1. Version 1.2 Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department Harcourt, Inc. 6277 Sea Harbor Drive Orlando, Florida 32887-6777 Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 7

2. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 7 Efficient Capital Markets Questions to be answered: What is meant by the concept that capital markets are efficient? Why should capital markets be efficient? What are the specific factors that contribute to an efficient market? Given the overall efficient market hypothesis, what are the three subhypotheses and what are the implications of each?

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 7 Efficient Capital Markets How do you test the weak-form efficient market hypothesis (EMH) and what are the results of the tests? How do you test the semistrong-form EMH and what are the test results? How do you test the strong-form EMH and what are the test results? For each set of tests, which results support the hypothesis and which results indicate an anomaly related to the hypothesis?

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 7 Efficient Capital Markets What are the implications of the results for –Technical analysis? –Fundamental analysis? –Portfolio managers with superior analysts? –Portfolio managers with inferior analysts? What is the evidence related to the EMH for markets in foreign countries?

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Capital Markets In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security Whether markets are efficient has been extensively researched and remains controversial

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. Why Should Capital Markets Be Efficient? The premises of an informationally efficient market: –A large number of competing profit-maximizing but risk- averse participants analyze and value securities, each independently of the others –New information regarding securities comes to the market in a random fashion –Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information Conclusion: the expected returns implicit in the current price of a security should reflect its risk

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. Alternative Efficient Market Hypotheses Early work was based on the random walk hypothesis, which Fama presented in terms of a “fair game” model

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. Alternative Efficient Market Hypotheses The difference between the actual price and the expected price can be defined as This defines excess market value, which in an efficient market should equal zero

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. Alternative Efficient Market Hypotheses Implies that, on average, realized returns should equal expected returns –I.e., returns that are realized on stock investments should, on average, be equal to the returns that had been expected, –given some set of information on which to form the expectations

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. Alternative Efficient Market Hypotheses There are three general forms of the EMH: –Weak-form efficient market hypothesis –Semistrong-form EMH –Strong-form EMH These differ based on the information set (  t ) that is assumed

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. Weak-Form EMH Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information This implies that past rates of return and other market data should have no relationship with future rates of return

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. Semistrong-Form EMH Current security prices reflect all public information, including market and non- market information This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. Strong-Form EMH Stock prices fully reflect ALL information from public and private sources This implies that no group of investors should be able to consistently derive above-average risk- adjusted rates of return This assumes perfect markets in which all information is cost-free and available to everyone at the same time –not always the case, even in the age of the internet –another problem – some information may really be misinformation or “noise”

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Weak-Form EMH Statistical tests of independence between rates of return –Autocorrelation tests have mixed results –Runs tests indicate randomness in prices

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Weak-Form EMH Comparison of trading rules to a buy-and-hold policy is difficult because trading rules can be complex and there are too many to test them all –Filter rules yield above-average profits with small filters, but only before taking into account transactions costs –Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Weak-Form EMH Testing constraints –Use only publicly available data –Include all transactions costs –Adjust the results for risk

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Weak-Form EMH Results generally support the weak-form EMH, but results are not unanimous

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Studies to predict future rates of return using public information beyond market information –Time series analysis –Cross-section distribution Event studies examine how fast stock prices adjust to significant economic events

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Test results should adjust a security’s rate of return for the rates of return of the overall market during the period considered: Ar it = R it - R mt where: Ar it = abnormal rate of return on security i during period t R it = rate of return on security i during period t R mt =rate of return on a market index during period t This was the adjustment made by researchers before 1970; subsequently, researchers also adjusted for the level of the stock’s beta

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Ar it = R it - E(R it ) where: –E(R it ) = 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)

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Time series tests for abnormal rates of return –short-horizon returns have limited results –long-horizon returns analysis has been successful based on dividend yield (D/P) default spread term structure spread –Quarterly earnings reports may yield abnormal returns due to unanticipated earnings change

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Tests of standardized unexpected earnings (SUE) normalize the difference in actual and expected earnings by the standard error of estimate from the regression used to derive the expected earnings figure SUE = Reported EPS t - Predicted EPS t Standard Error of Estimate for the Estimating Regression Equation

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Large SUEs result in abnormal stock price changes, with over 50% after the announcement Unexpected earnings can explain up to 80% of stock drift over a time period Tend to follow a pattern of under-reaction followed by over-reaction These are evidence against the EMH Additional tests include calendar studies …

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH The January Anomaly –Stocks with negative returns during the prior year had higher returns right after the first of the year - studies indicate an excess return on AMEX but not on NYSE

