Presentation on theme: "Efficient Markets and Behavioral Critique"— Presentation transcript:
1Efficient Markets and Behavioral Critique CHAPTER 8
2Efficient Capital Market Market in which securities prices reflect all available informationall securities are fairly pricedInvestors get exactly what they pay forFirms get exactly what their stocks and bonds are worth when they sell them.
3Price behavior in efficient market FCC Corporation is developing a camera that will double the speed of the auto-focusing system. It is highly profitable and the NPV will be positive.Day 0 represents the announcement day. Before the announcement day, FCC’s stock sells for $140 per share. The NPV per share is $40, so the new price will be $180 once the value of the new project is fully reflected.Hence, the solid line represents the path of stock price in an efficient market. The price will adjust immediately and no further change in the price of stock will take place later.The broken line represents a delayed reaction. It takes 8 day for the market to fully incorporate the information.The dotted line indicates an overreaction and subsequent adjustment to the correct priceBroken and dotted line show the path of the stock price if markets are inefficient.
5Figure 8-1 Cumulative Abnormal Returns Surrounding Takeover Attempts price response of 194 firms that were targets of takeover attempts
6Figure 8-2 Returns Following Earnings Announcements majority of the profit is in the first 30 minutes
7Three Versions of EMH Weak-form EMH: prices reflect all past info Semistrong-form EMH: prices reflect all public (past¤t) infoStrong-form EMH: prices reflect all (past¤t, public&private) infoStrongSemi-strongWeakFormFormForm
8Three Versions of EMH Weak-form: Semi-strong form Strong form price reflect all past info.using historical data to predict future prices is uselessSemi-strong formprice reflect all public info (current and past)using historical data and available financial statement to predict future price is uselessStrong formprice reflect all information: past, public and privatecannot predict price even with inside information
9Implications of EMH: price follow a random walk Price change randomly or follow a random walk. Why?EMH: price is in equilibrium or reflect the true valuePrice < true value: more investors to buy, push the price up to the true levelPrice > true value: more sell, drive the price down to the true levelPrice will stay at the true level if there is no new infoNew info, price will change accordinglyNew information is unpredictablestock price change is unpredictable
10Implications of EMH: Technical analysis using past info to search for patterns in stock prices to identify mispriced stocksEMH implies that technical analysis is useless because all past info is incorporated in current stock price. If one knows about the pattern, other people will also knowExample: you believe that you discover a pattern in stock price, the price will be $50 tomorrow, up from the current price is 45.you want to buy stock at 45 and sell it tomorrow for 50. Is it possible?If you know, sellers also know about it, the price will be pushed up to 50 before you can buy the stock
11Implications of EMH: Fundamental analysis Technical: look back at the past to forecast future priceFundamental: look ahead to forecast future info and then forecast true price. To forecast stock price, we need future cash flow and discount rateUse available financial statement to forecast earnings and dividends perspectives of the firmsCalculate risk of firm, using CAPM to get the discount ratecalculate the true value and compare with current pricecurrent price > trueCurrent price < trueEMH suggest that fundamental adds little valuepublic info is available to everyonenot much difference in analysts’ reportsprice reflect true valuemust be better than other analysts to make abnormal profit
12Implications of EMH: active and passive portfolio management Active: attempt to find mispriced securitiesPassive: no attempt, just buy and hold a well-diversified portfolioEMH: active is wasted effortsecurities are fairly pricedlose transaction costExample: create a portfolio that follows the index S&P 500
13Implications of EMH for Investment Policy Technical Analysis: uselessFundamental Analysis: adds little valueActive versus Passive PortfolioManagement: passive winsEMHYou can’t “Beat the Market”
14Common Misconceptions about EMH Efficient markets do not mean that you can’t make moneyThey do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returnsMarket efficiency will not protect you from wrong choices if you do not diversify – you still don’t want to put all your eggs in one basket
15The Role of Portfolio Management in an Efficient Market Need for a well-diversified portfolio:Tax considerationshigh tax-bracket: prefer municipal bondhigh tax-bracket: prefer securities that provide capital gains as opposed to interest income since gains are tax less heavilyIndividual considerationsGM executives, performance depends on GM stocks, should not invest too much in auto stocksAge considerationsolder investors might avoid long-term bondyounger might choose long-term bond
16But Are Markets Efficient? Hard question!The Magnitude IssueThe Selection Bias IssueThe Lucky Event Issue
17MagnitudeYou manage a portfolio $1 billion. If the return is 0.1%/year, should make 5 mil/year.A very small deviation from the true price can result in large profitStandard deviation of S&P 500/ year = 20%When a manager makes a lot of money on a large portfolio, does it mean the market is not efficient?
