Chapter 8

The Efficient Market

Hypothesis

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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8.1 Random Walks and the Efficient Market

Hypothesis

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Efficient Market Hypothesis (EMH)• Do security prices accurately reflect information?

– Informational Efficiency _____________________________________

– Allocational Efficiency

Huge implications concerning the answers to these questions ~ abnormal profits or waste of resources

Are price changes consistently predictable?

Are prices correct in that they _________ ________________________ associated with the security?

accuratelyreflect the (relative) value

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Implications of Efficiency• Allocational efficiency

– If markets are not allocationally efficient then perhaps there is a ________________________ ___________ in capital markets.

•

– – –

role for greater government intervention

Possible rules changes to attempt to improve allocational efficiency

Tax on trading activity

More taxes on short holding period returns

Changes in corporate compensation

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Implications of Efficiency

• Informational efficiency– If markets are not informationally efficient

•

–

–

Investors may not be able to trust that market prices are up to date and investors should then conduct their own research (or hire a researcher) to validate the price.

Privileged groups of investors will be able to consistently take advantage of the general public.

Active strategies could outperform passive strategies.

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EMH and Competition

* Competition among investors should imply that stock prices fully and accurately reflect publicly available information very quickly. Why?

Else there are unexploited profit opportunities.

* Once information becomes available, market participants quickly analyze it & trade on it & frequent, low cost trading assures prices reflect information.

Questions arise about efficiency due to:

• Unequal access to information

• Structural market problems

• Psychology of investors (Behavioralism) ~ irrational explanations like weather may have an impact on investment performance or people may be easily fooled, etc

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• Why are price changes random?–

– –

Random Price Changes

In very competitive markets prices should react to only NEW information

Flow of NEW information is random

Therefore, price changes are random

Idea that stock prices follow a “Random Walk”

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• Random Walk: stock price ______________________

• Stock prices actually follow a ____________________•

•

•

Random Walk and the EMHchanges are unpredictable

submartingale process

Expected price change should be positive over time

But random changes are superimposed on the positive trend

E(pricej,t) > E(pricej,t-1) t = time period

A “pure” random walk implies informational efficiency

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Security Prices

Time

Random Walk with Positive Trend

Evidence on Random Walk idea later.

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Forms of the EMH

• Prices reflect all relevant information• Vary the ________________

– WeakThe relevant information is historical data such as past prices and trading volume. If the markets are weak form efficient, use of such information provides no benefit at the margin.

information set

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Forms of the EMH– Semi-strong

The relevant information is "all publicly available information, including the past data and information just released to the public."

If the markets are semi-strong form efficient, then studying studying earnings and growth forecasts and reacting to news provides no net benefit in predicting price changes at the margin.

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Forms of the EMH– Strong

The relevant information is “all information” both public and private or “insider” information.

If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin.

SEC Rule 10b-5 limits trading by corporate insiders (officers, directors and major shareholders) using the insider information. Insider trading must be reported.

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Relationships between forms of the EMH

• Notice that _______________________________ __________________ (but _____________)

• Strong form efficiency would imply that __________________________________________.

semi-strong efficiency implies weakform efficiency holds NOT vice versa

both semi-strong and weak form efficiency hold

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8.2 Implications of the EMH (for Security

Analysis)

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Types of Stock Analysis & Relationship to the EMH

• Technical Analysis:

– If the markets are efficient, will technical analysis be able to consistently predict price changes?

NO

Technical Analysis using prices and volume information to predict future price changes

TA assumes prices follow predictable trends

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Basic Types of Technical AnalysisSupport and resistance levels• Support level:

– A price level below which it is supposedly unlikely for a stock or stock index to fall.

• Resistance level: – A price level above which it is supposedly

unlikely for a stock or stock index to rise.

A resistance level may arise at say $31.25 if a stock repeatedly rises to $31.25 and then declines, indicating that investors are reluctant to pay more than this price for the stock.

A stock price above $31.25 would then indicate a 'breakout' which would be a bullish signal.

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Types of Stock Analysis & Relationship to the EMH

• Fundamental Analysis:

– Will fundamental analysis be able to consistently predict price changes?

using economic and accounting information to predict stock price changes

If the markets are only weak form efficient?

Fundamental Analysis CAN predict price changes

If the markets are semi-strong or strong form efficient?

Fundamental Analysis CANNOT predict price changes

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Fundamental Analysis

• Fundamental analysis assumes that stock prices should be equal to

• Fundamental analysis is thus the

the discounted value (PV) of the expected future cash flows the stock is expected to provide to investors.

“art” of identifying over- and undervalued securities based on an analysis of the firm's future prospects.

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Fundamental Analysis

• Fundamental analysis varies in technique but generally focuses on

forecasting the firm's future dividends or earnings,

discounting those future cash flows by the required rate of return (usually obtained from the CAPM),

and comparing the resulting estimated price with the current stock price.

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Fundamental Analysis• If the estimated value is ______ than the current price

an investor should ___ the stock since it is ___________ and since its price should ________ (eventually) to the "true" or "fundamental" value uncovered by the analyst.

• If the estimated price is ____ than the current price the stock should be ____(or sold short) because the stock is currently __________ by the market.

• In either case if the analyst is correct the investor should receive an ________________.

undervalued increasebuy

greater

lesssold

overvalued

“abnormal return”

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Fundamental Analysis

• For FA to add value, your forecast must be better than the consensus forecast.

