2Stock market efficiency: Introduction What is efficiency?The value of an efficient marketRandom walksWeak-form efficiencySemi-strong form efficiency
3What is meant by efficiency? In an efficient capital market, security (for example shares) prices rationally reflect available informationIf new information is revealed about a firm, it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movementNo trader will be presented with an opportunity for making a return on a share greater than a fair return for the riskiness associated with that share, except by chanceStock market efficiency does not mean that investors have perfect powers of predictionThe current share price level is an unbiased estimate of its true economic value based on the information revealed
4Efficiency?Market efficiency does not mean that share prices are equal to true value at every point in timeErrors that are made in pricing shares are unbiased; price deviations from true value are randomThere is an equal chance of our being too pessimistic at £7 as being too optimisticPrices are set by the forces of supply and demandHundreds of analysts and thousands of tradersExample: BMW announces a prototype electric car
5What efficiency does not mean Prices do not depart from true economic valueYou will not come across an investor beating the market in any single time periodNo investor following a particular investment strategy will beat the market in the long term
7New information (an electric car announcement by BMW) and alternative stock market reactions – efficient and inefficient
8The value of an efficient market 1 To encourage share buying2 To give correct signals to company managersManagers need to be assured that the implication of a decision is accurately signalled to shareholders and to management through the share priceThe rate of return investors demand on securitiesInformation communicated to the market3 To help allocate resources
10A share price pattern disappears as investors recognise its existence
11The three levels of efficiency 1 Weak-form efficiency. Share prices fully reflect all information contained in past price movements2 Semi-strong form efficiency. Share prices fully reflect all the relevant publicly available information3 Strong-form efficiency. All relevant information, including that which is privately held, is reflected in the share price
12Weak-form testsThere will be no mechanical trading rules based on past movements which will generate profits in excess of the average market return (except by chance)A simple price chartHead & Shoulder’s pattern
14Weak-form tests The filter approach The Dow theory Focus on the long-term trends and to filter out short-term movementsThe Dow theory
15Weak form efficiency - general conclusion The evidence and the weight of academic opinion is that the weak form of the EMH is generally to be acceptedBenjamin Graham: “One principle that applies to nearly all these so-called ‘technical approaches’ is that one should buy because a stock or the market has gone up and should sell because it has declined… the exact opposite of sound business sense everywhere else… we have not known a single person who has consistently or lastingly made money by thus ‘following the market”’
16Return reversalDe Bondt and Thaler (1985)Shares that had given the worst returns over a three-year period outperformed the market by an average of 19.6 percent in the next 36 monthsChopra et al. (1992)Extreme prior losers outperform extreme prior winners by 5–10 per cent per year during the subsequent five yearsArnold and Baker (2005)Loser shares outperformed winner shares by 14 percent per year
17Cumulative market-adjusted returns for UK share portfolios constructed on the basis of prior five-year returnsSource: Arnold and Baker (2007).
18Market-adjusted buy-and-hold five-year test-period returns for loser minus winner strategies for each of the 39 portfolio formationsSource: Arnold and Baker (2007).
19Price (return) momentum Jegadeesh and Titman (1993): a strategy that selects shares on their past six-month returns and holds them for six months, realises a compounded return above the market of per cent per year on averagePossible explanations:Investors underreacting to new informationInvestors overreacting during the test periodRouwenhorst (1998) showed price momentum in 12 developedcountry stock marketsLiu et al. (1999)Hon and Tonks (2003)Arnold and Shi (2005)Tested the strategy over the period 1956 to 2001While on average, winners outperform losers by up to 9.92 percent per year the strategy is fairly unreliable
20Price momentumPortfolios are constructed on six-month prior-period returns and held for six months. Buy-and-hold monthly returns over the six months for the winner portfolio minus the loser portfolio. Each portfolio formation is shown separatelySource: Arnold and Shi (2005).
21Moving averages Brock et al. (1992) If investors (over the period 1897 to 1986) bought the shares in the Dow Jones Industrial Average when the short- term moving average of the index (the average over, say, days) rises above the long-term moving average (the average over, say, 200 days) they would have outperformed the investor who simply bought and held the market portfolio‘However, transaction costs should be carefully considered before such strategies can be implemented’ (Brock et al. 1992)The trading rules did not work in the 10 years following the study period (Sullivan et al. 1999)
22Semi-strong form tests Is worthwhile expensively acquiring and analysing publicly available information?Fundamental analysts try to estimate a share’s true value based on future business returnsMajority of the early evidence (1960s and 1970s) supported the hypothesisSome academic studies which appear to suggest that the market is less than perfectly efficient
23Semi-strong form tests Information announcementsBall and Brown (1968)Seasonal, calendar or cyclical effectsThe weekend effectThe January effectHour of the day effectCease to existHigh transaction costsAccusation of ‘data-snooping’
24Small firmsStudies in the 1980s found that smaller firms’ shares outperformed in the USA, Canada, Australia, Belgium, Finland, the Netherlands, France, Germany, Japan and BritainPerhaps the researchers had not adequately allowed for the extra risk of small shares, betaSome researchers have argued that small firms suffer more in recessionsProportionately more expensive to trade in small companies’ shares‘Institutional neglect’
25The small-cap reversal in the United States and the United Kingdom Source: Dimson, E., Marsh, P. and Staunton, M. (2002) Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton, NJ, and Oxford: Princeton University Press.
26UnderreactionInvestors are slow to react to the release of information in some circumstances‘Post-earnings-announcement drift’Bernard and Thomas (1989): cumulative abnormal returns (CARs) continue to drift up for firms that report unexpectedly good earnings and drift down for firms that report unexpectedly bad figures for up to 60 days after the announcement.The abnormal return in a period is the return of a portfolio after adjusting for both the market return in that period and risk
27The cumulative abnormal returns (CAR) of shares in the 60 days before and the 60 days after an earnings announcementSource: Bernard, V. and Thomas, J., 1989.
28Underreaction Other areas of research into underreaction Ikenberry et al. (1995) share prices rise on the announcement that the company will repurchase its own sharesMichaely et al. (1995) found evidence of share price drift following dividend initiations and omissionsIkenberry et al. (1996) found share price drift after share split announcementsJegadeesh and Titman (1993) found that trading strategies in which the investor buys shares that have risen in recent months produce significant abnormal returnsChan et al. (1996) confirm an underreaction to past price movements (a ‘momentum effect’) and also identify a drift after earnings surprises
29Value investing Low price-earning ratio shares The evidence generally indicates that these shares generate abnormal returns Basu (1975, 1977, 1983), Keim (1988), Lakonishok et al. 1994)Levis (1989), Gregory et al. (2001, 2003)Dispute whether it is the small-size effect that is really being observed Reinganum (1981), and Banz and Breen (1986)Levis (1989), and Gregory et al. (2001), concluded that low PERs were a source of excess returnsInvestors place too much emphasis on short-term earnings dataThe tendency for extreme profit and growth trends to moderate ‘to revert to the mean’(Little (1962), Fuller et al. (1993), Dremen (1998))Lakonishok et al. (1994) found that low PER shares are actually less risky than the average
30Value investingShares that sell at prices which are a low multiple of the net assets per share seem to produce abnormal returnsMany studies have concluded that shares offering a higher dividend yield tend to outperform the marketHigh sales-to-price ratio firms perform better than low sales-to-price firmsCash flow to price ratio (Lakonishok et al. (1994))Costs of issue/arrangementBubbles
31Lecture review An efficient market Types of efficiency The benefits of an efficient marketRandom walkWeak-form efficiencySemi-strong form efficiency