1. Efficient Markets and Behavioral Critique
CHAPTER 8

2. Efficient Capital Market
Market in which securities prices reflect all available information
all securities are fairly priced
Investors get exactly what they pay for
Firms get exactly what their stocks and bonds are worth when they sell them.

3. Price behavior in efficient market
FCC Corporation is developing a camera that will double the speed of the auto-focusing system. It is highly profitable and the NPV will be positive.
Day 0 represents the announcement day. Before the announcement day, FCC’s stock sells for $140 per share. The NPV per share is $40, so the new price will be $180 once the value of the new project is fully reflected.
Hence, the solid line represents the path of stock price in an efficient market. The price will adjust immediately and no further change in the price of stock will take place later.
The broken line represents a delayed reaction. It takes 8 day for the market to fully incorporate the information.
The dotted line indicates an overreaction and subsequent adjustment to the correct price
Broken and dotted line show the path of the stock price if markets are inefficient.

4. Price behavior in efficient market

5. Figure 8-1 Cumulative Abnormal Returns Surrounding Takeover Attempts
price response of 194 firms that were targets of takeover attempts

6. Figure 8-2 Returns Following Earnings Announcements
majority of the profit is in the first 30 minutes

7. Three Versions of EMH Weak-form EMH: prices reflect all past info
Semistrong-form EMH: prices reflect all public (past&current) info
Strong-form EMH: prices reflect all (past&current, public&private) info
Strong
Semi-strong
Weak
Form
Form
Form

8. Three Versions of EMH Weak-form: Semi-strong form Strong form
price reflect all past info.
using historical data to predict future prices is useless
Semi-strong form
price reflect all public info (current and past)
using historical data and available financial statement to predict future price is useless
Strong form
price reflect all information: past, public and private
cannot predict price even with inside information

9. Implications of EMH: price follow a random walk
Price change randomly or follow a random walk. Why?
EMH: price is in equilibrium or reflect the true value
Price < true value: more investors to buy, push the price up to the true level
Price > true value: more sell, drive the price down to the true level
Price will stay at the true level if there is no new info
New info, price will change accordingly
New information is unpredictable
stock price change is unpredictable

10. Implications of EMH: Technical analysis
using past info to search for patterns in stock prices to identify mispriced stocks
EMH implies that technical analysis is useless because all past info is incorporated in current stock price. If one knows about the pattern, other people will also know
Example: you believe that you discover a pattern in stock price, the price will be $50 tomorrow, up from the current price is 45.
you want to buy stock at 45 and sell it tomorrow for 50. Is it possible?
If you know, sellers also know about it, the price will be pushed up to 50 before you can buy the stock

11. Implications of EMH: Fundamental analysis
Technical: look back at the past to forecast future price
Fundamental: look ahead to forecast future info and then forecast true price. To forecast stock price, we need future cash flow and discount rate
Use available financial statement to forecast earnings and dividends perspectives of the firms
Calculate risk of firm, using CAPM to get the discount rate
calculate the true value and compare with current price
current price > true
Current price < true
EMH suggest that fundamental adds little value
public info is available to everyone
not much difference in analysts’ reports
price reflect true value
must be better than other analysts to make abnormal profit

12. Implications of EMH: active and passive portfolio management
Active: attempt to find mispriced securities
Passive: no attempt, just buy and hold a well-diversified portfolio
EMH: active is wasted effort
securities are fairly priced
lose transaction cost
Example: create a portfolio that follows the index S&P 500

13. Implications of EMH for Investment Policy
Technical Analysis: useless
Fundamental Analysis: adds little value
Active versus Passive Portfolio
Management: passive wins
EMH
You can’t “Beat the Market”

14. Common Misconceptions about EMH
Efficient markets do not mean that you can’t make money
They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns
Market efficiency will not protect you from wrong choices if you do not diversify – you still don’t want to put all your eggs in one basket

15. The Role of Portfolio Management in an Efficient Market
Need for a well-diversified portfolio:
Tax considerations
high tax-bracket: prefer municipal bond
high tax-bracket: prefer securities that provide capital gains as opposed to interest income since gains are tax less heavily
Individual considerations
GM executives, performance depends on GM stocks, should not invest too much in auto stocks
Age considerations
older investors might avoid long-term bond
younger might choose long-term bond

16. But Are Markets Efficient?
Hard question!
The Magnitude Issue
The Selection Bias Issue
The Lucky Event Issue

17. Magnitude
You manage a portfolio $1 billion. If the return is 0.1%/year, should make 5 mil/year.
A very small deviation from the true price can result in large profit
Standard deviation of S&P 500/ year = 20%
When a manager makes a lot of money on a large portfolio, does it mean the market is not efficient?

