Chapter 10-Efficient Capital Markets

8/13/2019 Chapter 10-Efficient Capital Markets

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Chapter 10

EFFICIENT CAPITAL MARKETS



Chapter 10 Questions

• What do we mean when we say that capital marketsare efficient?

• Why should capital markets be efficient?

•What factors contribute to an efficient market?

• Given the overall efficient market hypothesis (EMH),what are the three subhypotheses and what are theimplications of each of them?



Chapter 10 Questions

• How does one test the three efficient marketsubhypotheses, and what are the results of thetests?

•

For each set of tests, which results support the EMHand which indicate an anomaly related to thehypothesis?

• What are the implications of the results for stock

strategies and portfolio managers?• What is the evidence related to the EMH for markets

in foreign countries?



Efficient Capital Markets

• In an efficient capital market, security prices

adjust rapidly to the arrival of new

information, therefore the current prices

reflect all information about the security

• Whether markets are efficient has been

extensively researched and remains

controversial



Why does it matter?

• If prices do fully reflect all current information,

it would not be worth an investor’s time to

use information to find undervalued

securities.

• If prices do NOT fully reflect information, FIND

AND USE THAT INFORMATION, and perhaps

you will be able to make a killing in themarket.



Investing and Market Efficiency

• Would stock selection

amount to throwing darts

at a wall in an efficient

market?

• Hardly! Risk still matters.

We would still want to

research the risk-return

properties of securities.



Why Should Capital Markets Be

Efficient?

• What would be the ingredients of an“informationally” efficient market?

– A large number of profit-maximizing participants analyzeand value securities

– New information regarding securities comes to the marketin a random fashion

– Profit-maximizing investors adjust security prices rapidly toreflect the effect of new information

•Price adjustments are unbiased – correct on average.

• Under these conditions, a security’s price would beappropriate for its level of risk.



Alternative Efficient Market

Hypotheses

The various forms of the efficient market

hypothesis differ in terms of the information

that security prices should reflect.

• Weak-form EMH

• Semistrong-form EMH

•

Strong-form EMH



Weak-Form EMH

• Current prices fully reflect all security-market

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



Implications of the Weak-From

EMH• Examining recent trends

in price and other marketdata in order to predict

future price changeswould be a waste of timeif the market is weak-formefficient.

• A lot of people do price

charting and other formsof “technical analysis.”



Semistrong-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



Implications of the Semistrong-

Form EMH• If the market is efficient in

this sense, information in

The Wall Street Journal ,

other periodicals, andeven company annual

reports is already fully

reflected in prices, and

therefore not useful forpredicting future price

changes.





Tests and Results: Weak-Form EMH

Two Approaches

• Tests of “statistical memory” in security prices

and returns

• Tests of trading rules




• Statistical tests of independence betweenrates of return

– Autocorrelation tests

• Mostly support the weak-form EMH and indicate thatprice changes are random

• Some studies using more securities and morecomplicated tests cast some doubt

–

Runs tests• Indicate randomness in prices






Problems with tests

• Cannot be definitive since trading rules can becomplex and there are too many to test them all

•

Testing constraints – Use only publicly available data

– Should include all transactions costs

– Should adjust the results for risk (an apparently successful

strategy may just be a very risky strategy)



Conclusions:

Weak-Form EMH

• Results generally support the weak-form EMH,

but results are not unanimous

– Some strategies too subjective to test

– Not all trading rules are disclosed

• If you had a trading strategy that worked, would you

reveal it?!



Reality Check!

• If someone writes a bookon how to “beat themarket,” you can bet that

book sales are morelucrative than the tradingstrategy!

• Even if it once worked, ifit’s widely known, it won’t

work any more!• Don’t quit your day job to

trade on-line using apublished strategy!



Tests and Results: Semistrong-Form

EMHThree different groups of tests:

• Time series analysis using public information

• Event studies examine how fast stock prices adjust to

significant economic events• Cross-sectional analysis of returns based on public

information

Tests involve the estimation of “abnormal returns,”

where expected abnormal returns are zero in anefficient market.



