Presentation on theme: "EFFICIENT CAPITAL MARKETS"— Presentation transcript:
1EFFICIENT CAPITAL MARKETS Chapter 10EFFICIENT CAPITAL MARKETS
2Chapter 10 QuestionsWhat do we mean when we say that capital markets are efficient?Why should capital markets be efficient?What factors contribute to an efficient market?Given the overall efficient market hypothesis (EMH), what are the three subhypotheses and what are the implications of each of them?
3Chapter 10 QuestionsHow does one test the three efficient market subhypotheses, and what are the results of the tests?For each set of tests, which results support the EMH and which indicate an anomaly related to the hypothesis?What are the implications of the results for stock strategies and portfolio managers?What is the evidence related to the EMH for markets in foreign countries?
4Efficient Capital Markets In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices reflect all information about the securityWhether markets are efficient has been extensively researched and remains controversial
5Why does it matter?If prices do fully reflect all current information, it would not be worth an investor’s time to use information to find undervalued securities.If prices do NOT fully reflect information, FIND AND USE THAT INFORMATION, and perhaps you will be able to make a killing in the market.
6Investing and Market Efficiency Would stock selection amount to throwing darts at a wall in an efficient market?Hardly! Risk still matters. We would still want to research the risk-return properties of securities.
7Why Should Capital Markets Be Efficient? What would be the ingredients of an “informationally” efficient market?A large number of profit-maximizing participants analyze and value securitiesNew information regarding securities comes to the market in a random fashionProfit-maximizing investors adjust security prices rapidly to reflect the effect of new informationPrice adjustments are unbiased – correct on average.Under these conditions, a security’s price would be appropriate for its level of risk.
8Alternative Efficient Market Hypotheses The various forms of the efficient market hypothesis differ in terms of the information that security prices should reflect.Weak-form EMHSemistrong-form EMHStrong-form EMH
9Weak-Form EMHCurrent prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated informationThis implies that past rates of return and other market data should have no relationship with future rates of return
10Implications of the Weak-From EMH Examining recent trends in price and other market data in order to predict future price changes would be a waste of time if the market is weak-form efficient.A lot of people do price charting and other forms of “technical analysis.”
11Semistrong-Form EMHCurrent security prices reflect all public information, including market and non-market informationThis implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
12Implications of the Semistrong-Form EMH If the market is efficient in this sense, information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.
13Strong-Form EMHStock prices fully reflect all information from public and private sourcesThis would require perfect markets in which all information is cost-free and available to everyone at the same time (which is clearly not the case)Implication: Not even “insiders” would be able to “beat the market” on a consistent basis
14Tests and Results: Weak-Form EMH Two ApproachesTests of “statistical memory” in security prices and returnsTests of trading rules
15Tests and Results: Weak-Form EMH Statistical tests of independence between rates of returnAutocorrelation testsMostly support the weak-form EMH and indicate that price changes are randomSome studies using more securities and more complicated tests cast some doubtRuns testsIndicate randomness in prices
16Tests and Results: Weak-Form EMH Comparison of trading rules to a buy-and-hold policySome filter rules seem yield above-average profits with small filters, but only before taking into account the substantial transactions costs involvedTrading rule results have been mixed, and most have not been able to beat a buy-and-hold policy
17Tests and Results: Weak-Form EMH Problems with testsCannot be definitive since trading rules can be complex and there are too many to test them allTesting constraintsUse only publicly available dataShould include all transactions costsShould adjust the results for risk (an apparently successful strategy may just be a very risky strategy)
18Conclusions: Weak-Form EMH Results generally support the weak-form EMH, but results are not unanimousSome strategies too subjective to testNot all trading rules are disclosedIf you had a trading strategy that worked, would you reveal it?!
19Reality Check!If someone writes a book on how to “beat the market,” you can bet that book sales are more lucrative than the trading strategy!Even if it once worked, if it’s widely known, it won’t work any more!Don’t quit your day job to trade on-line using a published strategy!
20Tests and Results: Semistrong-Form EMH Three different groups of tests:Time series analysis using public informationEvent studies examine how fast stock prices adjust to significant economic eventsCross-sectional analysis of returns based on public informationTests involve the estimation of “abnormal returns,” where expected abnormal returns are zero in an efficient market.
