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Investment Analysis and PortfolioManagement

First Canadian EditionBy Reilly, Brown, Hedges, Chang

5

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5

Copyright 2010 by Nelson Education Ltd. 5-2

Chapter 5

Efficient Capital Markets

Why Should Capital Markets Be Efficient?

Alternative Efficient Market Hypotheses

Tests and Results of the Hypotheses

Behavioural Finance

Implications of Efficient Capital Markets

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A large number of competing profit-

maximizing participants analyze and value

securities, each independently of the others

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

Are Markets Efficient?

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Are Markets Efficient?

Security price changes should beindependent and random

The security prices that prevail at any time

should be an unbiased reflection of allcurrently available information

In an efficient market, the expected returns

implicit in the current price of a stock shouldbe consistent with the perceived risk of thestock

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Efficient Market Hypothesis (EMH)

Random Walk Hypothesis

Changes in security prices occur randomly

Fair Game Model

Current market price reflect all available information abouta security and the expected return based upon this price isconsistent with its risk


Divided into three sub-hypotheses depending on the

information set involved

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Weak-Form EMH

Current prices reflect all security-market historical

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

In short, prices reflect all historical information


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Tests of Weak Form Efficiency

Statistical Tests of Independence Autocorrelation tests

Runs tests

Tests of Trading Rules Testing constraints Use only publicly available data

Include all transactions costs

Adjust the results for risk

Only better-known technical trading rules examined Too much subjective interpretation of data Almost infinite number of trading rules

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Tests of Weak Form Efficiency

Simulations of Specific Trading Rules

Trades a stock when price change exceeds a filtervalue

Studies have used a range of filters from 0.5% to50%

When these trading costs were considered, all thetrading profits turned to losses

Testing results generally support the weak-formEMH, but results are not unanimous

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Semi-Strong 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

In short, prices reflect all public information

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Strong-Form EMH

Stock prices fully reflect all informationfrom public and private sources

This implies that no group of investorsshould be able to consistently deriveabove-average risk-adjusted rates ofreturn

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Tests of Semi-Strong Form EMH

Time Series Studies

Time series analysis of returns or the cross-section distribution of returns for individual

stocks. If the market is efficient, individual stock returns

shouldnt be predicted with past returns or otherpublic information

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Event studies that examine how fast stockprices adjust to specific significant economicevents. If the market is efficient, it would

not be possible for investors to experiencesuperior risk-adjusted returns by investingafter the public announcement and payingnormal transaction costs


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Test of Semi-Strong Form EMH:

Adjustments for Market Effects

Test results shouldadjust a securitysrate of return for the

rate of return of theoverall marketduring the periodconsidered

Abnormal Rate of Return

ARit= Rit Rmt

where:

ARit= abnormal rate of returnon security iduring period t

Rit = rate of return on security iduring period t

Rmt=rate of return on a marketindex during period t

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Return PredictionStudies

Predict the time series offuture rates of return for

individual stocks or theaggregate market usingpublic information

Predict Cross SectionalReturns

Look for publicinformation regarding

individual stocks that willhelp predict the cross-sectional distribution offuture risk-adjusted ratesof return

These tests involve a

joint hypothesis and aredependent both onmarket efficiency and theasset pricing model used

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Return Prediction Studies

Times Series Test for AbnormalReturns

Short-horizon returns have limited results Long-horizon returns analysis has beenquite successful based on

dividend yield (D/P)

default spread term structure spread

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Quarterly Earnings Reports May yield abnormal returns due to unanticipated earnings

change

Large Standardized Unexpected Earnings (SUEs) result inabnormal stock price changes, with over 50% of the change

happening after the announcement

Unexpected earnings can explain up to 80% of stock drift

over a time period

Suggests that the earnings surprise is notinstantaneously

reflected in security prices

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The January Anomaly Stocks with negative returns during the prior year had

higher returns right after the first of the year

Tax selling toward the end of the year has been

mentioned as the reason for this phenomenon

Such a seasonal pattern is inconsistent with the EMH

Several studies in foreign markets found abnormal

returns in January, but the results could not beexplained by tax laws


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Other Calendar Effects All the markets cumulative advance occurs during the

first half of trading months

Monday/weekend returns were significantly negative

For large firms, the negative Monday effect occurred

before the market opened (it was a weekend effect),

whereas for smallerfirms, most of the negative

Monday effect occurred during the day on Monday (itwas a Monday trading effect)


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Price/Earnings Ratios

Low P/E stocks experienced superior risk-

adjusted results relative to the market, whereas

high P/E stocks had significantly inferior risk-

adjusted results

Publicly available P/E ratios possess valuable

information regarding future returns

This is inconsistent with semi-strong efficiency

Predicting Cross-Sectional Returns

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Price-Earnings/Growth Rate (PEG) Ratios

Studies have hypothesized an inverse relationship

between the PEG ratio and subsequent rates of

return. This is inconsistent with the EMH.