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Other calendar effects –All the market’s cumulative advance occurs during the first half of trading months –Monday/weekend returns were significantly negative

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Predicting cross-sectional returns –All securities should have equal risk-adjusted returns Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk- adjusted returns Tests face a joint hypothesis problem – results are dependent on both of two factors: –market efficiency –the asset pricing model used

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Price-earnings ratios and returns –Examine historical P/E ratios and returns –Stocks are divided into five P/E classes –Low P/E stocks had higher returns and had lower risk –Publicly available P/E ratios could be used for abnormal returns –This is inconsistent with semistrong efficiency –Similar results are found with Market-to-Book ratios (will come back to this in a bit …)

28. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH The size effect (total market value) –All stocks on NYSE and AMEX were ranked by market value and divided into ten equally weighted portfolios –The risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms –Could this have caused the P/E results previously studied?

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH The P/E studies and size studies are dual tests of the EMH and the CAPM Abnormal returns could occur because either –markets are inefficient or –market model is not properly specified and provides incorrect estimates of risk and expected returns (but why should low P/E stocks tend to be riskier than high P/E stocks?)

30. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Adjustments for riskiness of small firms did not explain the large differences in rate of return The impact of transactions costs of investing in small firms depends on frequency of trading –Daily trading reverses small firm gains The small-firm effect is not stable from year to year

31. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Neglected Firms –Firms divided into three groups based on number of analysts following a stock –Neglected firm effect caused by lack of information, crosses size classes –Contradictory results from another study – confounding with capitalization effect Trading volume –Studied relationship between returns, market value, and trading activity

32. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Firm size has emerged as a major predictor of future returns This is an anomaly in the efficient markets literature Attempts to explain the size anomaly in terms of superior risk measurements, transactions costs, analysts attention, trading activity, and differential information have not succeeded

33. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Book value-market value ratio –As a predictor of stock returns –Significant positive relationship between the current values for this ratio and future stock returns are evidence against EMH Size and BV/MV dominate other ratios such as E/P ratio or leverage But this combination may only work during expansive monetary policy

34. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Event studies –Stock split studies show that splits do not result in abnormal gains after the split announcement, but before –Initial public offerings seem to be underpriced by about 15%, but that varies over time, and the price is adjusted within one day after the offering –Being listed on an exchange may offer some short term profit opportunities (but volatility increases and price decreases again after listing)

35. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Semistrong-Form EMH Event studies (continued) –Unexpected world events and economic news are quickly adjusted to and do not provide opportunities –Announcements of accounting changes are quickly adjusted for and do not seem to provide opportunities –Corporate events such as mergers and offerings are adjusted to within a few days

36. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Evidence is mixed

37. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Evidence is mixed Strong support from numerous event studies with the exception of exchange listing studies

38. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient

39. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient –Dividend yields

40. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient –Dividend yields, risk premiums

41. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient –Dividend yields, risk premiums, calendar patterns

42. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient –Dividend yields, risk premiums, calendar patterns, and earnings surprises

43. Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary on the Semistrong-Form EMH Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient –Dividend yields, risk premiums, calendar patterns, and earnings surprises This also included cross-sectional predictors such as size, the BV/MV ratio (when there is expansive monetary policy), E/P ratios, and neglected firms.

44. Copyright © 2000 by Harcourt, Inc. All rights reserved. Tests and Results of Strong-Form EMH Strong-form EMH contends that stock prices fully reflect all information, both public and private This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits

45. Copyright © 2000 by Harcourt, Inc. All rights reserved. Testing Groups of Investors Corporate insiders

46. Copyright © 2000 by Harcourt, Inc. All rights reserved. Testing Groups of Investors Corporate insiders Stock exchange specialists

47. Copyright © 2000 by Harcourt, Inc. All rights reserved. Testing Groups of Investors Corporate insiders Stock exchange specialists Security analysts

48. Copyright © 2000 by Harcourt, Inc. All rights reserved. Testing Groups of Investors Corporate insiders Stock exchange specialists Security analysts Professional money managers

49. Copyright © 2000 by Harcourt, Inc. All rights reserved. Corporate Insider Trading Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities

50. Copyright © 2000 by Harcourt, Inc. All rights reserved. Corporate Insider Trading Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities Insiders must report to the SEC each month on their transactions as insiders

51. Copyright © 2000 by Harcourt, Inc. All rights reserved. Corporate Insider Trading Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities Insiders must report to the SEC each month on their transactions as insiders These insider trades are made public about six weeks later and allow for study

