2. The Inefficient Stock Market What Pays Off and Why (Prentice Hall, 1999) Visit our web-site at HaugenSystems.com

3. Why

4. The Topography of the Stock Market

5. TrueAbnormal Profit True Abnormal Profit F Best estimate (using all relevant information and state-of-the-art analysis) of the risk adjusted, present value of a firms future abnormal profits.

6. Priced Abnormal Profit F Risk adjusted, present value of future abnormal profits reflected in the stock price.

7. True Abnormal Profit Priced Abnormal Profit Growth Stocks Value Stocks Efficient Market Line under- priced stock The Position of Portfolios in Abnormal Profit Space

8. willproduceexcessreturn True Abnormal Profit Priced Abnormal Profit Efficient Market Line over- priced stock The Position of Portfolios in Abnormal Profit Space Growth Stocks Value Stocks

9. willproduceexcessreturn True Abnormal Profit Priced Abnormal Profit Efficient Market Line willproduce deficient return The Position of Portfolios in Abnormal Profit Space Growth Stocks Value Stocks

10. Imprecision Imprecision

11. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

12. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

13. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

14. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

15. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

16. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

17. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

18. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

19. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

20. Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

21. Efficient Market Line Priced Abnormal Profit True Abnormal Profit

22. The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

23. The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

24. The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

25. Available assets IMPRECISION: Different prices for stocks with the same TRUE Abnormal Profit The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

26. Available assets IMPRECISION: Stocks with the same price have different TRUE abnormal profit The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

27. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

28. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

29. Bias Bias

30. The Market Over-reacts to Success and Failure

31. Mean-reversion in Relative Profitability How Fast? Fuller Huberts & Levinson (1973 - 1990)

32. Relative Subsequent Growth in Highest, High, Low and Lowest Quintiles of E/P Ratio Low and Lowest Quintiles of E/P Ratio -10%-8%-6%-4%-2%0%2%4%6%8%10% Growth in Earnings per Share Relative to Middle Quintile Lowest E/P(Growth) Low E/P High E/P Highest E/P (Value) 1 Year ahead 2 Years ahead 3 Years ahead 4 Years ahead 5 Years ahead 6 Years ahead 7 Years ahead 8 Years ahead Number of Years After Ranking

33. Is the Market Surprised by the Speed of Mean- reversion? La Porta Lakonishok Shleifer & Vishny (1971-1992)

34. -1.0%-0.5%0.0%0.5%1.0%1.5%2.0% Three day rate of return -2.0%-1.5% Value Growth First year following ranking Second year following ranking Third year following ranking Fourth year following ranking Fifth year following ranking Returns of Growth and Value Stocks Around Earnings Announcement Dates Around Earnings Announcement Dates

35. Implications for Market’s Topography

36. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

37. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

38. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

39. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

40. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

41. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

42. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

43. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

44. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

45. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

46. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

47. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

48. Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space BIAS: Overreaction to Abnormal Profit True Priced over- priced Efficient Market Line under- priced Priced Abnormal Profit True Abnormal Profit

49. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Available assets Value investors head West GrowthinvestorsheadNorth Priced Abnormal Profit

50. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Available assets Priced Abnormal Profit PureGrowth willunderperform GARP willoutperformmarket

51. The Relative Positions of Positions of the Deciles the Deciles

52. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Super Stocks Stupid Stocks Priced Abnormal Profit

53. What’s Behind the Payoff to Profitability? Imprecision

54. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

55. What’s Behind the Payoff to Cheapness? Imprecision & Bias

56. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

57. Efficient Market Line True Abnormal Profit Priced Abnormal Profit

58. What’s Behind the Negative Payoff to Risk?

59. Cumulative Difference in Return Between Low Volatility Portfolio and S&P 500 -35% -25% -15% -5% 5% 15%25%CumulativeDifference1928193819481958196819781988

60. Cumulative Difference in Return Between Low Volatility Portfolio and S&P 500 -35% -25% -15% -5% 5% 15% 25% 1928193819481958196819781988 CumulativeDifference

61. Cumulative Difference in Return Between Low Volatility Portfolio and S&P 500 -35% -25% -15% -5% 5% 15% 25% 1928193819481958196819781988 CumulativeDifference

62. I. Over-valued and Risky Growth Stocks Expensive growth stocks tend to produce low future returns They also tend to be more risky (Fama/French 1992 Table II.)

63. Book to Market Equity of Portfolios Ranked by Beta 0.5 0.6 0.7 0.8 0.9 1 0.60.811.21.41.61.8 Beta Book to Market Equity

64. II. Agency Problems of Financial Analysts (Sias, Financial Analysts’ Journal, 1996) Studies NYSE stocks (1977-91). Forms size deciles in each year. Within each size decile, he forms 3 equal-numbered groupings based on percentage institutionally held. Computes volatility using weekly data.

65. Median Institutional Holdings, Capitalization, and Volatility by Capitalization Institutional Holdings Sorted Portfolios, NYSE Firms, 1977-91 Portfolio Smallest Decile 2 Decile 3 Decile 4 Decile 5 Decile 6 Decile 7 Decile 8 Decile 9 Largest Institutional Holdings (%) HighLow Confidence Level (High minus Low).2275.214499%.3335.308299%.3978.362399%.4760.422799%.5268.451099%.5564.455899%.5916.439099%.6361.440899%.6566.388799%.6428.345599% Capitalization ($millions) HighLow Confidence Level (High minus Low) 28.5618.5699% 60.4652.1599% 91.8784.0599% 151.10135.2599% 222.35207.4599% 364.45326.8099% 562.80514.9099% 926.75838.2099% 1,629.001,491.5099% 3,777.004,338.5099% Annualized Standard Deviation Of Weekly Returns (%) HighLow Confidence Level (High minus Low) 43.2749.4799% 36.7032.8199% 36.4930.8699% 35.0529.8599% 33.3928.7099% 32.0225.5699% 30.6527.1999% 29.2125.3899% 28.3424.5299% 26.0323.8099%

66. Thus, There May be Two Causes for the Inversion in the Relationship Between Risk and Expected Return The market’s tendency to over-price the more volatile, growth stocks. The attraction of institutional investors to the more newsworthy, volatile stocks.

67. What’s Behind the Technical Payoffs to Price History? Short-term reversals Intermediate momentum Long-term reversals

68. Short-term Reversals Price pressure Reversals of over-reactions

69. Intermediate Momentum and Long-term Reversals Repetition of earnings surprises of the same sign (Bernard & Thomas). Over-estimating the length of the short- run.

70. Jegadeesh and Titman (Journal of Finance, 1993) Observe stock returns around earnings announcement dates Compute difference in returns to decile winners and losers over previous 6 months Study spans the period 1965 -89

71. Cumulative Difference Between Winner and Loser Portfolio Rates of Return at Announcement Dates -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00%5.00% Cumulative Difference Between Winner and Loser Portfolio Rates of Return 1357 17 9111315192123252729313335 Months Following 6-Month Performance Period

72. Cumulative Difference Between Winner and Loser Portfolio Rates of Return at Announcement Dates -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00%5.00% Cumulative Difference Between Winner and Loser Portfolio Rates of Return 1357 17 9111315192123252729313335 Months Following 6-Month Performance Period

73. Cumulative Difference Between Winner and Loser Portfolio Rates of Return at Announcement Dates -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00%5.00% Cumulative Difference Between Winner and Loser Portfolio Rates of Return Months Following 6-Month Performance Period 1357 17 9111315192123252729313335

74. Building Weak Expected Return Factor Models Brennan Chordia & Subrahmanyam

75. Methodology Study 970 NYSE stocks over the period 1977-89. Rank stocks first by size and form quintiles. Within each quintile, rank by book-to-price and form quintiles again to obtain a total of 25 groupings. Construct 5 stock portfolios, the returns to which account, as closely as possible, for the correlations among the returns to the 980 stocks. Use the portfolios as factors to explain the time-series of individual stock returns. Do the same with the size and B/P portfolio returns. In any given month, regress the cross-section of returns to the 25 portfolios on a profile of 13 portfolio characteristics. Do the same with the unexplained returns to the 25 portfolios. Compute means for the 13 regression coefficients (1977-89).