Studies are mixed:

Several studies using either monthly or quarterly

rebalancing indicate an anomaly

In contrast, a study with more realistic annual

rebalancing indicated that no consistent relationship

exists between the PEG ratio and subsequent rates of

return


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The Size Effect

Several studies have examined the impact of size on the

risk-adjusted rates of return

The studies indicate that risk-adjusted returns for extendedperiods indicate that the small firms consistently

experienced significantly larger risk-adjusted returns than

large firms

Firm size is a major efficient market anomaly

The small-firm effect is not stable from year to year


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Book Value to Market Value Ratio Significant positive relationship found between

current values for this ratio and future stock

returns Results inconsistent with the EMH

Size and BV/MV dominate other ratios such as E/P

ratio or leverage

This combination only works during expansive

monetary policy

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Event Studies

Stock split studies show that splits do not result inabnormal gains after the split announcement, butbefore

Initial public offerings (IPOs)

Over the past 20 years a number of companies have gonepublic

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Initial Public Offerings (IPOs)

Average underpricing exists &varies over time

Price adjustment tounder pricing takes

place within 1 year ofthe IPO

Institutionalinvestors capturedmost of the short

term profits fromunder pricing

Support for semi-strong EMH

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Exchange Listing

Results of studies are mixed

Studies show that stock prices rose before listing

announcement Prices consistently declined after actual listing

No solid understanding of why anomaly occurs

Thus evidence does NOT support EMH

Event Studies

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Unexpected World Events & Economic News

Stock prices quickly adjust to unexpected worldevents and economic news and hence do not

provide opportunities for abnormal profits

Event Studies

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Announcements of Accounting Changes

Quickly adjusted for and do not seem to provideopportunities

Corporate Mergers

Stock prices rapidly adjust to corporateevents such as mergers and offerings

Event Studies

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Event Studies

Strong-Form EMH

This assumes perfect markets in which allinformation is cost-free and available toeveryone at the same time

Prices reflect all public and private

information

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Corporate Insider Information

Corporate insiders must report to the System forElectronic Disclosure for Insiders (SEDI)

Insiders are corporate officers, executives,directors and investors with ownership of 10% ormore in a firms equity

Transactions must be reported within 10 days of

the transaction date

Tests of Strong-Form EMH

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Corporate Insider Information

Chowdhury et al, found that insiders generallyhave enjoyed above average profits (1993)

Implies that many insiders had privateinformation from which they derived above-average returns on their company stock

Other studies have found that insiders did not

enjoy above average profits after consideringtrading costs

Studies provide mixed support for strong-formEMH


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Stock Exchange Specialists

monopolistic access to information about unfilledlimit orders

expect specialists to derive above-averagereturns from this information

data generally supports this expectation


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Security Analysts

Tests have considered whether it is possible toidentify a set of analysts who have the ability to

select undervalued stocks The analysis involves determining whether, after

a stock selection by an analyst is made known, asignificant abnormal return is available to those

who follow their recommendations


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Value Line (VL) Enigma Value Line (VL) publishes financial information on

about 1,700 stocks

Includes timing rank from 1 down to 5 Firms ranked 1 substantially outperform the

market

Rankings change result in fast price adjustment

Value Line effect may be due to unexpected

earnings anomaly due to changes in rankings

from unexpected earnings


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Analysts Recommendations Evidence in favour of existence of superior

analysts who apparently possess private

information Analysts appear to have both market timing and

stock-picking ability

Consensus recommendations do not contain

incremental information, but changesinconsensus recommendations are useful

Most useful information consisted of upwardearning revision


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Money Managers

Trained professionals,

working full time at

investment management

If any investor can achieveabove-average returns, it

should be this group

If any non-insider can

obtain inside information,

it would be this group dueto the extensive

management interviews

that they conduct

Performance

Most tests examine mutual

funds

New tests also examine

trust departments,insurance companies, and

investment advisors

Risk-adjusted, after

expenses, returns of

mutual funds generallyshow that most funds did

not match aggregate

market performance

Professional Money Managers

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Behavioural Finance

Analysis of various psychological traits of individualsand how these traits affect the manner in whichthey act as investors, analysts, and portfoliomanagers

