Presentation on theme: "1 C HAPTER 7, L ecture N otes Stock Price Behavior and Market Efficiency Chapter Sections: Introduction to Market Efficiency What Does Best the Market."— Presentation transcript:
1 C HAPTER 7, L ecture N otes Stock Price Behavior and Market Efficiency Chapter Sections: Introduction to Market Efficiency What Does Best the Market Mean? Foundations of Market Efficiency Forms of Market Efficiency Why Would a Market Be Efficient? Some Implications of Market Efficiency Informed Traders and Insider Trading How Efficient are Markets? Market Efficiency and the Performance of Money Managers Anomalies Bubbles and Crashes All Stars of Investing A better name for this chapter might be, Can You Beat the Market? I can calculate the movement of the stars, but not the madness of men. – Sir Isaac Newton
2 Random Walks & Efficient Markets Random Walk Hypothesis The theory that stock price movements are unpredictable In the short term, yes, they appear random In the long term, no (We hope – Failure is not an option!) Efficient Market Hypothesis A market in which securities reflect all possible information quickly and accurately If there are large numbers of knowledgeable investors who react quickly to new information, security prices will adjust quickly and accurately The New York Stock Exchange is an efficient market A Random Walk Down Wall Street
3 Levels of Market Efficiency Weak Efficiency Hypothesis Past data on stock prices are of no use in predicting future prices However, stock prices do tend to demonstrate momentum Stock prices tend to rise more often than they fall And they tend to move far higher than is usually justified (mania, bubble) or far lower than is usually warranted (crash) The market can stay irrational longer than you can stay solvent. John Maynard Keynes If this theory is true, then technical analysis (which we will cover in Chapter 8) is useless.
4 Levels of Market Efficiency Semi-strong Efficiency Hypothesis Abnormally large profits cannot be consistently earned using publicly available information In other words, no amount of analysis that you do to determine the future price of a stock will help you beat the market But there are many, many investors who have We will look at some of them later What does the theory say about those investors? They are just lucky! The more I practice, the luckier I get. (continued) If this theory is true, then fundamental analysis (which we covered in Chapters 6 & 17) is useless.
5 Levels of Market Efficiency Strong Efficiency Hypothesis No information, public or private, allow investors to earn abnormally large profits consistently But one insider information trade can make you rich instantly If you do not get caught, that is… (continued) This is obviously false. If you had material nonpublic information (the legal term for insider information) about a company, you could make a fortune overnight! But you could also go to jail.
6 Market Efficiency Rational The Random Walk and Efficient Market theorists are often also major proponents of index funds They point to the fact that many professional money managers simply do not Beat the Market Especially during bull markets From 1963 to 1998, the S&P 500 index outperformed general equity mutual funds 22 out of 36 times They reason that you are better off accepting (close to) the markets return with low-cost index funds since their theory tells them that no one can consistently beat the market.
7 Market Efficiency Rational Why cant many pros beat the averages? Many mutual funds have high annual operating expenses and high turnover rates, and… Many mutual fund managements have a very short time horizon Consequently, many mutual fund managers have a very short lifespan But the premises and casual observations of the Efficient Market theories show them to be patently absurd Many money managers have Beaten the Market Over long periods of time (the more I practice…) (continued) Plus if markets are efficient and rational, how do you explain …?
8 Manias Occasionally, investors get caught up in what are called manias (a.k.a. bubbles) The Internet bubble of the 1990s was the latest stock mania Before that, there was the Nifty-Fifty of the early 1970s The mania of the 1920s resulted in the Crash of 1929 In the 1840s, there were 400 railroad firms The Granddaddy of all Manias was the Dutch tulip bulb craze of the early 1600s Extraordinary Popular Delusions & the Madness of Crowds The Botany of Desire Each time, the phrase was… Its a New Era or Its Different This Time or The old ways of valuing stock are gone Each time, they were wrong! So much for Rational Efficient Markets!
9 Manias Why do manias occur over and over again? Why havent investors learned their lesson? Any ideas? [market manias] will happen over and over again because the public is infinitely stupid. – Leonard Kaplan, president of commodities brokerage firm Prospector Asset Management in Evanston, Illinois. (continued)
10 Manias Benjamin Graham sez… The speculative public is incorrigible. It will buy anything, at any price, if there seems to be some action in progress. It will fall for any company identified with franchising, computers, electronics, science, technology, or what have you, when the particular fashion is raging. … the abuses are so largely the result of the publics own heedlessness and greed. – The Intelligent Investor, 1972 edition Replace franchising, computers, etc. with Internet, biotechnology, etc. and Good Ol Ben could have been writing in 2000 instead of 1972. Today, the buzz words are social networking and China. (continued)
11 Crashes How do most manias end? Yep – You guessed it! They invariably end with a crash. The bigger the party, the bigger the hangover They are not fun but the odds are you will live through at least one during your investing career With this many strong years, I have the concern that there are a vast majority of companies that are significantly overvalued on a long-term basis. -- Jon Lovelace, August 1999, mutual fund manager with almost 50 years experience at the time Oh, by the way, the 2008/2009 market crash was not caused by a stock market bubble. It was a real estate bubble (and the mortgage- backed bonds that were tied to the real estate mortgages).
12 Crashes DateNet ChangeClose% Decline 19-Oct-1987-508.001,738.74-22.61% 28-Oct-1929-38.33260.64-12.82% 29-Oct-1929-30.57230.07-11.73% 6-Nov-1929-25.55232.13-9.92% 18-Dec-1899-5.5758.27-8.72% 12-Aug-1932-5.7963.11-8.40% 14-Mar-1907-6.8976.23-8.29% 26-Oct-1987-156.831793.93-8.04% 21-Jul-1933-7.5588.71-7.84% 15-Oct-2008-724.008577.91-7.78% 18-Oct-1937-10.57125.73-7.75% (continued) Eleven Worst Days of the Dow Jones Industrial Average
13 Index Funds, Market Indices, Manias, and Crashes Recall: Index funds and ETFs rely on indices Instead of trying to beat the market, just buy the market and be happy with the market return But sometimes an index can become skewed Especially when a sector or region becomes hot Japan, 59.8% P/E: 51.9 All else, 40.2% P/E: 13.0 MSCI EAFE 12/31/89 Info Tech, 33.3% P/E: 59.2 All else, 66.7% P/E: 19.3 S&P 500 3/31/00
14 Anomalies, Silly Theories, Oddities Timing Theories The Monday Effect – Best day to buy (or is it sell?) The January Effect – As goes January, so goes the year The Santa Claus Rally – Turn-of-the-year effect Sell in May and Go Away! September and October – Worst months of the year November to March – Best months of the year Super Bowl Theory National League Wins – bullish American League Wins – bearish Hemlines of skirts Mini skirts – bullish (1920s, 1960s) Long skirts – bearish (1930s, 1970s) Politics and the Stock Markets There are many other silly theories such as the Lipstick Indicator, the Boston Snow Indicator (a.k.a. the BS Indicator), the Hot Waitress Indicator, and the Aspirin Count Theory.