21Tests and Results: Semistrong-Form EMH Tests often involve “market-adjusted returns,” created by subtracting the market return from the security’s return, thereby defining a security’s “abnormal return:”ARit = Rit - Rmtwhere:ARit = abnormal return on security i during period tRit = return on security i during period tRmt = return on a market index during period t
22Tests and Results of Semistrong-Form EMH Another definition of abnormal return is a “risk-adjusted return” or “market model” which adjusts for the security’s own required rate of return, given its systematic risk (as measured by beta):ARit = Rit - E(Rit)where:E(Rit) = the expected rate of return for stock i during period t based on the market rate of return and the stock’s normal relationship with the market (its beta)
23Tests and Results: Semistrong-Form EMH Time series tests for predictability of returns and profit opportunitiesShort-horizon returns have shown very limited predictabilityLong-horizon returns analysis shown some predictability of returns based on:Dividend yield (D/P)Default spreadTerm structure spread
24Tests and Results: Semistrong-Form EMH Time series tests for predictability of returns and profit opportunitiesQuarterly earnings reports informationUnanticipated earnings changes or “earnings surprises” are not immediately reflected in security pricesThe January Anomaly (A “calendar” effect)Large returns in January present opportunities to purchase in December, and sell in January and earn abnormal returns.
25Tests and Results: Semistrong-Form EMH Time series tests for predictability of returns and profit opportunitiesOther calendar effectsMonthly effectDay-of-the-week effectsMonday returns were significantly negative
26Tests and Results: Semistrong-Form EMH Predicting cross-sectional returnsIn an efficient market, all securities should have equal risk-adjusted returnsStudies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returnsThese tests include a joint hypothesis of both market efficiency and the asset pricing model used to generate abnormal returns
27Tests and Results: Semistrong-Form EMH Predicting cross-sectional returnsPrice-earnings ratiosExamine historical P/E ratios and returnsLow P/E stocks had higher risk-adjusted returns than high P/E stocksPublicly available P/E ratios could be used for abnormal returnsPrice-earnings/Growth ratiosMixed results
28Tests and Results: Semistrong-Form EMH Predicting cross-sectional returnsThe size effectThe risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firmsAbnormal returns could occur because either markets are inefficient or the market model is not properly specified and provides incorrect estimates of risk and expected returns (joint test)
29Tests and Results: Semistrong-Form EMH Predicting cross-sectional returnsThe size effectAdjustments for riskiness of small firms did not explain the large differences in rate of returnThe impact of transactions costs of investing in small firms is substantial (takes away the differential with a short-term trading strategy)Even after risk and transaction costs, small firms outperform large firms with annual tradingThe small-firm effect is not stableFirm size is an important anomaly
30Tests and Results: Semistrong-Form EMH Predicting cross-sectional returnsNeglected firms and trading activityIs there an effect related to the number of analysts following a stock and how frequently a stock trades?Mixed results, mostly any apparent effects explained by taking the size effect into consideration
31Tests and Results: Semistrong-Form EMH Predicting cross-sectional returnsBook value-market value (BV/MV) ratioSignificant positive relationship between the current values for this ratio and future stock returnsAlthough various measures including the P/E ratio seem to help predict future returns, the size effect and BV/MV ratio have the greatest predictive ability.
32Tests and Results: Semistrong-Form EMH Event studiesEvent studies examine abnormal returns surrounding various eventsThe EMH is that abnormal returns are zeroStock split studiesMostly show no positive impact on returns because of a stock splitInitial public offeringsSignificant IPO underpricing, but it quickly adjust away in the first day, consistent with the EMH
33Tests and Results: Semistrong-Form EMH Event studiesExchange listingsSome evidence of short-term profit potential following the “listing announcement”Unexpected world events and economic newsQuickly reflected in security prices, do not provide opportunities
34Tests and Results: Semistrong-Form EMH Event StudiesAnnouncements of accounting changesQuickly reflect in security prices and do not seem to provide abnormal profit opportunitiesCorporate eventsPrices react quickly to announcements of mergers, financing decisions, etc.No systematic profit opportunities
35Summary on the Semistrong-Form EMH Evidence is mixedStrong support of the EMH from numerous event studies with the exception of exchange listing studiesStrong evidence against the EMH from both time series and cross-sectional studiesDividend yields, earnings surprises, calendar effectsThe size effect, BV/MV, P/E ratios, etc.
