EFFICIENT CAPITAL MARKETS Chapter 10 EFFICIENT CAPITAL MARKETS

Chapter 10 Questions What do we mean when we say that capital markets are efficient? Why should capital markets be efficient? What factors contribute to an efficient market? Given the overall efficient market hypothesis (EMH), what are the three subhypotheses and what are the implications of each of them?

Chapter 10 Questions How does one test the three efficient market subhypotheses, and what are the results of the tests? For each set of tests, which results support the EMH and which indicate an anomaly related to the hypothesis? What are the implications of the results for stock strategies and portfolio managers? What is the evidence related to the EMH for markets in foreign countries?

Efficient Capital Markets In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices reflect all information about the security Whether markets are efficient has been extensively researched and remains controversial

Why does it matter? If prices do fully reflect all current information, it would not be worth an investor’s time to use information to find undervalued securities. If prices do NOT fully reflect information, FIND AND USE THAT INFORMATION, and perhaps you will be able to make a killing in the market.

Investing and Market Efficiency Would stock selection amount to throwing darts at a wall in an efficient market? Hardly! Risk still matters. We would still want to research the risk-return properties of securities.

Why Should Capital Markets Be Efficient? What would be the ingredients of an “informationally” efficient market? A large number of profit-maximizing participants analyze and value securities 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 Price adjustments are unbiased – correct on average. Under these conditions, a security’s price would be appropriate for its level of risk.

Alternative Efficient Market Hypotheses The various forms of the efficient market hypothesis differ in terms of the information that security prices should reflect. Weak-form EMH Semistrong-form EMH Strong-form EMH

Weak-Form EMH Current prices fully 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

Implications of the Weak-From EMH Examining recent trends in price and other market data in order to predict future price changes would be a waste of time if the market is weak-form efficient. A lot of people do price charting and other forms of “technical analysis.”

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

Implications of the Semistrong-Form EMH If the market is efficient in this sense, information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.

Strong-Form EMH Stock prices fully reflect all information from public and private sources This would require perfect markets in which all information is cost-free and available to everyone at the same time (which is clearly not the case) Implication: Not even “insiders” would be able to “beat the market” on a consistent basis

Tests and Results: Weak-Form EMH Two Approaches Tests of “statistical memory” in security prices and returns Tests of trading rules

Tests and Results: Weak-Form EMH Statistical tests of independence between rates of return Autocorrelation tests Mostly support the weak-form EMH and indicate that price changes are random Some studies using more securities and more complicated tests cast some doubt Runs tests Indicate randomness in prices

Tests and Results: Weak-Form EMH Comparison of trading rules to a buy-and-hold policy Some filter rules seem yield above-average profits with small filters, but only before taking into account the substantial transactions costs involved Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy

Tests and Results: Weak-Form EMH Problems with tests Cannot be definitive since trading rules can be complex and there are too many to test them all Testing constraints Use only publicly available data Should include all transactions costs Should adjust the results for risk (an apparently successful strategy may just be a very risky strategy)

Conclusions: Weak-Form EMH Results generally support the weak-form EMH, but results are not unanimous Some strategies too subjective to test Not all trading rules are disclosed If you had a trading strategy that worked, would you reveal it?!

Reality Check! If someone writes a book on how to “beat the market,” you can bet that book sales are more lucrative than the trading strategy! Even if it once worked, if it’s widely known, it won’t work any more! Don’t quit your day job to trade on-line using a published strategy!

Tests and Results: Semistrong-Form EMH Three different groups of tests: Time series analysis using public information Event studies examine how fast stock prices adjust to significant economic events Cross-sectional analysis of returns based on public information Tests involve the estimation of “abnormal returns,” where expected abnormal returns are zero in an efficient market.