15 All Stars of Investing Peter Lynch Fund Manager of Fidelitys Magellan mutual fund Buy what you know Warren Buffet Dont buy a stock; buy a company Puts emphasis on the value of the entire company Benjamin Graham He was Warren Buffets teacher Father of Value Investing Wrote The Intelligent Investor and Security Analysis John Templeton One of the first mutual fund managers to invest globally
16 All Stars of Investing Bill Miller Fund Manager of Legg Mason Value Trust For 15 years calendar years in a row, he beat the S&P 500, an unprecedented record! He became (unfortunately for him, as far as I was concerned) the financial medias mega-star But then he did not beat the S&P 500 in 2006 and lagged badly in 2007 and 2008 during the turmoil He seemed to redeem himself in 2009 when he was up over 40% beating the 26% return of the S&P 500 But then again trailed the S&P 500 badly in 2010 and 2011 He will be retiring this year I was surprised Legg Mason let him stay as long as they did (continued)
17 All Stars of Investing What do all these people have in common? Courage to not follow the crowd The conventional wisdom is usually not very wise! A eye for unrecognized value Almost a sixth sense Gary Kasparov was once asked why he and Anatoly Karpov were the two best chess players in the world His answer was astonishingly simple and direct We attack better than anybody else and we defend better than anybody else These people bought the best companies and they avoided the worst companies (continued)
18 All Stars of Investing Speaking of avoidance… As a mutual fund investor, I am not looking to find the next Peter Lynch or Bill Miller or Warren Buffet I am looking to avoid the next Charles Steadman Charles Steadman ran his own mutual fund, the Steadman American Industry Fund, from December 1959 until his death in late 1997 His cumulative total return was -42.9% He would have done much better simply placing his investors funds into a savings account at a bank He would have done better putting it in a mattress! Maybe he came from the life insurance industry… (continued)
19 Warren Buffet sez… Be fearful when others are greedy. Be greedy when others are fearful. His mentor, Benjamin Graham said it this way, Buy when most people including experts are overly pessimistic, and sell when they are actively optimistic.
20 John Templeton sez… Bear markets are born of pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy. On a similar note, he also said, To buy when others are despondently selling and sell when others are avidly buying requires the greatest fortitude and pays the greatest reward.
21 Famous Myths & Stupid Sayings It cant go any lower Oh, yes it can! It can go to zero! It cant go any higher Oh, yes it can! If the earnings are continuing to grow, there is no limit to how high the price can go It is only $3 a share – What can I lose? It does not matter how low the price is, the price can go to zero and you can lose all your money Remember: Price is irrelevant; valuation is the key It has to come back Have any of you ever heard of Penn Central?
22 Famous Myths & Stupid Sayings It is always darkest before the dawn Sometimes its always darkest before its pitch black When it rebounds to $10, I will sell A stock has no idea you bought it at $10 If you would not buy it now at this price, sell it now! If it goes down 10%, sell Stock prices fluctuate greatly, even blue chips If you sold each stock that lost 10%, you would almost always sell your winners along with your losers It is taking too long Patience is an investors most important trait Besides, it gives you a chance to buy more! (continued)
23 Famous Myths & Stupid Sayings Look at all the money Ive lost – I didnt buy it Coulda, Woulda, Shoulda You did not lose a cent by not buying a stock that did well – Do not fret over it! I missed that one, I will catch the next one The next one rarely makes it Why wait for the next Microsoft? Buy Microsoft! The stock has gone up, I must be a genius Never mistake a bull market for brains Old Wall Street saying The stock has gone down, I must be an idiot Ditto (but in reverse) (continued)
24 Famous Myths & Stupid Sayings Its Different This Time Well, technically, yes. It is different every time. But that does not mean you should pay an astronomical price for a company that probably will never make a dollar of profit (Hint: Internet stocks) Its a New Era Ditto (When you hear this one, it is time to sell) Its a Permanent Trend Aint No Such Thing! Markets move in cycles. Stocks are too risky Even with all the shenanigans and stupidity, they are still the best long-term financial investment (continued)
25 C HAPTER 7 – R EVIEW Stock Price Behavior and Market Efficiency Next week: Chapter 8, Behavioral Finance and the Psychology of Investing Chapter Sections: Introduction to Market Efficiency What Does Best the Market Mean? Foundations of Market Efficiency Forms of Market Efficiency Why Would a Market Be Efficient? Some Implications of Market Efficiency Informed Traders and Insider Trading How Efficient are Markets? Market Efficiency and the Performance of Money Managers Anomalies Bubbles and Crashes All Stars of Investing