Presentation on theme: "6/1/2014 Market Efficiency 1 Market Efficiency and Information Processing in Financial Markets Andrei Simonov."— Presentation transcript:
6/1/2014 Market Efficiency 1 Market Efficiency and Information Processing in Financial Markets Andrei Simonov
6/1/2014 Market Efficiency 2Outline Efficient Markets Hypothesis Predicting future returns from the past returns –Value strategies –Momentum Strategies Analysts & Information dissemination
6/1/2014 Market Efficiency 3 Do security prices reflect information ? Why look at market efficiency –Implications for business and corporate finance Mitigation of agency problems: market sees through –Implications for investment Impossibility to beat the market Efficient Market Hypothesis (EMH)
6/1/2014 Market Efficiency 4 Random Walk - stock prices are random –Actually submartingale Expected price is positive over time Positive trend and random about the trend Random Walk and the EMH Security Prices Time
6/1/2014 Market Efficiency 5 Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Random Price Changes
6/1/2014 Market Efficiency 7 Case study:Challenger Disaster Jan 28, 1986 at 11:39 am Shuttle explodes on live TV Four companies involved: Rockwell, Martin Marietta, Morton Thiokol and Lockheed. Trading is suspended for 90 min, companies are in no comments mode. Feb. 2 nd : first mention of faulty seals Feb. 5 th : First time MT is mentioned as prime suspect March 31 st : Problems with O-rings reported by Fortune.
6/1/2014 Market Efficiency 9 Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information Grossman-Stigliz Paradox Forms of EMH EMH and Competition Strong All available info,Incl. private Semi- Strong All public Info Weak Old stock prices
6/1/2014 Market Efficiency 10 Econometric tool to study EMH Event study Measure abnormal return Problem: what is normal return? Problem: How to measure event date?
6/1/2014 Market Efficiency 11 Example: Takeover premium before and after introduction of insider trading laws (Bris, 2000)
6/1/2014 Market Efficiency 13 Predicting from past returns
6/1/2014 Market Efficiency 14 Buying losers and selling winners (1) "Contrarian" strategy; the opposite is a "price- momentum" or "relative strength" strategy de Bondt and Thaler (1986) considered all NYSE stock return data from 1926 to 1983. They measured cumulative abnormal returns over 36- month periods and identified the 35 best and worst performers which they called winners and losers. The diagram shows the performance of these stocks over the subsequent months.
6/1/2014 Market Efficiency 16 Buying winners and selling loosers Short-run momentum effect: Select 6mo past winners/loosers and create 0-cost portfolio. Hold it for 3-6 mo. –Industry effect (Grinblatt/Moskowitz) – essentially missed macroeconomic trend –Cross-sectional variability in stock returns (Caul& Condrad, but rejected by Grundy&Martin) Money are lost in 261 out of 828 mo. Feasible only by institutions (high transaction cost)
6/1/2014 Market Efficiency 17 Earnings announcements Bernard and Thomas (1989) and many others before them document that, subsequent to the announcement of earnings, the stock price continues to drift up for "good news" firms and down for "bad news" firms [Price/earnings momentum]. The enclosed figures are based on a sample of approximately 85,000 observations for NYSE and AMEX stocks over the 1974-1986 period.
6/1/2014 Market Efficiency 20 Event driven investing Extension of the same idea to other events: –Analysts forecasts and revisions –Share buy backs –Dividend continuations or not –Etc.. In my opinion, most promising form of active (tactical) investing
6/1/2014 Market Efficiency 21 Newsletters from Graham and Harvey, FAJ, Nov/Dec 97 As a group, newletters do not appear to possess any special information about the future direction of the market (see picture), Nevertheless, investment newsletters that are on a hot streak (have correctly anticipated the direction of the market in previous recommendations) may provide valuable information about future returns.
