1. Professor John Zietlow MBA 621 Market Efficiency & Modern Financial Management Chapter 10

2. Market Efficiency & Modern Financial Management Introduction to market efficiency –Key feature of modern economic thought & market workings Efficiency in financial versus product markets –Why financial markets tend to be more competitive & efficient What is an efficient market? –The three forms of market efficiency The three “forms” of market efficiency –Weak form, semi-strong form, and strong-form efficiency What does market efficiency imply for corporate financial management? –How do markets process firm-specific information releases? –How should managers communicate with investors & analysts?

3. Financial Versus Product Markets Many examples of corporations creating value through real asset investments –R&D, product innovations, marketing programs create value –Few product markets (except commodities) approach perfect competition standard –Manufactured goods face barriers to entry (branding, capital requirements, physical distribution costs) Far fewer opportunities to create value through purely financial activities –Financial markets much larger, more competitive, more transparent, more homogeneous than product markets –Innovations cannot be patented; easily immitated –Arbitrage is easy & safe; keeps relative prices in line Much harder to create value thru purely financial activities

4. What Is An Efficient Market? Most people equate efficiency with competitiveness –For product markets, this is reasonably correct –For financial markets, “efficiency” is less clear-cut Three ways to define “efficiency” of financial markets –Informational efficiency most important for financial markets –Allocative efficiency: Measures whether financial markets allocate capital to its highest and best use. –Operational efficiency: (aka technical efficiency) Measures whether outputs are produced at lowest possible input cost. –Informational efficiency: Measures whether markets react fully and instantaneously to new information. The “Efficient Markets Hypothesis” (EMH) first formally proposed in 1970 by Eugene Fama –Described how financial markets process information, and defined three “forms” of informational efficiency.

5. Economic Definitions Of Efficiency FormDefinitionExample AllocativeA financial system exhibits allocative efficiency if it allocates capital to its highest and best (most productive) use. Stock market investors shun security offers from firms in declining industries, but welcome offerings from firms in more promising industries. OperationalA financial system exhibits operational efficiency if it produces a given output at lowest possible input cost-- or, alternatively, it maximizes output for any given level of inputs. Average daily trading volume on the New York Stock Exchange now over 10 times its level of 20 years ago--in the same Wall Street location. The NASDAQ market’s trading volume has increased even more. InformationalIn a market exhibiting informational efficiency, asset prices incorporate all relevant information fully and instantaneously. When company A receives a takeover bid from company B that seems certain to succeed, the stock price of A increases immediately to reflect the per share bid premium.

6. Three Forms Of Market Efficiency FormDefinitionExample Weak Form Financial asset (stock) prices incorporate all historical information into current prices; future stock prices cannot be predicted based on an analysis of past stock prices. Nothing of value is to be gained by analyzing past stock price changes, since this doesn’t help you predict future price changes. Renders “technical analysis” useless. Semi- strong Form Stock prices incorporate all publicly available information (historical and current); there will not be a delayed response to information disclosures. The relevant information in an SEC filing will be incorporated into a stock price as soon as the filing is made public. Strong Form Stock prices incorporate all information--private as well as public; prices will react as soon as new information is generated, rather than as soon as it is publicly disclosed. Stock prices will react to a dividend increase as soon as the firm’s board of directors votes--and before the board announces its decision publicly.

7. Were Internet Values A Bubble?

8. Random Walks And Technical Analysis Even weak form (WF) market efficiency suggests that stock price changes are not predictable based on past changes –Expressed mathematically as: P t = P t-1 + Expected return + Random error The random component not predictable, so if WF efficiency holds, stock prices should follow a random walk –Could be a pure random walk, or a “random walk with drift” WF efficiency alone enough to make technical analysis useless--and empirical testing supports this –Figure shows how investor behavior tends to eliminate cyclical patterns in stock prices –Figure shows two widely believed technical patterns Another implication: stock price changes should be serially uncorrelated, and tests show very low corr for most stocks

9. Simulated & Real Price Movements: Which Is Which? Simulated market levels for 52 weeksActual DJIA closing prices for 52 weeks Source: Harry V. Roberts, “Stock Market “Patterns” and Financial Analysis: Methodological Suggestions,” Journal of Finance 14 (March 1959), pp. 1-10.

10. Technical Analysis Patterns; Double Tops

11. Technical Analysis Patterns; Double Bottoms

12. Technical Analysis Patterns; Head And Shoulders

13. Technical Analysis Patterns; Inverse Head And Shoulders

14. Potential Returns From An Overreaction Strategy

15. Implications Of Semi-Strong Form Efficiency Semi-strong form (SSF) efficiency says prices reflect all publicly available information. Several ways to test: –Event studies measure market response to a corporate announcement by lining dates up in “event time” –Measure cumulative abnormal returns (CAR) after event announcement on day t=0 Another test of SSF efficiency is to see if mutual fund managers can out-perform S&P 500 after expenses –Most studies show managers under-perform S&P 500, even before taking account of expenses –“Superstar” fund managers (Warren Buffett, Peter Lynch) identified due to severe selection bias [Malkiel, JF 1995] Other tests show prices react efficiently to new information –Also find that purely accounting rule changes that do not affect cash flow--or which can be predicted--have no impact

