1. Market Efficiency
Chapter 10

2. Efficient Markets stock prices quickly and unbiasedly reflect all
the stock market is efficient if:
stock prices quickly and unbiasedly reflect all
information which would affect the value of the stock
an efficient market does not mean that all stock prices are
always correct in that they exactly represent the true value
of the stock
Rather, in an efficient market, stock prices are unbiased
estimates of the true intrinsic value
i.e. the current stock price is the best guess possible
about the value of the stock, given the available information

3. Forms of Efficiency Weak Form Efficiency Semi-Strong Form Efficiency
Three forms of efficiency, depending on what type of information is thought to be incorporated into stock prices
Weak Form Efficiency
Semi-Strong Form Efficiency
Strong Form Efficiency

4. Implications of Efficiency
Weak Form: if true, then should not expect to earn excess
returns by performing technical analysis as there are no patterns
in stock prices
Semi-Strong Form: if true, then should not expect to earn
excess returns based upon performing fundamental analysis as
public information is already incorporated into stock
prices before it can be acted upon
Strong Form: if true, then investing based upon (non-public)
inside information will not create excess returns

5. General Implications of Market Efficiency
If markets are (generally) efficient there are some major implications:
(1) For investors, efficient markets are consistent with a passive investment strategy
active investment strategies not expected to produce excess returns
(2) Changes in a firm’s stock price are rational reflections of new information
a change in price in reaction to news is an unbiased
evaluation of whether that news is good or bad
changes in stock prices are meaningful

6. Study: Kaplan and Weisbach Journal of Finance (1992)
examine a sample of large acquisitions that were eventually divested
classify them as successful or unsuccessful (based on prices paid and sold for, and on reasons given for sale)
look at abnormal returns on announcement of acquisition

7. Kaplan and Weisbach (cont.)
Results:
abnormal returns are negative for acquisitions that eventually turn out to be unsuccessful
abnormal returns for unsuccessful acquisitions are significantly lower than for successful ones
Implication:
the market is able to do a good job predicting which
acquisitions will be successful
changes in stock prices provide a “report card” on actions of the firm

8. How do markets become efficient?
If markets are efficient, how do they become efficient?
How does information get into prices?
The actions of investors trying to take advantage of information as quickly as possible affects the stock price
The stock price will then reflect information almost immediately

9. “On the Impossibility of Informationally Efficient Markets”
- Grossman and Stiglitz (American Economic Review, 1980)
argue that efficient markets are impossible
if cannot expect to profit from information (since
already reflected in the current price), then no one
would gather information
no one gathers information, how could it get into stock prices?
Current view of efficient markets:
not possible for most investors to gain from trading
based on information (after including effect of transaction costs)
for an intra-marginal investor, there may be gains to be had
from gathering and acting on information
intra-marginal investor is someone who can trade on
information before the price has fully reflected it.

10. How long until prices reflect information?
How long does it take for stock prices to reflect new information?
or, how quick do you have to be to be intra-marginal?
May vary by type of information and by stock
widely followed stocks will tend to react more quickly, there
may be more of a delay for thinly traded stocks
Study: Busse and Green (Journal of Financial Economics, 2002)
look at effect of news announcements on trading
have sample of announcements timed to the second
find trading based on the information can make a profit if done within 15 seconds - information is fully reflected within 1 minute

11. Evidence for Market Efficiency
lots of academic studies which seem to show the market is generally efficient (others that find it isn’t)
Important evidence that the market may be efficient:
mutual funds do not generally beat the market
After including the effect of management expense ratio, only 10% of actively managed US equity funds were able to do better than the S&P 500 over the last 5 years
Only 8% were able to beat the market over the last 10 years.

12. Further…mutual fund performance is inconsistent
funds that are the best performers one year tend not to be the best performers the next year
Implication: if mutual fund managers, with all of their expertise and resources, cannot beat the market, maybe the stock is efficient

13. Market Anomalies there seem to be certain anomalies in the market
situations that are inconsistent with efficient markets
certain types of stocks have been found to do better than others
some investors base their investing strategies on trying
to take advantage of these
Important: the following anomalies are not guarantees of excess
returns
studies have shown they hold on average for stocks
in the past…no guarantee that they will hold in the future
and definitely no guarantee they hold all the time

14. Size Effect
stock of small firms (by market cap.) tend to outperform the stock of large firms
holds after adjusting for risk (using traditional risk measures)

15. January Effect January tends to be the best month for stocks
i.e. stocks tend to jump up a bit at the beginning if the year
Note: this effect is often explained by tax loss selling in
December, with people repurchasing stocks in January
Note: it turns out the that the January Effect and the Size Effect
are related, on average, it is only small stocks that experience
excess returns at the beginning of the year
small stocks on NYSE earn about 8% in January,
on average, and less than 1% in each of the other months
on average

16. Value Stocks high dividend yields, and/or low market-book
Value Stocks: stocks with low price-earnings, and/or
high dividend yields, and/or low market-book
after adjusting for risk, value stocks tend to outperform growth stocks
this is a long term phenomenon…for some periods of time, growth stocks perform the best. Over the long term, however, value stocks tend to be the best stocks.

17. Momentum there is evidence of momentum in stock returns
the stocks that have performed the best over the previous 6 to 12 months will tend to perform well over the next 6 to 12 months
there is evidence of momentum in stock returns
stocks that do well tend to keep on doing well
possible explanation is people “jumping on the bandwagon”

18. Overreaction (Price Reversals)
Debondt and Thaler (Journal of Finance, 1985)
1926 to 1980 data
find that the best performing stocks over the last 3 to 5 years
perform badly over the next 3 to 5 years
the worst performing stocks over the last 3 to 5 years
perform very well over the next 3 to 5 years
by 3 years after identifying best and worst stocks,
the “worst” stocks had outperformed the “best” by 25%
Implication:
the market overreacts
e.g. when a stock does well, it gets pushed up too high,
eventually this is corrected

19. Momentum and Reversals
momentum and reversals (overreaction) are, in a sense, opposites
momentum says: buy the stocks that have performed
well, since this will likely continue
overreaction says: buy the stocks that have performed
poorly, since this will likely reverse itself
Important:
timing for the two effects is different
evidence seems to indicate short term momentum
(3 to 12 months) and long term reversals (3 to 5 years)

20. Volume, Momentum, and Reversals
study by Lee and Swaminathan (Journal of Finance, 2000)
look at effect of high or low volume trading on momentum
and reversals
classify stocks as “winners” and “losers” based on past year’s
performance , also look at trading volume over that last year
Results:
High volume “winners” - tend to do badly next year, reversal
Low volume “winners” - tend to do well next year, momentum
High volume “losers” - tend to badly next year, momentum
Low volume “losers” - tend to do well next year, reversal

21. Anomalies - conclusions
based, in part, on some of these anomalies, many investors feel
the market is not efficient
many investment strategies now based on behavioural finance
fairly new field that tries to explain the stock market
with psychology theories
Warning: just because a study purports to have found evidence of
some way to “beat the market” does not mean that it can or
should actually be used

22. one of the most accurate predictors of the stock market:
Super Bowl Effect: market will go up when an NFC
team wins Super Bowl, and will go down when AFC
wins
1967 to 2002, Super Bowl predicted market correctly
29 out of 37 times