6/1/2014 Market Efficiency 22 Over the past decade, I have attempted to exploit many of the seemingly most promising inefficiences by actually trading significant amount of money... Many of these effects are surprisingly strong in the reported empirical work, but I have never yet found one that worked in practice. Richard Roll
6/1/2014 Market Efficiency 23 How information is reflected in prices? Via trading and price discovery Via public announcements Via investment research –Analyzing analysts Task Accuracy just how good are analysts at what they do? well examine estimates and recommendations –Evaluating their Decision Making are they better at some things than others? why do they make the errors they make? –Debiasing and Using Analyst Information we do get their info, how best can we use it?
6/1/2014 Market Efficiency 24 What do (sell-side) security analysts do? Tasks? –Estimate industry & company models & EPS –Recommend the best securities –Sell new securities to investors Ultimate Goal? –Find the right price for MSFT or Amazon.com? Not a trivial task... Incentives? –On the folly of rewarding A, while hoping for B
6/1/2014 Market Efficiency 25 Task #1: forecasting EPS EPS: a virtual sub-industry in investing –IBES, First Call, others –A separate II All-American category: EPS accuracy How good are analysts at forecasting EPS? –An opinion: somewhere between mediocre and bad –Dreman and Berry (1995): off by more than 10% over 55% of the time
6/1/2014 Market Efficiency 26 Dreman and Berry, FAJ, 95
6/1/2014 Market Efficiency 27 … and Montier (DKW)
6/1/2014 Market Efficiency 28 Task #1: forecasting EPS (cont.) Why between mediocre and bad ? –In spite of help from the companies –not yet adept at Games Firms Play Incentives of firms Earnings Manipulation to Exceed Thresholds Why? –A discretionary component in EPS? –Listening too carefully to the firms? Or not carefully enough? –Missing the macro-economic trends! See Chopra (FAJ, Nov/Dec 98) Great article!
6/1/2014 Market Efficiency 29 Task #2: recommending stocks Predicting relative stock price performance is hard –Recommendations: a pure test of market skill –Efficient markets argues against success The Catch 22 of market efficiency –The markets need information snoopers –Grossman and Stiglitz: An equilibrium level of inefficiency is needed in markets. The inefficiency is needed to pay the snoopers.
6/1/2014 Market Efficiency 30 Do Brokerage Analysts Recommendations Have Investment Value?, Womack, JF 96 Buy Recommendations –Lots of them –Do move stocks, about 3% on average –Stocks continue to go up 4-6 more weeks Sell Recommendations –1 for every 15 Buys –Taken seriously, -5% –Stocks drift lower for 6 more months, -9%
6/1/2014 Market Efficiency 31 Do Brokerage Analysts Recommendations Have Investment Value?, Womack, JF 96 Removals of Buy Recs –Analysts pick stocks that have recently outperformed by 5%ish –Stocks have negative abnormal returns for 3-4 months after removal –Total underperformance of stocks after a buy removal: - 7%
6/1/2014 Market Efficiency 32 Brokerage Analysts Recommendations, Womack, JF 96 Other conclusions –Smaller stocks respond more, and drift more after recommendations, too –Are the abnormal returns from stock picking or market timing? –Very substantial asymmetry between the value of 1) (the large amount of) positive new and 2) the small amount of negative news When they say sell or remove from buy, watch out!