Tests and Results:

Semistrong-Form EMH• Tests often involve “market-adjusted returns,”

created by subtracting the market return from the

security’s return, thereby defining a security’s

“abnormal return:”ARit = Rit - Rmt

where:

– ARit = abnormal return on security i during period t

– Rit = return on security i during period t

– Rmt = return on a market index during period t



Tests and Results of

Semistrong-Form EMH• Another definition of abnormal return is a “risk-

adjusted return” or “market model” which adjustsfor the security’s own required rate of return, givenits systematic risk (as measured by beta):

ARit = Rit - E(Rit)

where:

– E(Rit) = the expected rate of return for stock i during periodt based on the market rate of return and the stock’s

normal relationship with the market (its beta)




EMHTime series tests for predictability of returns and profit

opportunities

• Short-horizon returns have shown very limitedpredictability

• Long-horizon returns analysis shown somepredictability of returns based on:

– Dividend yield (D/P)

–

Default spread – Term structure spread




EMHTime series tests for predictability of returns and profit

opportunities

• Quarterly earnings reports information

–

Unanticipated earnings changes or “earnings surprises” arenot immediately reflected in security prices

• The January Anomaly (A “calendar” effect)

– Large returns in January present opportunities to purchasein December, and sell in January and earn abnormal

returns.




EMH

Time series tests for predictability of returns and

profit opportunities

• Other calendar effects

– Monthly effect

– Day-of-the-week effects

• Monday returns were significantly negative




EMHPredicting cross-sectional returns

• In an efficient market, all securities should have

equal risk-adjusted returns

• Studies examine alternative measures of size orquality as a tool to rank stocks in terms of risk-

adjusted returns

– These tests include a joint hypothesis of both market

efficiency and the asset pricing model used to generate

abnormal returns





• Price-earnings ratios

– Examine historical P/E ratios and returns

– Low P/E stocks had higher risk-adjusted returns than highP/E stocks

– Publicly available P/E ratios could be used for abnormal

returns

• Price-earnings/Growth ratios – Mixed results





• The size effect

– The risk-adjusted returns for extended periods indicate

that the small firms consistently experienced significantlylarger risk-adjusted returns than large firms

– Abnormal returns could occur because either markets are

inefficient or the market model is not properly specified

and provides incorrect estimates of risk and expectedreturns (joint test)





• The size effect

– Adjustments for riskiness of small firms did not explain thelarge differences in rate of return

– The impact of transactions costs of investing in small firmsis substantial (takes away the differential with a short-termtrading strategy)

– Even after risk and transaction costs, small firms

outperform large firms with annual trading – The small-firm effect is not stable

– Firm size is an important anomaly




EMH

Predicting cross-sectional returns

• Neglected firms and trading activity

– Is there an effect related to the number of

analysts following a stock and how frequently a

stock trades?

– Mixed results, mostly any apparent effects

explained by taking the size effect intoconsideration





• Book value-market value (BV/MV) ratio

– Significant positive relationship between the current

values for this ratio and future stock returns• Although various measures including the P/E ratio

seem to help predict future returns, the size effect

and BV/MV ratio have the greatest predictive ability.




EMHEvent studies

• Event studies examine abnormal returns surroundingvarious events

•

The EMH is that abnormal returns are zero• Stock split studies

– Mostly show no positive impact on returns because of astock split

•Initial public offerings – Significant IPO underpricing, but it quickly adjust away in

the first day, consistent with the EMH




EMHEvent studies

• Exchange listings

– Some evidence of short-term profit potential following the

“listing announcement” • Unexpected world events and economic news

– Quickly reflected in security prices, do not provide

opportunities




EMHEvent Studies

• Announcements of accounting changes

– Quickly reflect in security prices and do not seem to

provide abnormal profit opportunities• Corporate events

– Prices react quickly to announcements of mergers,

financing decisions, etc.

– No systematic profit opportunities



Summary on the

Semistrong-Form EMH• Evidence is mixed

• Strong support of the EMH from numerous event

studies with the exception of exchange listing studies

• Strong evidence against the EMH from both timeseries and cross-sectional studies

– Dividend yields, earnings surprises, calendar effects

– The size effect, BV/MV, P/E ratios, etc.



Tests and Results: Strong-Form

EMHTesting Groups of Investors

• Tests usually center on whether any group ofinvestors consistently earn abnormal profits.

• Corporate insiders

• Stock exchange specialists

• Security analysts

• Professional money managers




EMHCorporate Insiders

• Insiders include major corporate officers, directors,

and owners of 10% or more of any equity class of

securities• Insiders must report to the SEC each month on their

transactions as insiders

• These insider trades are made public about six weeks

later and allow for study




EMHCorporate Insiders

• Mixed results

• Corporate insiders generally experience above-

average profits especially on purchase transactions – This implies that many insiders had private information

from which they derived above-average returns on theircompany stock

• Later studies indicate that insiders may no longer beable to generate abnormal returns




EMH

Stock Exchange Specialists

• Specialists have monopolistic access to

information about unfilled limit orders

• You would expect specialists to derive above-

average returns because of their superior

information, and this appears to be the case.