18. The selection bias
When you discover a technique to beat the market, should you
publish it to get reputation
keep it as secrets to make money
Technique available in the market is the one that cannot make abnormal profit
EMH only looks at those techniques available in market, and conclude that these cannot beat the market, it is not necessarily true.

19. Lucky event
Read WSJ, some investors outperform others, is this evidence against EMH?
Flip a fair coin, 50% head, 50% tail, 50 times, on average, will get 25 times H, 25 times T.
If someone can get more than 25 times H, does it mean he is better than you?

20. Test of EMH: weak form-pattern in stock return
short-horizon (<1 year): rank stocks based on past performance
Winner
Loser
Next 3-12 months, winners continue to outperform losers
Momentum strategy
Long horizon
reversal effect, loser outperform winner
Contrarian strategies
Fad hypothesis
short term: market overreact to news, sell more losers, price(losers) < true level, buy more winner, price(winner) > true level. Therefore, winner continue to outperform loser
Long term: market makes correction, price of loser goes back up to the true level, winner goes back down to the true level, loser outperform winner

21. Test of EMH: semi-strong form, test of fundamental analysis
Anomalies: evidence that contradicts EMH
P/E Effect: low P/E, High returns,
Small-firm-in-January effect: Small firm, High return, in January,
Neglected-Firm Effect: Less known firms have higher return,
Book-to-Market effect: high B/M, high returns
Post-earnings effect: sluggish response of price to earnings announcements

22. January effect
Studies of returns in the US and other major financial markets reveal strong difference in return behaviors across months of the year
Returns in January is much stronger than returns in any other month of the year. This is called January effect and most of the January effect can be traced to the first 2 weeks of January
The January effect is much more accentuated for small firms than for large firms

23. Return in January

24. The size effect in January

26. Explanation for January effect
Tax-loss selling by investors: at the end of the year when investors, starting to worry about taxes, sell some stocks that are down so the losses can be written off against capital gains. This selling causes stocks to go down near the end of the year and back up in January when investors buy back the stocks they sold.

27. Weekend effect
The weekend effect is another phenomenon that has persisted over time in the US as well as in international markets. It refers to the differences in Monday return and the return of other days in the week
Over the year, the return on Monday has been consistently lower than the return of other days in the week

30. Weekend effect: explanations
the weekend effect might be the results of bad news being revealed after Friday close and during the weekend.
Others state that the weekend effect might be linked to short selling, which would affect stocks with high short interest positions. Or, the effect could simply be a result of traders' fading optimism between Friday and Monday.
May be attributed to absence of trading over the weekend. However, this should not be the reason if we consider the return after the holidays. Usually, the returns after holidays are positive not negative

32. Size effect

33. Book-to-market effect

34. Response to Earnings Announcements
Form stocks into 10 portfolios based on magnitude of earning surprise (difference between historical analysts’ forecast and actual announcement) Portfolio 1 being the lowest, 10 being the highest.
Positive surprise firms continue to have positive abnormal return. Negative surprise firms continue to have negative abnormal return
higher surprise has higher abnormal return
No explanation so far.

35. Figure 8-5 Cumulative Abnormal Returns in Response to Earnings Announcements

36. Problems in Testing EMH
Most tests require risk adjustments
Risk adjustment require a model of risk (typically uses CAPM)
Tests of risk-adjusted returns are joint tests
of the EMH and the risk adjustment procedure
Rejecting risk-adjustment procedure leaves
no conclusions about EMH
EMH is essentially untestable. .

37. Tests of the Strong-form EMH
With private info, can we beat the market?
SEC regulations
insider register all trading activities
publish all these trades
insider must report large trades to SEC within 2 days

38. Are markets efficient?
Anomalies: momentum, contrarian, size, book-to-market, P/E ratio, post announcement drift, etc.
Evidence against EMH
market is efficient but sources of risk are not fully identified
On going debate

39. Reality Check of the Semistrong-form EMH
Mutual fund performance
Skilled equity investment professionals do not consistently beat the market.

40. Figure 8-6 Estimates of Individual Mutual Fund Alphas

41. Figure 8-7 Persistence of Mutual Fund Performance

42. Conclusion
Example: 2 finance persons walk on street, one see $20 bill, and is going to pick it up, the other says: don’t bother, if it was real money, someone else would have picked it up already.
The same idea applies to the market
Market is very competitive, generally efficient.
However the evidence of anomalies suggest that there might be reward for hard-working, intelligent, creative investors.

43. Summary Research shows stock prices tend to follow a random walk
Three forms of the efficient market hypothesis
Technical analysis
Fundamental analysis
Empirical studies have generally shown that technical analysis does not generate trading profits
Several anomalies exist regarding fundamental analysis
Professionally managed funds generally cannot consistently beat the market