18The selection biasWhen you discover a technique to beat the market, should youpublish it to get reputationkeep it as secrets to make moneyTechnique available in the market is the one that cannot make abnormal profitEMH only looks at those techniques available in market, and conclude that these cannot beat the market, it is not necessarily true.
19Lucky eventRead WSJ, some investors outperform others, is this evidence against EMH?Flip a fair coin, 50% head, 50% tail, 50 times, on average, will get 25 times H, 25 times T.If someone can get more than 25 times H, does it mean he is better than you?
20Test of EMH: weak form-pattern in stock return short-horizon (<1 year): rank stocks based on past performanceWinnerLoserNext 3-12 months, winners continue to outperform losersMomentum strategyLong horizonreversal effect, loser outperform winnerContrarian strategiesFad hypothesisshort term: market overreact to news, sell more losers, price(losers) < true level, buy more winner, price(winner) > true level. Therefore, winner continue to outperform loserLong term: market makes correction, price of loser goes back up to the true level, winner goes back down to the true level, loser outperform winner
21Test of EMH: semi-strong form, test of fundamental analysis Anomalies: evidence that contradicts EMHP/E Effect: low P/E, High returns,Small-firm-in-January effect: Small firm, High return, in January,Neglected-Firm Effect: Less known firms have higher return,Book-to-Market effect: high B/M, high returnsPost-earnings effect: sluggish response of price to earnings announcements
22January effectStudies of returns in the US and other major financial markets reveal strong difference in return behaviors across months of the yearReturns in January is much stronger than returns in any other month of the year. This is called January effect and most of the January effect can be traced to the first 2 weeks of JanuaryThe January effect is much more accentuated for small firms than for large firms
26Explanation for January effect Tax-loss selling by investors: at the end of the year when investors, starting to worry about taxes, sell some stocks that are down so the losses can be written off against capital gains. This selling causes stocks to go down near the end of the year and back up in January when investors buy back the stocks they sold.
27Weekend effectThe weekend effect is another phenomenon that has persisted over time in the US as well as in international markets. It refers to the differences in Monday return and the return of other days in the weekOver the year, the return on Monday has been consistently lower than the return of other days in the week
30Weekend effect: explanations the weekend effect might be the results of bad news being revealed after Friday close and during the weekend.Others state that the weekend effect might be linked to short selling, which would affect stocks with high short interest positions. Or, the effect could simply be a result of traders' fading optimism between Friday and Monday.May be attributed to absence of trading over the weekend. However, this should not be the reason if we consider the return after the holidays. Usually, the returns after holidays are positive not negative
34Response to Earnings Announcements Form stocks into 10 portfolios based on magnitude of earning surprise (difference between historical analysts’ forecast and actual announcement) Portfolio 1 being the lowest, 10 being the highest.Positive surprise firms continue to have positive abnormal return. Negative surprise firms continue to have negative abnormal returnhigher surprise has higher abnormal returnNo explanation so far.
35Figure 8-5 Cumulative Abnormal Returns in Response to Earnings Announcements
36Problems in Testing EMH Most tests require risk adjustmentsRisk adjustment require a model of risk (typically uses CAPM)Tests of risk-adjusted returns are joint testsof the EMH and the risk adjustment procedureRejecting risk-adjustment procedure leavesno conclusions about EMHEMH is essentially untestable..
37Tests of the Strong-form EMH With private info, can we beat the market?SEC regulationsinsider register all trading activitiespublish all these tradesinsider must report large trades to SEC within 2 days
38Are markets efficient?Anomalies: momentum, contrarian, size, book-to-market, P/E ratio, post announcement drift, etc.Evidence against EMHmarket is efficient but sources of risk are not fully identifiedOn going debate
39Reality Check of the Semistrong-form EMH Mutual fund performanceSkilled equity investment professionals do not consistently beat the market.
40Figure 8-6 Estimates of Individual Mutual Fund Alphas
41Figure 8-7 Persistence of Mutual Fund Performance
42ConclusionExample: 2 finance persons walk on street, one see $20 bill, and is going to pick it up, the other says: don’t bother, if it was real money, someone else would have picked it up already.The same idea applies to the marketMarket is very competitive, generally efficient.However the evidence of anomalies suggest that there might be reward for hard-working, intelligent, creative investors.
43Summary Research shows stock prices tend to follow a random walk Three forms of the efficient market hypothesisTechnical analysisFundamental analysisEmpirical studies have generally shown that technical analysis does not generate trading profitsSeveral anomalies exist regarding fundamental analysisProfessionally managed funds generally cannot consistently beat the market