d l




EMHSecurity Analysts

• Tests have considered whether it is possible to

identify a set of analysts who have the ability to

select undervalued stocks• This looks at whether, after a stock selection by an

analyst is made known, a significant abnormal return

is available to those who follow their

recommendation

d l




EMHSecurity Analysts

• The Value Line Enigma

– Firms ranked 1 for “timeliness” substantially outperformthe market; firms ranked 5 substantially underperform the

market

– Prices now adjust quickly to changes in rankings

– Net of transaction costs, rankings do not appear to havevalue in terms of producing abnormal returns

• There is some evidence of superior analysts whoapparently posses private information

d l




EMHProfessional Money Managers

• Trained professionals, working full time atinvestment management

•

If any investor can achieve above-average returns, itshould be this group

• If any non-insider can obtain inside information, itwould be this group due to the extensive

management interviews that they conduct

T d R l S F




EMH

Professional Money Managers

• Most tests examine mutual funds

• Risk-adjusted returns of mutual funds

generally show that most funds did not match

aggregate market performance

S h



Summary on the

Strong-Form EMH• Mixed results

• Some strong support

– Professional money managers

• Some strong evidence against the EMH – Tests for corporate insiders and stock exchange specialists

do not support the hypothesis

• Both groups seem to have monopolistic access to important

information and use it to derive above-average returns



Behavioral Finance• A growing field of study in finance.

• Rather than assuming ultra-rational behavior, the

area of behavioral finance seeks to incorporate how

humans actually behave. – Incorporates the ways in which psychology may impact

investment decisions

– It has been useful for explaining various “anomalies” that

we observe in decision-making that are difficult toreconcile with rationality



Behavioral FinanceUsing psychological biases to explain behavior

– Why do investors persistently “ride” losers and sell

winners?

• Can be explained by prospect theory

– Why do investors display overconfidence in forecasts?

• Can be explained by the confirmation bias

– Why do investors tend to put more money into failing

investments?

• Can be explained by the escalation bias



Implications of Market Efficiency

• Overall results indicate the capital markets are

efficient as related to numerous sets of information

• There are substantial instances where the market

fails to rapidly adjust to public information – So, what techniques will or won’t work?

– What do you do if you can’t beat the market?

Effi i t M k t



Efficient Markets

and Technical Analysis• Assumptions of technical analysis directly oppose the

notion of efficient markets

• Technicians believe that stock prices move inpatterns that persist and are predictable to theinformed investor.

• Technical analysts develop systems to detect trendsand patterns in prices

•

If the capital market is weak-form efficient, a tradingsystem that depends on past trading data can haveno value

Effi i t M k t d F d t l



Efficient Markets and Fundamental

Analysis• Fundamental analysis involves determining an

investment’s intrinsic values based on company andeconomic “fundamentals”

– The intrinsic value is compared to the market price to

determine whether the investment is undervalued orovervalued

• In an efficient market, prices already reflect publicinformation, so determining “intrinsic value” using

that information is not a worthwhile exercise

Effi i t M k t d F d t l



Efficient Markets and Fundamental

Analysis• Past vs. Future

– The EMH, importantly, considers the incorporation of

available information, which is primarily historic in nature.

– Much of what is involved in fundamental analysis,

including aggregate market analysis and industry analysis,

involves estimating future values.

– Superior analysts are those who will be better at predicting

this uncertain future.

Effi i t M k t d P tf li



Efficient Markets and Portfolio

Management• Does active portfolio management pay off?

– Research indicates that most money managers dokeep pace with the market

•Certainly with a superior analyst,recommendations should be followed

– Opportunities may be present in smaller,neglected stocks (although risk must be taken into

account)

Effi i t M k t d P tf li



Efficient Markets and Portfolio

Management

• Without superior analysts, passive

management may outperform active

management

– Build a globally diversified portfolio with a risklevel matching client preferences

– Minimize transaction costs (taxes, trading

turnover, liquidity costs)

The Rationale and



The Rationale and

Use of Index Funds• Efficient capital markets and a lack of superior

analysts imply that many portfolios should be

managed passively (so their performance matches

the aggregate market, minimizes the costs ofresearch and trading)

• Institutions created market (index) funds which

duplicate the composition and performance of a

selected index series



Insights from Behavioral Finance

• There may be trading opportunities created by

persistent investor biases and “herd

mentality”

– Supports the notion of contrarian investmentstrategies

– Some mutual funds employ behavioral finance

strategies

Efficiency in European Equity



Efficiency in European Equity

Markets

• Hawawini study indicates behavior of

European stock prices is similar to U.S.

common stocks

– Despite market differences, most results areessentially similar

– Appropriate to assume a similar level of efficiency

in European markets to those in the United States

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Chapter 10-Efficient Capital Markets

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