Tests and Results: Semistrong-Form EMH Tests often involve “market-adjusted returns,” created by subtracting the market return from the security’s return, thereby defining a security’s “abnormal return:” ARit = Rit - Rmt where: ARit = abnormal return on security i during period t Rit = return on security i during period t Rmt = return on a market index during period t

Tests and Results of Semistrong-Form EMH Another definition of abnormal return is a “risk-adjusted return” or “market model” which adjusts for the security’s own required rate of return, given its systematic risk (as measured by beta): ARit = Rit - E(Rit) where: E(Rit) = 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)

Tests and Results: Semistrong-Form EMH Time series tests for predictability of returns and profit opportunities Short-horizon returns have shown very limited predictability Long-horizon returns analysis shown some predictability of returns based on: Dividend yield (D/P) Default spread Term structure spread

Tests and Results: Semistrong-Form EMH Time series tests for predictability of returns and profit opportunities Quarterly earnings reports information Unanticipated earnings changes or “earnings surprises” are not immediately reflected in security prices The January Anomaly (A “calendar” effect) Large returns in January present opportunities to purchase in December, and sell in January and earn abnormal returns.

Tests and Results: Semistrong-Form EMH Time series tests for predictability of returns and profit opportunities Other calendar effects Monthly effect Day-of-the-week effects Monday returns were significantly negative

Tests and Results: Semistrong-Form EMH Predicting cross-sectional returns In an efficient market, 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 These tests include a joint hypothesis of both market efficiency and the asset pricing model used to generate abnormal returns

Tests and Results: Semistrong-Form EMH Predicting cross-sectional returns Price-earnings ratios Examine historical P/E ratios and returns Low P/E stocks had higher risk-adjusted returns than high P/E stocks Publicly available P/E ratios could be used for abnormal returns Price-earnings/Growth ratios Mixed results

Tests and Results: Semistrong-Form EMH Predicting cross-sectional returns The size effect The risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms Abnormal returns could occur because either markets are inefficient or the market model is not properly specified and provides incorrect estimates of risk and expected returns (joint test)

Tests and Results: Semistrong-Form EMH Predicting cross-sectional returns The size effect 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 is substantial (takes away the differential with a short-term trading strategy) Even after risk and transaction costs, small firms outperform large firms with annual trading The small-firm effect is not stable Firm size is an important anomaly

Tests and Results: Semistrong-Form EMH Predicting cross-sectional returns Neglected firms and trading activity Is there an effect related to the number of analysts following a stock and how frequently a stock trades? Mixed results, mostly any apparent effects explained by taking the size effect into consideration

Tests and Results: Semistrong-Form EMH Predicting cross-sectional returns Book value-market value (BV/MV) ratio Significant positive relationship between the current values for this ratio and future stock returns Although various measures including the P/E ratio seem to help predict future returns, the size effect and BV/MV ratio have the greatest predictive ability.

Tests and Results: Semistrong-Form EMH Event studies Event studies examine abnormal returns surrounding various events The EMH is that abnormal returns are zero Stock split studies Mostly show no positive impact on returns because of a stock split Initial public offerings Significant IPO underpricing, but it quickly adjust away in the first day, consistent with the EMH

Tests and Results: Semistrong-Form EMH Event studies Exchange listings Some evidence of short-term profit potential following the “listing announcement” Unexpected world events and economic news Quickly reflected in security prices, do not provide opportunities

Tests and Results: Semistrong-Form EMH Event Studies Announcements of accounting changes Quickly reflect in security prices and do not seem to provide abnormal profit opportunities Corporate events Prices react quickly to announcements of mergers, financing decisions, etc. No systematic profit opportunities

Summary on the Semistrong-Form EMH Evidence is mixed Strong support of the EMH from numerous event studies with the exception of exchange listing studies Strong evidence against the EMH from both time series and cross-sectional studies Dividend yields, earnings surprises, calendar effects The size effect, BV/MV, P/E ratios, etc.