52. Copyright © 2000 by Harcourt, Inc. All rights reserved. Corporate Insider Trading Corporate insiders generally experience above-average profits especially on purchase transactions

53. Copyright © 2000 by Harcourt, Inc. All rights reserved. Corporate Insider Trading Corporate insiders generally experience above-average profits especially on purchase transaction This implies that many insiders had private information from which they derived above- average returns on their company stock

54. Copyright © 2000 by Harcourt, Inc. All rights reserved. Corporate Insider Trading Studies showed that public investors who traded with the insiders based on announced transactions would have enjoyed excess risk-adjusted returns, but the markets now seem to have eliminated this inefficiency (soon after it was discovered)

55. Copyright © 2000 by Harcourt, Inc. All rights reserved. Corporate Insider Trading Other studies indicate that you can increase returns from using insider trading information by combining it with key financial ratios and considering what group of insiders is doing the buying and selling Next group – Stock Exchange Specialists

56. Copyright © 2000 by Harcourt, Inc. All rights reserved. Stock Exchange Specialists Specialists have monopolistic access to information about unfilled limit orders

57. Copyright © 2000 by Harcourt, Inc. All rights reserved. Stock Exchange Specialists Specialists have monopolistic access to information about unfilled limit orders You would expect specialists to derive above-average returns from this

58. Copyright © 2000 by Harcourt, Inc. All rights reserved. Stock Exchange Specialists Specialists have monopolistic access to information about unfilled limit orders You would expect specialists to derive above-average returns from this The data generally supports this Next group – Security Analysts

59. Copyright © 2000 by Harcourt, Inc. All rights reserved. Security Analysts Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks

60. Copyright © 2000 by Harcourt, Inc. All rights reserved. Security Analysts Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks This 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

61. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Value Line Enigma Value Line (VL) publishes financial information on about 1,700 stocks

62. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Value Line Enigma Value Line (VL) publishes financial information on about 1,700 stocks The report includes a timing rank from 1 down to 5

63. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Value Line Enigma Value Line (VL) publishes financial information on about 1,700 stocks The report includes a timing rank from 1 down to 5 Firms ranked 1 substantially outperform the market

64. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Value Line Enigma Value Line (VL) publishes financial information on about 1,700 stocks The report includes a timing rank from 1 down to 5 Firms ranked 1 substantially outperform the market Firms ranked 5 substantially underperform the market Ability to profit from this after transactions costs depends upon the frequency of rebalancing

65. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Value Line Enigma Changes in rankings are quickly price adjusted into the market

66. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Value Line Enigma Changes in rankings are quickly price adjusted into the market Some contend that the Value Line effect is “merely” a consequence of the unexpected earnings anomaly, due to changes in rankings from unexpected earnings

67. Copyright © 2000 by Harcourt, Inc. All rights reserved. Security Analysts There is evidence in favor of existence of superior analysts who apparently possess private information Next group – Professional Money Managers

68. Copyright © 2000 by Harcourt, Inc. All rights reserved. Professional Money Managers Trained professionals, working full time at investment management If any investor can achieve above-average returns, it should be this group If any non-insider can obtain inside information, it would be this group, due to the extensive management interviews that they conduct

69. Copyright © 2000 by Harcourt, Inc. All rights reserved. Performance of Professional Money Managers Most tests examine mutual funds New tests also examine trust departments, insurance companies, and investment advisors Risk-adjusted, after expenses, returns of mutual funds generally show that most funds did not match aggregate market performance –Most underperform

70. Copyright © 2000 by Harcourt, Inc. All rights reserved. Performance of Professional Money Managers Quote from “Wall Street:” –“Do you want to know why fund managers can’t beat the S&P 500? Because fund managers are sheep … and sheep get slaughtered.” –Fund managers also face agency problems that contribute to poor performance –Compensation structure encourages “sheep-like” behavior Some notable exceptions include: –“The Superinvestors of Graham-and-Doddsville”

71. Copyright © 2000 by Harcourt, Inc. All rights reserved. Conclusions Regarding the Strong-Form EMH Mixed results, but some support Tests for corporate insiders and stock exchange specialists do not support the hypothesis (Both groups seem to have monopolistic access to important information and use it to derive above- average returns)

72. Copyright © 2000 by Harcourt, Inc. All rights reserved. Conclusions Regarding the Strong-Form EMH Tests results for analysts are concentrated on Value Line rankings –Results have changed over time –Currently tend to support EMH Individual analyst recommendations seem to contain significant information Performance of professional money managers seems consistent with strong-form EMH –But, tend to underperform S&P 500 by an even larger margin (more than administrative costs and costs of research) than an explanation of market efficiency would suggest

73. Copyright © 2000 by Harcourt, Inc. All rights reserved. Implications of Efficient Capital Markets Overall results indicate the capital markets are relatively efficient with respect to numerous sets of information But numerous anomalies and inconsistencies also remain There are substantial instances where the market fails to rapidly adjust to public information –So, what techniques will or won’t work? –What do you do if you can’t beat the market?

74. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Markets and Technical Analysis Assumptions of technical analysis directly oppose the notion of efficient markets Technicians believe that new information is not immediately available to everyone, but is disseminated: –from the informed professional first … –then to the aggressive investing public … –and then to the masses

75. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Markets and Technical Analysis Technicians also believe that investors do not analyze information and act immediately - it takes time Therefore, stock prices move to a new equilibrium after the release of new information in a gradual manner, causing trends in stock price movements that persist for periods

76. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Markets and Technical Analysis Technical analysts develop systems to detect movement to a new equilibrium (breakout) and trade based on that Contradicts EMH rapid price adjustments If the capital market is weak-form efficient, a trading system that depends on past trading data can have no value Nonetheless, technical analysts and technical trading systems persist

77. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Markets and Fundamental Analysis Fundamental analysts believe that there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities and these values depend on underlying economic factors Investors should determine the intrinsic value of an investment at a point in time and compare it to the market price

78. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Markets and Fundamental Analysis If you can do a superior job of estimating intrinsic value you can make superior market timing decisions and generate above-average returns This involves aggregate market analysis, industry analysis, company analysis, and portfolio management Intrinsic value analysis should start with aggregate market analysis –But market is most likely to be relatively inefficient at the firm level, and especially for smaller, less well- known firms

79. Copyright © 2000 by Harcourt, Inc. All rights reserved. Aggregate Market Analysis with Efficient Capital Markets EMH implies that past economic events should not lead to outperforming a buy-and- hold policy Merely using historical data to estimate future values is not sufficient You must estimate the relevant variables that cause long-run movements

80. Copyright © 2000 by Harcourt, Inc. All rights reserved. Industry and Company Analysis with Efficient Capital Markets Wide distribution of returns from different industries and companies justifies industry and company analysis (Chapters 19 and 20) Must understand the variables that affect rates of return and … Do a superior job of estimating movements in these relevant valuation variables, not just look at past data

81. Copyright © 2000 by Harcourt, Inc. All rights reserved. Industry and Company Analysis with Efficient Capital Markets Important relationship between expected earnings and actual earnings Accurately predicting earnings surprises allows for superior performance Tests of strong-form EMH suggests existence of superior analysts Studies indicate that fundamental analysis based on E/P ratios, size, and the BV/MV ratios can lead to differentiating future return patterns

82. Copyright © 2000 by Harcourt, Inc. All rights reserved. How to Evaluate Analysts or Investors Examine the performance of numerous securities that this analyst recommends over time in relation to a set of randomly selected stocks in the same risk class Selected stocks should consistently outperform the randomly selected stocks (a random selection should outperform the market about half the time, so the results from only a few periods would be inconclusive)

83. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Markets and Portfolio Management Management depends on analysts With superior analysts, follow them and look for opportunities in neglected stocks

84. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficient Markets and Portfolio Management Without superior analysts, passive management may outperform active management by: –Building a globally diversified portfolio with a risk level matching client preferences –Minimizing transaction costs (taxes, trading turnover, liquidity costs)

85. Copyright © 2000 by Harcourt, Inc. All rights reserved. The 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 that duplicate the composition and performance of selected index series

86. Copyright © 2000 by Harcourt, Inc. All rights reserved. Efficiency in European Equity Markets Hawawini study indicates behavior of European stock prices is similar to U.S. common stocks

87. Copyright © 2000 by Harcourt, Inc. All rights reserved. The Internet Investments Online www.bloomberg.com www.ft.com www.wsj.com www.pointcast.com www.cnnfn.com www.cnn.com www.cnbc.com www.abcnews.com www.nbcnews.com www.msnbc.com

88. Copyright © 2000 by Harcourt, Inc. All rights reserved. End of Chapter 7 –Efficient Capital Markets

89. Copyright © 2000 by Harcourt, Inc. All rights reserved. Upcoming topics “Shift Happens” – Michael Mauboussin “The Wrong 20-Yard Line” –Ch. 15 of The Inefficient Stock Market, by Robert A. Haugen Behavioral and Institutional Finance

90. Copyright © 2000 by Harcourt, Inc. All rights reserved.