2 Learning Objectives Understand the concept of market efficiency Understand the investment implications of the various levels of market efficiencyDevelop a thorough understanding of the tests of market efficiency and observed market anomalies
3 Market EfficiencyA market is efficient when it uses all available information is quickly incorporated into prices.Efficiency is the degree to which prices reflect available information.If prices reflect all available information then what causes prices to move?
4 New InformationWhen information is released it contains two componentsAnticipated: Information already included in the priceUnexpected: New information that is not currently pricedThe market prices assets based on what is expected to happen (Anticipated Information)Unexpected information causes the market to change its expectations → Moving pricesResult: Prices change until expected returns are exactly commensurate with risk.
8 Why are price changes random? Prices react to informationFlow of information is randomResults in random price changes
9 How prices moveStock prices are the consequence of intelligent investors competing to discover relevant informationThese discoveries occur randomlyWe expected returns to generally be positive over timeThese two trends results in stock prices having:→Positive trend with random movements around trendDraw graph with price on Y-axis, Time on X-axis, and upward trend line (expected price) and random price movements around trend line.
10 Information The MOST precious commodity on Wall Street Strong competition assures prices reflect information.The first to learn something new will make moneyThe marginal return on research activity may be so small that only managers of the largest portfolios will find them worth pursuing.Only ones with enough capital to make it worth whileCan use leverage to juice returns
11 The Value of Information: Real Ex Pacific Century CyberworksWas going to be added to Hong Kong Index, in a major waySince Index would be buying up shares, price would rise, so everyone started buying sharesOne investor in Japan went to Hong Kong to get as much information about the deal as possibleDiscovered the share weren’t being bought on the marketShares would come from the founder, increasing the supplyWhat do the investors who bought need to do?What does our investor do?Short and made millions in minutes
12 Potential Causes of Efficient Markets Investor RationalityEveryone is rational → Everyone makes the right decisionIndependent Deviation from RationalityNo one is rational → Everyone makes the wrong decision but each makes a different wrong decisionAverage out the wrongnessArbitrageOnly some people are rational → Smart money takes from less smart money
13 Types of Efficient Markets StrongSemi-StrongWeak
14 Weak Form EfficiencyPrices reflect all information contained in past prices and volumesNo investor is able to form a trading strategy based on historic prices and volumes and earn an excess return
15 Disbelievers Chartists, or Technical Analysts Analyze “charts” of a stock‘s Price and/or VolumeChartist believe in identifiable and predictable patterns in these characteristicsMake investment decisions based on these patternsBrokerage firms tend to love chartists
18 Why Technical Analysis Fails Stock Price-If there is a profitable pattern, everyone would do it-If everyone follows the same strategy competition will eliminate any opportunity associated with the patternSellSellBuyBuyTime
19 Semi-Strong Form Efficiency Security prices reflect all publicly available information.Encompasses weak form efficiencyPublicly available information includes:Historical price and volume informationPublished accounting statementsInformation found in the WSJ
20 Disbelievers Fundamental Analysts Use economic and accounting information to predict stock pricesTry to find firms that are better than everyone else’s estimate.Try to find poorly run firms that are not as bad as the market thinks.
22 Strong Form Efficiency Strong form efficiency says that anything pertinent to the stock price and known to at least one investor is already incorporated in the security’s price.Public & PrivateImplies: Insider trading will not earn excess returnStrong form efficiency incorporates weak and semi-strong form efficiency.
23 Disbelievers Pretty much everyone Insiders trading is generally profitableGalleonRaj Rajaratnam
24 EMH: Active v Passive Management Passive Management: Believes the market is efficient → Does NOT attempt to outsmart the marketBuy well-diversified portfolios without looking for mispricingIndex Funds and ETFsActive Management: Believes the market is not perfectly efficient → Hunts for mispricingAn expensive strategySuitable only for very large portfolios
25 Are Markets Efficient: Will the Debate End Wall Street is predicated on the idea that the market is inefficient, Academics general need an efficient marketMagnitude IssueOnly managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort.Selection Bias IssueOnly unsuccessful investment schemes are made public; good schemes remain private.Lucky Event Issue
26 Weak-Form Efficiency Tests Look for patterns in stock returnsReturns over the Short HorizonMomentum: Good or bad recent performance continues over short to intermediate time horizonsReturns over Long HorizonsReversal Effect: Episodes of overshooting followed by correction
29 Average Annual Return: 10 Size-Based Portfolios, 1926-2010
30 Average Annual Return as Function of Book-to-Market Ratio, 1926-2010
31 Event StudiesStudy the impact of a particular event on a firm’s stock price.EX: Earnings or Dividend announcementsTest of the Semi-Strong EMHLook at how quickly prices adjust to the announcementLooking for under, over, early, delayed reactions
32 Event Studies: Dividend Omissions Efficient market response to “bad news”S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997).
34 Interpreting the Anomalies The most puzzling anomalies are price-earnings, small-firm, market-to-book, momentum, and long-term reversal.Fama and French argue that these effects can be explained by risk premiums.Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets.
35 Interpreting the Evidence Anomalies or data mining?Some anomalies have disappeared (e.g. size).Book-to-market, size, and momentum may be real anomalies as they exist in many markets and asset classes around the world.
36 Mutual Funds Performance If the market is semi-strong form efficient, then mutual fund managers, should not be able to consistently beat the average market returnWhen we compare the record of mutual fund performance to a market index, we see that mutual funds are not able to CONSISTENTLY beat the market.Consistent with the market being semi-strong form efficient
37 Figure 8.8 Persistence of Mutual Fund Performance
38 Figure 8.9 Risk-Adjusted Performance in Ranking Quarter, Following Quarter
39 Mutual Fund Performance Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
40 So, Are Markets Efficient? The performance of professional managers is broadly consistent with market efficiency.Most managers do not do better than the passive strategy.There are, however, some notable superstars:Peter Lynch, Warren Buffett, John Templeton, George Soros
41 Efficient Markets & Portfolio Management Even if the market is efficient a role exists for portfolio management:DiversificationAppropriate risk levelTax considerations
42 Efficient Markets & Resource Allocation If markets were inefficient, resources would be systematically misallocated.Firm with overvalued securities can raise capital too cheaply.Firm with undervalued securities may have to pass up profitable opportunities because cost of capital is too high.Efficient market ≠ perfect foresight market
43 EMH ExercisesIndicate whether or not the EMH is contradicted, if so which form of EMH is contradictedAn investor consistently earn an abnormal return over that expected by the market by examining charts of historical pricesThe acquisition of the latest annual report of a company enables an investor to earn an abnormal return.A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows.By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments.