Errors in recorded security prices and the turn-of-the year effect

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III. The Low-Priced Security Hypothesis

The low-priced security hypothesis (LPSH) is a general version of the tax-
selling hypothesis (see C41, [7], [8], ClOJ, П5], [21], [23], [25], [27],
[28]) and the price-pressure hypothesis (Harris and Gurel [13]). The LPSH
argues that flow-supply pressures at the end of the calendar year cause the
recorded-price errors in security returns to be nonrandom during the turn-of-
the-year period. The LPSH is a tax-selling hypothesis because it views
tax-selling by investors to optimally exercise tax-timing options at the end
of the tax year as the source of the flow-supply pressures at the end of the
calendar year.⁶ The LPSH is a price-pressure hypothesis because it views
returns earned by liquidity traders (such as market specialists) who accom-
modate flow pressures to be consistent with market efficiency. That is,
liquidity traders are paid for the risk-bearing services associated with
accommodating flow pressures.

The LPSH argues that the TOY effect is a low-priced security effect and
not a size effect. LPSH predicts that the largest TOY effects will be assoc-
iated with low-priced stocks because the relative magnitude of the recorded-
price error is inversely related to price. The LPSH predicts that recorded-
price errors will cause both observed returns in January and the estimated β
to be high-biased. The LPSH contends that the size-related TOY effect docu-
mented by Reinganum C221 and others (see [2], C61, [15], [23]) is really a
low-priced security effect with size proxying for price during the TOY
period. The positive relationship (found by Basu [1] and Kross [17]) between
price variables and size is consistent with size proxying for price during the
TOY period. Roll's C231 finding that the largest TOY return is associated
with stocks priced under $2 per share is further evidence consistent with the
LPSH. In addition, Thomson [29] shows that low-priced security portfolios

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