No unified theory of behavioural finance and theemphasis has been on identifying portfolioanomalies that can be explained by variouspsychological traits

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Behavioural Finance

Prospect Theory

Contends that utilitydepends on deviations

from moving referencepoint rather thanabsolute wealth

Over Confidence

Also referred to as theconfirmation bias

Look for informationthat supports theirprior opinions anddecision

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Behavioural Finance

Noise Traders

Influenced strongly bysentiment

Tend to movetogether, whichincreases the pricesand the volatility

Escalation Bias

Investors continue toput more money into

a failing investmentthat they feelresponsible for ratherthan into a successfulinvestment

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Behavioural Finance

Fusion Investing

Integration of two elements of investment

valuation-fundamental value and investor

sentiment

During some periods, investor sentiment is

muted and noise traders are inactive, so that

fundamental valuation dominates market returns

In other periods, when investor sentiment is

strong, noise traders are very active and market

returns are more heavily impacted by investor

sentiments

I li ti f EMH

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Implications of EMH

on Capital Markets

Results of many studies indicate the capital marketsare efficient as related to numerous sets ofinformation

On the other hand, there are substantial instanceswhere the market fails to rapidly adjust to publicinformation

I li ti f EMH

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Implications of EMH

on Capital Markets

What are the implications for investorsin light of these mixed evidence?

Technical Analysis

Fundamental Analysis

Portfolio Management

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EMH and Technical Analysis

Assumptions of technical analysis directly opposethe notion of efficient markets

Technicians believe that new information is notimmediately available to everyone, butdisseminated from the informed professional first tothe aggressive investing public and then to themasses

Technicians also believe that investors do notanalyze information and act immediately

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EMH and Technical Analysis

Stock prices move to a new equilibrium after therelease of new information in a gradual manner,causing trends in stock price movements thatpersist for periods of time

Technical analysts develop systems to detectmovement to a new equilibrium (breakout) andtrade based on that

If the capital market is weak-form efficient, atrading system that depends on past trading datahas no value

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EMH and Fundamental Analysis

Fundamental analysts believe that there is a basicintrinsic value for the aggregate stock market,various industries, or individual securities and thesevalues depend on underlying economic factors

Investors should determine the intrinsic value of aninvestment at a point in time and compare it to themarket price

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EMH and Fundamental Analysis

If you can do a superior job of estimating intrinsicvalue, you can make superior market timingdecisions and generate above-average returns

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Aggregate Market Analysis

EMH implies that examining only past economicevents is not likely to lead to outperforming a buy-and-hold policy because the market adjusts rapidlyto known economic events

Merely using historical data to estimate futurevalues is not sufficient

You must estimate the relevant variables that causelong-run movements

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Industry and Company Analysis

Wide distribution of returns from different industriesand companies justifies industry and companyanalysis

Must understand the variables that effect rates ofreturn and

Do a superior job of estimating future values ofthese relevant valuation variables, not just look atpast data

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Industry and Company Analysis

Important relationship between expected earningsand actual earnings

Accurately predicting earnings surprises

Strong-form EMH indicates likely existence ofsuperior analysts

Studies indicate that fundamental analysis based onE/P ratios, size, and the BV/MV ratios can lead todifferentiating future return patterns

Conclusions on

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Conclusions on

Fundamental Analysis

Estimating the relevant variables is as much an artand a product of hard work as it is a science

Successful investor must understand what variablesare relevant to the valuation processes and havethe ability and work ethic to do a superior job ofestimating these important valuation variables

Efficient Markets

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Concentrate efforts in mid-cap stocks that do not

receive the attention given by institutional

portfolio managers to the top-tier stocks

The market for these neglected stocks may beless efficient than the market for large well-

known stocks

Efficient Markets

& Portfolio Management

Efficient Markets

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Efficient Markets


The Use of Index Funds

Efficient capital markets and a lack of superior

analysts imply that many portfolios should be

managed passively

Institutions created market (index) funds which

duplicate the composition and performance of a

selected index series

Efficient Markets

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Insights from Behavioural Finance

Growth companies will usually not be growth

stocks due to the overconfidence of analysts

regarding future growth rates and valuations

Notion of herd mentality of analysts in stock

recommendations or quarterly earnings estimates

is confirmed

Efficient Markets


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