16. Survivorship Bias And Measured Returns On Mutual Funds, 1982-1991 [Malkiel JF 95] 17.5217.0915.69All General Equity Funds 17.5216.9015.66Equity Income Funds 17.5216.4115.97Growth & Income Funds 17.5214.0313.46Small Comp Growth Funds 17.5217.8915.81Growth Funds 17.52%18.08%16.32%Capital Appreciation Funds S&P 500 Index Return Funds That Survive From 1982-1994 All Funds In Existence Each Year

17. Can Security Analysts Beat The Market? Portfolio Returns Based on Analysts’ Forecasts

18. How Do Markets React To Corporate Financing Announcements? Studies show the following announcements are taken to be “good news” causing stock prices to rise, on average: –Dividend initiations and increases, share repurchases –Leverage increasing transactions (i.e., debt-for-equity swaps) –Acquisitions paid for with cash, spin-offs & divestitures –Some new debt offerings--especially bank loan renewals –Control-concentrating events (new blocholder announced) Following announcements received as “bad news” –Dividend cuts or suspensions (catastrohpic news) –Adoption/proposal of anti-takeover defenses –Any type of equity financing (including convertibles) –Merger financed with new stock issue –Any focus-decreasing transactions (diversification strategies)

19. The First Event Study--Stock Splits Average stock price response to the “event” of a stock split. The stock prices are lined up In “event time,” where the month of the stock split is t=0. Because all of the information in the stock split is incorporated into stock prices by the event date, there is on average no tendency for prices to change after the split.

20. How Do Markets Process Accounting & Other Information Releases? Managers often obsess about accounting policies and other things that do not affect cash flow –LIFO vs FIFO accounting, FASB 52, capitalization of leases all did not affect stock prices. –Studies show acctg rules that don’t impact taxable profits--or which are already disclosed--don’t impact stock prices. Other accounting rules/policies are extremely important to market participants –Any policies that impact taxable earnings –Rules governing accounting for stock options and pooling vs purchase treatment of M&A currently very controversial Basic rule: Assume investors cannot be consistently “fooled” by accounting gimmicks

21. “Contrary” Evidence About Semi-Strong Form Efficiency Not all empirical evidence totally supports market efficiency –Small Firm effect: small firms out-perform large, and most of 5% excess return occurs in January (January effect) –Temporal anomalies: January effect (all firms), Monday effect –Value vs glamour stocks: High book-to-market (value) stocks out-perform low book-to-market (glamour) stocks Many people feel that “bubbles” form quite frequently in financial asset prices –South Sea Company, Tulip Mania early examples –Japanese stock prices late 1980s –NASDAQ prices through March 2000 Though issue remains unresolved, mass of evidence strongly supports SSF market efficiency

22. The Strong Form Of Market Efficiency Says prices should reflect all information--public & private –Usually tested by seeing if corporate insiders earn superior returns on their trades in company stock –Evidence suggests insiders can “beat the market,” but those who trade on SEC filings by insiders cannot –Trading by insiders can be legal; “Insider trading” is illegal, but can be highly profitable Insiders’ ability to earn superior returns on stocks suggest their decision to trade at corporate level may be informative –If they think stock price too high, they will sell new stock –If they think stock price too low, they can re-purchase shares –Can affect their decision to use cash or stock in mergers Also some evidence that managers can “time” new issues –Loughran & Ritter show IPOs and SEOs severely under- perform after issuance

23. Bubble Or Rational Value? U.S. Stock Prices Versus Earnings, 1871-2000

24. Bubble Or Rational Value? U.S. Stock Prices Versus P/E Ratios, 1871-2000

25. Theoretical Models of Overreaction And Underreaction

26. How To Devise A Corporate “Communications” Policy Market efficiency has clear implications for how a wise manager should “communicate” with investors –Press coverage can be both bane & benefit –Fortune 500 CEOs give more public speeches than politicians Assume Your Actions (& Words) Have Consequences –Try to predict how a particular announcement will be interpreted by investors and be ready to respond if they actually respond differently. True for both good & bad news. –Don’t withhold info that will likely come out anyway. Loose Lips Sink Corporate Ships –Do not discuss publicly information that should be kept private, or to prematurely disclose sensitive information. –Try not to comment on earnings speculation unless necessary--then say as little as possible

27. How To Devise A Corporate “Communications” Policy (Continued) Honesty is the Best Policy –Managers who convey good and bad information honestly-- and who do not try to fool the market --will be believed, while managers with reputations for deception will not be. –Managers also develop reputations for maximizing or squandering shareholder wealth. Listen to Your Stock Price –There are essentially two types of information that markets convey to managers: (1) reactions to specific corporate announcements, and (2) movements in the firm’s stock price relative to the overall market over extended periods of time. Both can be very informative to the sentient manager. The company is always for sale –Unless you own 100% of the stock, you should always be ready to sell to a bidder if the price is high enough