Tests and Results: Strong-Form EMH Testing Groups of Investors Tests usually center on whether any group of investors consistently earn abnormal profits. Corporate insiders Stock exchange specialists Security analysts Professional money managers

Tests and Results: Strong-Form EMH Corporate Insiders 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

Tests and Results: Strong-Form EMH Corporate Insiders Mixed results Corporate insiders generally experience above-average profits especially on purchase transactions This implies that many insiders had private information from which they derived above-average returns on their company stock Later studies indicate that insiders may no longer be able to generate abnormal returns

Tests and Results: Strong-Form EMH Stock Exchange Specialists Specialists have monopolistic access to information about unfilled limit orders You would expect specialists to derive above-average returns because of their superior information, and this appears to be the case.

Tests and Results: Strong-Form EMH 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

Tests and Results: Strong-Form EMH Security Analysts The Value Line Enigma Firms ranked 1 for “timeliness” substantially outperform the market; firms ranked 5 substantially underperform the market Prices now adjust quickly to changes in rankings Net of transaction costs, rankings do not appear to have value in terms of producing abnormal returns There is some evidence of superior analysts who apparently posses private information

Tests and Results: Strong-Form EMH 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

Tests and Results: Strong-Form EMH Professional Money Managers Most tests examine mutual funds Risk-adjusted returns of mutual funds generally show that most funds did not match aggregate market performance

Summary on the Strong-Form EMH Mixed results Some strong support Professional money managers Some strong evidence against the EMH 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

Behavioral Finance A growing field of study in finance. Rather than assuming ultra-rational behavior, the area of behavioral finance seeks to incorporate how humans actually behave. Incorporates the ways in which psychology may impact investment decisions It has been useful for explaining various “anomalies” that we observe in decision-making that are difficult to reconcile with rationality

Behavioral Finance Using psychological biases to explain behavior Why do investors persistently “ride” losers and sell winners? Can be explained by prospect theory Why do investors display overconfidence in forecasts? Can be explained by the confirmation bias Why do investors tend to put more money into failing investments? Can be explained by the escalation bias

Implications of Market Efficiency Overall results indicate the capital markets are efficient as related to numerous sets of information 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?

Efficient Markets and Technical Analysis Assumptions of technical analysis directly oppose the notion of efficient markets Technicians believe that stock prices move in patterns that persist and are predictable to the informed investor. Technical analysts develop systems to detect trends and patterns in prices If the capital market is weak-form efficient, a trading system that depends on past trading data can have no value

Efficient Markets and Fundamental Analysis Fundamental analysis involves determining an investment’s intrinsic values based on company and economic “fundamentals” The intrinsic value is compared to the market price to determine whether the investment is undervalued or overvalued In an efficient market, prices already reflect public information, so determining “intrinsic value” using that information is not a worthwhile exercise

Efficient Markets and Fundamental Analysis Past vs. Future The EMH, importantly, considers the incorporation of available information, which is primarily historic in nature. Much of what is involved in fundamental analysis, including aggregate market analysis and industry analysis, involves estimating future values. Superior analysts are those who will be better at predicting this uncertain future.

Efficient Markets and Portfolio Management Does active portfolio management pay off? Research indicates that most money managers do keep pace with the market Certainly with a superior analyst, recommendations should be followed Opportunities may be present in smaller, neglected stocks (although risk must be taken into account)

Efficient Markets and Portfolio Management Without superior analysts, passive management may outperform active management Build a globally diversified portfolio with a risk level matching client preferences Minimize transaction costs (taxes, trading turnover, liquidity costs)

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 which duplicate the composition and performance of a selected index series

Insights from Behavioral Finance There may be trading opportunities created by persistent investor biases and “herd mentality” Supports the notion of contrarian investment strategies Some mutual funds employ behavioral finance strategies

Efficiency in European Equity Markets Hawawini study indicates behavior of European stock prices is similar to U.S. common stocks Despite market differences, most results are essentially similar Appropriate to assume a similar level of efficiency in European markets to those in the United States