36Tests and Results: Strong-Form EMH Testing Groups of InvestorsTests usually center on whether any group of investors consistently earn abnormal profits.Corporate insidersStock exchange specialistsSecurity analystsProfessional money managers
37Tests and Results: Strong-Form EMH Corporate InsidersInsiders include major corporate officers, directors, and owners of 10% or more of any equity class of securitiesInsiders must report to the SEC each month on their transactions as insidersThese insider trades are made public about six weeks later and allow for study
38Tests and Results: Strong-Form EMH Corporate InsidersMixed resultsCorporate insiders generally experience above-average profits especially on purchase transactionsThis implies that many insiders had private information from which they derived above-average returns on their company stockLater studies indicate that insiders may no longer be able to generate abnormal returns
39Tests and Results: Strong-Form EMH Stock Exchange SpecialistsSpecialists have monopolistic access to information about unfilled limit ordersYou would expect specialists to derive above-average returns because of their superior information, and this appears to be the case.
40Tests and Results: Strong-Form EMH Security AnalystsTests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocksThis looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendation
41Tests and Results: Strong-Form EMH Security AnalystsThe Value Line EnigmaFirms ranked 1 for “timeliness” substantially outperform the market; firms ranked 5 substantially underperform the marketPrices now adjust quickly to changes in rankingsNet of transaction costs, rankings do not appear to have value in terms of producing abnormal returnsThere is some evidence of superior analysts who apparently posses private information
42Tests and Results: Strong-Form EMH Professional Money ManagersTrained professionals, working full time at investment managementIf any investor can achieve above-average returns, it should be this groupIf any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct
43Tests and Results: Strong-Form EMH Professional Money ManagersMost tests examine mutual fundsRisk-adjusted returns of mutual funds generally show that most funds did not match aggregate market performance
44Summary on the Strong-Form EMH Mixed resultsSome strong supportProfessional money managersSome strong evidence against the EMHTests for corporate insiders and stock exchange specialists do not support the hypothesisBoth groups seem to have monopolistic access to important information and use it to derive above-average returns
45Behavioral Finance A growing field of study in finance. Rather than assuming ultra-rational behavior, the area of behavioral finance seeks to incorporate how humans actually behave.Incorporates the ways in which psychology may impact investment decisionsIt has been useful for explaining various “anomalies” that we observe in decision-making that are difficult to reconcile with rationality
46Behavioral Finance Using psychological biases to explain behavior Why do investors persistently “ride” losers and sell winners?Can be explained by prospect theoryWhy do investors display overconfidence in forecasts?Can be explained by the confirmation biasWhy do investors tend to put more money into failing investments?Can be explained by the escalation bias
47Implications of Market Efficiency Overall results indicate the capital markets are efficient as related to numerous sets of informationThere are substantial instances where the market fails to rapidly adjust to public informationSo, what techniques will or won’t work?What do you do if you can’t beat the market?
48Efficient Markets and Technical Analysis Assumptions of technical analysis directly oppose the notion of efficient marketsTechnicians believe that stock prices move in patterns that persist and are predictable to the informed investor.Technical analysts develop systems to detect trends and patterns in pricesIf the capital market is weak-form efficient, a trading system that depends on past trading data can have no value
49Efficient Markets and Fundamental Analysis Fundamental analysis involves determining an investment’s intrinsic values based on company and economic “fundamentals”The intrinsic value is compared to the market price to determine whether the investment is undervalued or overvaluedIn an efficient market, prices already reflect public information, so determining “intrinsic value” using that information is not a worthwhile exercise
50Efficient Markets and Fundamental Analysis Past vs. FutureThe EMH, importantly, considers the incorporation of available information, which is primarily historic in nature.Much of what is involved in fundamental analysis, including aggregate market analysis and industry analysis, involves estimating future values.Superior analysts are those who will be better at predicting this uncertain future.
51Efficient Markets and Portfolio Management Does active portfolio management pay off?Research indicates that most money managers do keep pace with the marketCertainly with a superior analyst, recommendations should be followedOpportunities may be present in smaller, neglected stocks (although risk must be taken into account)
52Efficient Markets and Portfolio Management Without superior analysts, passive management may outperform active managementBuild a globally diversified portfolio with a risk level matching client preferencesMinimize transaction costs (taxes, trading turnover, liquidity costs)
53The Rationale and Use of Index Funds Efficient capital markets and a lack of superior analysts imply that many portfolios should be managed passively (so their performance matches the aggregate market, minimizes the costs of research and trading)Institutions created market (index) funds which duplicate the composition and performance of a selected index series
54Insights from Behavioral Finance There may be trading opportunities created by persistent investor biases and “herd mentality”Supports the notion of contrarian investment strategiesSome mutual funds employ behavioral finance strategies
55Efficiency in European Equity Markets Hawawini study indicates behavior of European stock prices is similar to U.S. common stocksDespite market differences, most results are essentially similarAppropriate to assume a similar level of efficiency in European markets to those in the United States