1. 1 Chapter 8 The Capital Markets and Market Efficiency Portfolio Construction, Management, & Protection, 4e, Robert A. Strong Copyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

2. 2 No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn into pumpkins and mice. Warren Buffett

3. 3 Outline u Introduction u Role of the Capital Markets u Efficient Market Hypothesis u Anomalies

4. 4 Introduction u Capital market theory springs from the notion that: People like return People do not like risk Dispersion around expected return is a reasonable measure of risk

5. 5 Role of the Capital Markets u Definition u Economic Function u Continuous Pricing Function u Fair Price Function

6. 6 Definition u Capital markets trade securities with lives of more than one year u Examples of capital markets New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Chicago Board of Trade Chicago Board Options Exchange (CBOE)

7. 7 Economic Function u The economic function of capital markets facilitates the transfer of money from savers to borrowers e.g., mortgages, Treasury bonds, corporate stocks and bonds

8. 8 Continuous Pricing Function u The continuous pricing function of capital markets means prices are available moment by moment Continuous prices are an advantage to investors Investors are less confident in their ability to get a quick quotation for securities that do not trade often

9. 9 Fair Price Function u The fair price function of capital markets means that an investor can trust the financial system The function removes the fear of buying or selling at an unreasonable price The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

10. 10 Efficient Market Hypothesis u Definition u Types of Efficiency u Weak Form u Semi-Strong Form u Strong Form u Semi-Efficient Market Hypothesis u Security Prices and Random Walks

11. 11 Definition u The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair The EMH is perhaps the most important paradigm in finance

12. 12 Types of Efficiency u Operational efficiency measures how well things function in terms of speed of execution and accuracy It is a function of the number of order that are lost or filled incorrectly It is a function of the elapsed time between the receipt of an order and its execution

13. 13 Types of Efficiency (cont’d) u Informational efficiency is a measure of how quickly and accurately the market reacts to new information It relates directly to the EMH The market is informationally very efficient –Security prices adjust rapidly and accurately to new information –The market is still not completely efficient

14. 14 Weak Form u Definition u Charting u Runs Test

15. 15 Definition u The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past The current price is a fair one that considers any information contained in the past price data Charting techniques are of no use in predicting stock prices

16. 16 Definition (cont’d) Example Which stock is a better buy? Stock A Stock B Current Stock Price

17. 17 Definition (cont’d) Example (cont’d) Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

18. 18 Charting u People who study charts are technical analysts or chartists Chartists look for patterns in a sequence of stock prices Many chartists have a behavioral element

19. 19 Runs Test u A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance A run is an uninterrupted sequence of the same observation A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number

20. 20 Conducting A Runs Test

21. 21 Semi-Strong Form u The semi-strong form of the EMH states that security prices fully reflect all publicly available information e.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

22. 22 Semi-Strong Form (cont’d) u Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as: Stock splits Cash dividends Stock dividends u This means investors are seldom going to beat the market by analyzing public news

23. 23 Semi-Strong Form (cont’d) u Burton Malkiel points out that two-thirds of professionally managed portfolios are consistently beaten by a low-cost index fund Suggests that securities are accurately priced and that in the long run returns will be consistent with the level of systematic risk taken

24. 24 Strong Form u The strong form of the EMH states that security prices fully reflect all relevant public and private information u This means even corporate insiders cannot make abnormal profits by using inside information about their company Inside information is information not available to the general public

25. 25 Semi-Efficient Market Hypothesis u The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others Less well-known companies are less efficiently priced The market may be tiered A security pecking order may exist

26. 26 Security Prices and Random Walks u The unexpected portion of news follows a random walk News arrives randomly and security prices adjust to the arrival of the news –We cannot forecast specifics of the news very accurately

27. 27 Anomalies u Definition u Low PE Effect u Low-Priced Stocks u Small Firm and Neglected Firm Effect u Market Overreaction u January Effect

28. 28 Anomalies (cont’d) u Day-of-the-Week Effect u Turn-of-the Calendar Effect u Persistence of Technical Analysis u Chaos Theory

29. 29 Definition u A financial anomaly refers to unexplained results that deviate from those expected under finance theory Especially those related to the efficient market hypothesis

30. 30 Low PE Effect u Stocks with low PE ratios provide higher returns than stocks with higher PEs u Supported by several academic studies u Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)

31. 31 Low-Priced Stocks u Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price u There is an optimum trading range

32. 32 Small Firm and Neglected Firm Effects u Small Firm Effect u Neglected Firm Effect

33. 33 Small Firm Effect u Investing in firms with low market capitalization will provide superior risk- adjusted returns u Supported by academic studies u Implies that portfolio managers should give small firms particular attention

34. 34 Neglected Firm Effect u Security analysts do not pay as much attention to firms that are unlikely portfolio candidates u Implies that neglected firms may offer superior risk-adjusted returns

35. 35 Market Overreaction u The tendency for the market to overreact to extreme news Investors may be able to predict systematic price reversals u Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

36. 36 January Effect u Stock returns are inexplicably high in January u Small firms do better than large firms early in the year u Especially pronounced for the first five trading days in January

37. 37 January Effect (cont’d) u Possible explanations: Tax-loss trading late in December (Branch) The risk of small stocks is higher early in the year (Rogalski and Tinic)

38. 38 Types of Firms in January 7.71%10.72%11.32%Neglected Non-S&P 500 Companies 5.03%6.87%7.62%Neglected 1.69%4.19%4.95%Moderately Researched -1.44%1.63%2.48%Highly Researched S&P 500 Companies Average January return after adjusting for systematic risk Average January return minus average monthly return in rest of year Average January return Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.

39. 39 Day-of-the-Week Effect u Mondays are historically bad days for the stock market u Wednesday and Fridays are consistently good u Tuesdays and Thursdays are a mixed bag

40. 40 Day-of-the-Week Effect (cont’d) u Should not occur in an efficient market Once a profitable trading opportunity is identified, it should disappear u The day-of-the-week effect continues to persist

41. 41 Turn-of-the-Calendar Effect u The bulk of the return comes from the last trading day of the month and the first few days of the following month u For the rest of the month, the ups and downs approximately cancel out

42. 42 Persistence of Technical Analysis u Technical analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices u Studies show the markets are efficient in the weak form u Literature based on technical techniques continues to appear but should be useless

43. 43 Chaos Theory u Chaos theory refers to instances in which apparently random behavior is systematic or even deterministic u Econophysics refers to the application of physics principles in the analysis of stock market behavior e.g., an investment strategy based on studies of turbulence in wind tunnels