Chapter 13: The Efficiency of Capital Markets Why is market efficiency important? The various categories of the Efficient Markets Hypothesis (EMH) The evidence for market efficiency Speculative bubbles WSU EMBA Corporate Finance

Concept of Market Efficiency Prices in informationally efficient capital or financial markets should reflect all available information. Current market prices should represent a fair and unbiased forecast or estimate of the intrinsic or fundamental value of the firm, i.e., the Present Value of all future expected cash flows. In an efficient market, market prices respond instantaneously to new and material information and fully reflect that information. Delayed responses (under-reaction and overreaction) to new information would suggest that markets are inefficient. WSU EMBA Corporate Finance

Market Efficiency – driven by competition among investors A normal return on an investment is a return that is consistent with the systematic risk of the investment. Assuming that the CAPM is the correct asset pricing model, then a return estimated from the CAPM is assumed to be a normal return. Everyone that invests obviously wants to make above normal returns on investments. Therefore, much analysis, using common or public information sources, is performed by investors in order to identify mispriced stocks and bonds. Due to intense competition among investors, it should become difficult to earn above normal returns. Be suspicious of anyone that promotes some investment technique that purportedly earns above normal returns. If the method really worked, then any rational person would keep the technique undisclosed! WSU EMBA Corporate Finance

Information and forms of the Efficient Markets Hypothesis (EMH) Three (nested) information sets are used to define three degrees or levels of market efficiency (1) Weak-form efficiency (2) Semistrong-form efficiency (3) Strong-form efficiency (1) above is a subset of (2), and (2) above is a subset of (3). WSU EMBA Corporate Finance

Three forms of the Efficient Markets Hypothesis (EMH) (1) Weak-form efficiency: asset prices should reflect all historical market related information such as past prices, returns, trading volume, or trends in volume or prices. Investors should not be able to generate or earn abnormal returns using this information. Stock prices should follow what appears to be a random walk, i.e., successive price changes are uncorrelated. If this form of market efficiency holds, then technical analysis should not work. WSU EMBA Corporate Finance

Three forms of the Efficient Markets Hypothesis (EMH) (2) Semistrong-form efficiency: asset prices should reflect all information that is publicly available, i.e., earnings, dividends, analyst forecasts, historical market data, public expectations of the future, etc. The market's reaction to new and material information should be both instantaneous and unbiased, i.e., no systematic pattern of either over or underreaction. In addition, the market reacts to unexpected information, i.e., news that changes our forecasts of cash flows or risk. Most fundamental analysis should not work, unless someone is superior in interpreting information. WSU EMBA Corporate Finance

Three forms of the Efficient Markets Hypothesis, continued (3) Strong-form efficiency: asset prices should reflect all private and public information. We know that insider information is very valuable to most that choose to (usually illegally) act upon this information, so the market is certainly not strong form efficient, based on what we observe. What does the actual empirical evidence suggest concerning market efficiency? Most empirical evidence suggests that the U.S. stock market is largely semistrong-form efficient. Extreme profit opportunities would exist for anyone that could persistently and successfully exploit publicly available information, hence the intense competition among investors should largely winnow away the mispriced stocks. WSU EMBA Corporate Finance

Implications of a market that is largely semistrong efficient On average, stocks should trade at their intrinsic value. Deviations from intrinsic value should be random. The market stock price deviations from the true or intrinsic value cannot be identified using publicly available information. As many stocks should be 20% overpriced as there are stocks that are 20% underpriced. These deviations from intrinsic value can, of course, often be identified by using inside or private information since we assume that capital markets are not strong-form efficient. WSU EMBA Corporate Finance

Implications of a market that is largely semistrong efficient If stock analysis did not exist, then markets would be very inefficient, and thus extremely profitable opportunities would exist. In our real world, the intense competition among investors and analysts will largely eliminate most mispriced stocks. Prices increase over time, as investors expect compensation for systematic risk. WSU EMBA Corporate Finance

Empirical evidence concerning the weak-form market efficiency Most tests indicate that past returns (and other market data) cannot be exploited to generate future abnormal returns. Often, in the absence of transactions or trading costs, some strategies appear to work. However, when transactions costs are then incorporated, the strategy does not work. In an economics context, much of this information is available at no or little cost. Is it easy to earn above normal returns on costless information? It should be difficult! WSU EMBA Corporate Finance

Empirical evidence concerning the semistrong-form market efficiency Event studies Stock prices appear to react appropriately to most material corporate events or announcements Performance of actively managed mutual funds In any given year, most actively managed funds do not outperform a simple market index fund and most that do will not repeat the performance the following year. Value Line Investment Survey VL ranks stocks’ future prospects on a 1 (best) to 5 (worst) scale. On paper, stocks ranked as 1 or 2 appear to overperform. However, VL’s two actively managed mutual funds have consistently underperformed the market! WSU EMBA Corporate Finance

Observations contrary to the EMH Size effect Small firms appear to outperform, after adjusting for risk. However, small firms don’t really add up to much. Value (low market/book ratio) versus glamour (high market/book ratio) Low market-to-book equity firms appear to outperform. Long-term studies Some studies show that the market underreacts to some events and overreacts to others, and abnormal returns can be earned over 1 to 5 year horizons. For example, IPO firms were shown to underperform after going public; however, more recent studies show that they don’t. WSU EMBA Corporate Finance

Where you may find deviations from the EMH Firms having little or no analyst coverage, e.g., neglected firms. Typically a characteristic of many small firms. Such firms have limited investor interest and are not widely held by investors. Firms that are subject to short-sale constraints If pessimists cannot participate fully in the market by short selling those stocks they feel are overvalued, then the optimists may be driving the price of the stock. Such stocks may become overpriced. WSU EMBA Corporate Finance

Speculative Bubbles ― periods of irrational exuberance in markets Some examples in history of speculative bubbles: Dutch tulip bulb craze of early 1600s South Sea bubble in Britain in early 1700s Electric related stocks in 1880s U.S. stock market of late 1920s Radio bubble of late 1920s “Tronics” bubble of early 1960s “Nifty fifty” bubble of early 1970s (large firm bubble!) Japanese stock market bubble of 1980s Internet and dotcom bubble of late 1990s and 2000 WSU EMBA Corporate Finance

WSU EMBA Corporate Finance Speculative Bubbles The “bigger fool” theory of speculation Those that buy in the mania feel like a fool, but they believe an even bigger fool will purchase the asset from them in the near future. People aren’t buying based on actual value. In each bubble, one often hears such phrases: “This time its different” “The old rules no longer apply” “We’re living in a new economy” Bubbles often occur in new (and perceived as exciting) industries where true fundamentals are difficult to ascertain. The Internet bubble was a prime example. WSU EMBA Corporate Finance

Japanese stock market bubble of late 1980s (Nikkei 225 index) WSU EMBA Corporate Finance

Cisco Systems stock during the Internet bubble WSU EMBA Corporate Finance

Nasdaq Composite Index during Internet bubble WSU EMBA Corporate Finance

Philadelphia Stock Exchange Internet Index during Internet bubble WSU EMBA Corporate Finance

The U.S. stock market bubble of the late 1920s WSU EMBA Corporate Finance

The radio bubble and stock market bubble of the late 1920s WSU EMBA Corporate Finance