-1968, second was from 1968-1974, and the most recent sub-period was from 1974-1983. In the pre 1974 periods, results showed that the hourly returns on Monday were significantly lower than the other trading days in the week. However, in the post 1974 period, there was nothing odd about Monday returns compared to the other trading days. To break this down further, the first sub-period showed that returns from Friday close to Monday open were positive. These returns were eliminated by the negative returns that occurred all day during Monday, resulting in a negative return for the entire day. In the second sub-period, the non-trading weekend returns were vaguely negative. This affected the opening hours of Monday in a negative manner