6/1/2014 Market Efficiency 33 What are analysts good at? A study of Womack: –Reasons analysts give for their recommendations –Then, categorizing them into four or five broad categories, then sub-categories –Two very common categories of reasons its really cheap by relative or historical valuation standards something new is or will happen, new news
6/1/2014 Market Efficiency 34 Can Investors Prophet from the Prophets? by Barber, Lehavy, McNichols & Trueman 99 In a non-event study context, they find that the consensus recommendation average has value –Uses top and bottom quintiles of averages –But, not if you wait 30 days to act on the revisions –Therefore, the important finding of both studies: value of buy recs is gone in a month, but, value of negative recs lasts longer
6/1/2014 Market Efficiency 35 Task #3: Selling new securities Underwriting transactions are highly profitable for firm and analyst –The changing role of security analysts in last decade: theyre now the main pitch people –Compensation to analyst for this is very big (double or triple the salary) 2nd year analyst at M.S offered $500K vs. corporate finance at $250K
6/1/2014 Market Efficiency 36 Why do firms switch underwriters? Krigman, Shaw, and Womack 99 Examined issuers switching to a new lead underwriter for second offering (30% of second-time issuers) –Conducted a survey of switching CFOs –Analyzed other empirical data for switchers vs. non-switchers Research coverage and influential analyst were top reasons to switch –Along with trade up to higher reputation
6/1/2014 Market Efficiency 37 Conflicts of Interest and the Credibility of Underwriter Analyst Recommendations, Michaely and Womack, RFS 99 Are analysts truth telling or rent seeking? –MW examine recommendations by the lead underwriter vs. all other analysts during the first year after the IPO Their behavior is quite suspicious –underwriters recommendations are often called booster shots are more likely to be made by underwriter when stock is doing poorly; not so for non-underwriters!
6/1/2014 Market Efficiency 39 Underwriters Conflicts of Interest: Does the market understand ? Investors do discount the initial info in the underwriters buy recommendation –But, stock still goes up +2.7% (vs. +4.4%) On average, stocks recommended by non- underwriters increase 13% in next six months, market adjusted –But, for underwriters, stocks decrease 5%! Interestingly, most brokerage firms analysts do better on other peoples stocks –For 12 of the 14 large firms, their recs on their own underwritings do worse than their recs on others !
6/1/2014 Market Efficiency 41 Scandals: Spinning: Allocating hot IPOs to the personal brokerage accounts of top executives in return for company business Global settlement bans spinning by major underwriters Laddering: Requiring the purchase of additional shares in the aftermarket in return for IPOs Analyst conflicts of interest: Giving buy recommendations in return for underwriting and M&A business Commission business in return for IPOs: Underwriters allocated IPOs primarily to investors that generated a lot of commissions on other trades
6/1/2014 Market Efficiency 43 Conflicts of Interest Case: Lehman Brothers and RealNetworks 07/11/2000 Stock drops from $52 to $38 in 10 days. Analyst issues report calming investors and reiterating the strong buy 07/18/2000 Stock bounces back. Analyst sends a message to one investor saying RNWK has to be a short big time. He explains its inconsistency regarding public reports: We bank these guys 07/19/2000 One day later, analyst issues report describing quarter results as stellar and reiterating strong buy Lehman co-managed SEO for RealNetworks in June 1999 and kept a strong buy on the stock until June 2001 Source: Global Settlement Letter of AWC for Lehman Brothers days (Jun/2000-Jun/2001) Jan/2001 Stock is already at $9. Analyst explains privately to an investor that RNWK is a short, but does not change its strong buy rating 9
6/1/2014 Market Efficiency 44 Where were regulators?
6/1/2014 Market Efficiency 45 Survey of IPO Investors Do you think that investors expect reputable underwriters to take some account of true investment value in deciding the offering price in an IPO, rather than just the price the market will bear on the day of the offering? 84% agree
6/1/2014 Market Efficiency 46 Survey of IPO Investors Have you done any calculations of what the true fundamental value of a share in the company was, and compared the price of a share with this value? –80% no.
6/1/2014 Market Efficiency 47 Is underwriter bias intentional? Analysts are conflicted between two goals: their long-term reputation (truth telling) and profit generation for their firm –Survey results suggest intentional Kahneman and Lovallo, MS, 93 –The inside view vs. the outside view a very important behavioral concept The most important issue w.r.t. analysts
6/1/2014 Market Efficiency 48 Other possible conflicts & problems Between sell-side and proprietary trading side Analysts invests their own money Other pressure from the management Herding –Follow the crowd –Career concern
6/1/2014 Market Efficiency 49 Using analyst information: conclusions The on average value of analysts info is short- lived and only modestly positive –especially for the positive news My rules-of-thumb: –When hearing a new recommendation: Is the analysts firm the investment banker? What in this is out of consensus? Is is a news or valuation story? –When hearing a negative report: Its probably true.