76. Most Important Factors 1979/01 through 1986/06 1986/07 through 1993/12 FactorMeanConfidenceMeanConfidence One-month excess return-0.97%99%-0.72%99% return Twelve-month excess0.52%99%0.52%99% Trading volume/market cap -0.35%99%-0.20%98% Two-month excess return-0.20%99%-0.11%99% Earnings to price0.27%99%0.26%99% Return on equity0.24%99%0.13%97% Book to price0.35%99%0.39%99% Trading volume trend-0.10%99%-0.09%99% Six-month excess return0.24%99%0.19%99% Cash flow to price0.13%99%0.26%99%

77. Average Payoffs to the BCS Factor Model Factor Covering Size Book-to-Market Volume of Trading Number of Analysts Dispersion of Earnings Estimates Percentage Bid-Asked Spread Percentage Institutional Ownership 1.00 if in S&P 0 Otherwise Reciprocal of Share Price Dividend – to – Price Two-Month Past Return Five-Month Past Return Eleven-Month Past Return Portfolio Returns Mean Payoff Confidence %.20593%.73098% -.03360% -.02320% -.05070% 1.02099% -.21180% -.10710% -.0065% -.93893% -.30080%.15075%.43099% Residual Portfolio Returns Mean Payoff Con f idence % -.09280%.55980% -.23180% -.16665% -.69492%.2596%.44898%.73493%.30165% -3.7065% -2.1880% -.26820% 1.5693% Residual Stock Returns Mean Payoff Confidence % -.44299% -.25699% -.10890%.21499% -.28799% -.53499%.17999%.18495%.06960% 2.3385% -.28020% -.92980%.77897%

78. Response In the case of the 25 portfolios its, proportionately, like trying to estimate the payoffs to 2 factors with 4 plot points. In the case of the 25 portfolios, the exposures to all factors except size and B/P are likely to be quite homogeneous. The unexplained returns to the 25 portfolios are likely to be extremely small.

79. DiversifiableRisk Decreases with the Number of Stocks in a Portfolio Diversifiable Risk Decreases with the Number of Stocks in a Portfolio 40 1 4 7 10 13 16 19 22 25 28 31 34 37.00.01.02.03.04.05.06.07.08.09.10 Diversifiable Risk Number of Stocks in Portfolio

80. A Test of Relative Predictive Power (1980 -97) Model employing factors exploiting the market’s tendencies to over- and under-react vs. Models employing risk factors only

81. The Ad Hoc Expected Return Factor Model Risk Liquidity Profitability Price level Price history Earnings revision and surprise

82. Decile Returns for the Ad Hoc Factor Model 2345678910 Decile 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 1AverageAnnualized Return

83. The Capital Asset Pricing Model Market beta (Measured over the trailing 5-year periods)

84. Decile Returns for CAPM Model 345678910 Decile 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 12AverageAnnualized Return

85. The Arbitrage Pricing Theory Macroeconomic Factors Monthly T-bill returns Long-term T-bond returns less short-term T-bond returns less low-grade Monthly inflation Monthly change in industrial production Beta Estimation Betas re-estimated monthly by regressing stock returns on economic factors over trailing 3-5 years Payoff Projection Next month’s payoff is average of trailing 12 months

86. Average Returns for APT Model Annualized 2345678910 Decile 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 1AverageReturn

87. Overall Results Ad Hoc Expected Return Factor Model –Average Annualized Spread Between Deciles 1 & 10 46.04% –Years with Negative Spreads 0 years Models Based on MODERN FINANCE –CAPM Average Annualized Spread Between Deciles 1 & 10 -6.94% Years with Negative Spreads13 years –APT Average Annualized Spread Between Deciles 1 & 10 6.06% Years with Negative Spreads 6 years

88. Getting to Heaven and Hell in the Stock Market

89. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Super Stocks Stupid Stocks Priced Abnormal Profit

90. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven Stupid Stocks Priced Abnormal Profit

91. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven InvestmentHell Priced Abnormal Profit

92. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven InvestmentHell Priced Abnormal Profit Can’t get to heaven by going around the corner You must go directly to heaven

93. The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit InvestmentHeaven InvestmentHell Can’t get to hell by going around the corner You must go directly to hell