• Not enough to find a good company, you must find a company that is better than others believe, i.e., mispriced.

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• Active Management– – –

• Passive Management– –

Implications of Efficiency for Active or Passive Management

Assumes inefficiency, use technical and/or fundamental analysis to pick securitiesSecurity analysis

Timing strategies

Investment Newsletters

Buy and Hold portfolios

Index Funds or Index ETFs (Exchange Traded Funds)

Consistent with semi-strong efficiency

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Even if the market is efficient (=> “the price is right ” & you cannot beat the market ex-ante),

a role still exists for portfolio management– – –

Market Efficiency and Portfolio Management

Identify risk & choose appropriate risk level

Tax considerations

Other considerations such as liquidity needs or diversify away from the client’s industry.

Aside) EMH=> The price is right and you get what you paid for. No ripoffs & No great deals! However, you still need to know what you want (e.g., read consumer reports, etc). You don’t want to buy a car with A/C in Alaska.

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8.3 Are Markets Efficient?

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• Recall that over time stock prices tend to follow a ____________________ => a randomly chosen portfolio of securities is expected to have a positive return.

Empirical Tests of Informational Efficiency

submartingale process

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• This means that when trying to figure out if some portfolio manager is earning abnormal returns we try to ____________________________ ______________________ in an ex-ante sense.

• I.E. they must ____________________________, or in practice they must beat ____________________ _______ on a consistent basis.

Empirical Tests of Informational Efficiency

compare their performance to arandomly chosen portfolio

outperform the random portfolio some benchmark rate

of return

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a.

b.

Empirical Tests of Informational Efficiency

Can anyone consistently earn an abnormal return?

This says that EMH=> investors do not repeat the same mistakes over and over in an irrational fashion.

For example, sometimes they may overestimate the impact on earnings of some event and sometimes they underestimate the impact on earnings but on average the estimates are unbiased.

Do investors systematically misinterpret information?

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• Event studies

• Assessing performance of professional managers

• Testing a trading rule

Empirical Tests of Informational Efficiency

Examine how quickly information is integrated into prices around an informational event.

EMH suggests a rapid assimilation of information into prices.

Can professional managers, using their resources and tools, “beat” the market after considering risk?

EMH suggests professionals will not outperform the market.

Testing whether a rule that uses available information can earn abnormal returns after considering the risk and cost of using the rule.

EMH suggests that such rules will not work.

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1. Examine prices and returns around some material announcement

How Tests Are Structured

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00 +t+t-t-t

Announcement DateAnnouncement Date

= abnormal return

Individual Abnormal Returns Surrounding the Event in an _______________Efficient Market

Earnings above forecast for exampleEarnings above forecast for example

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00 +t+t-t-t

Announcement DateAnnouncement DateEarnings above forecast for exampleEarnings above forecast for example

= abnormal return

Inefficient MarketIndividual Abnormal Returns Surrounding the Event in an _______________

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2. How do we determine if the returns are abnormal?

Market Model approach

a.

b.

How Tests Are Structured (cont.)

rt = a + b(rindex,t) + et

Estimate a and b coefficients

Abnormal Return or AR = (Actual - Expected)

ARt = et = Actual return – [a + b(rindex,t)]

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2. continued:

c. Cumulate the abnormal returns over time:

00 +t+t-t-t

How Tests Are Structured (cont.)

In this case there appears to be information leakage before the announcement date (day 0), is this a violation of EMH? Maybe, but wait!

Add up the ARs over time

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Cumulative Abnormal Returns before Takeover Attempts: Target Companies

In this case there appears to be information leakage before the announcement date (day 0)

Keown & Pinkerton

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Stock Price Reaction to CNBC Midday Reports

Patell & Wolfson

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• Magnitude Issue

Issues in Examining the Results

Even _____________________________ may be worthwhile for managers of large investments.

Eg.

The problem is that these __________________________ would be _________________ to measure since the standard deviation of many portfolios ______________.

small changes in performance

$5 billion dollar portfolio. Use research to improve results

by 1/10 of a percent (or 10 basis points) per year

= $5 million in value.

small changes in performancevirtually impossible

is 20% or more

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• (Sample) Selection Bias Issue

• Lucky Event Issue

Issues in Examining the Results

“I have this foolproof new trading scheme that will make me millions. I want to tell everyone about it.”

We rarely hear about the schemes that don’t really work!

If 10,000 people flip fair coins 50 times we can expect some people to flip 75% or more heads. => Do they have special skills to produce such results?

In a large group of stock analysts, some will be correct most of the time in their picks, and they will look very smart even though their results are due to a pure chance!

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• Possible Model Misspecification•

•

–

Issues in Examining the Results

Results have to be adjusted for the risk of the given stock or strategy.

This means that tests of efficiency are necessarily joint tests of the model (e.g., CAPM) used to measure risk and market efficiency.

Results counter to efficiency may be due to the fact the right model was not used to measure the risk and hence the expected return.

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Counter Evidence: Some Apparent Predictors of Broad Market Returns• Fama and French

–

• Campbell and Shiller–

• Keim and Stambaugh–

Aggregate returns tend to be higher for firms with higher dividend yields

Aggregate returns tend to be higher for firms with higher earnings yields

Changes in bond credit spreads can predict market returnsEach of these may also be consistent with changing risk premiums (=> failing to capture the “correct” risks) and may have nothing to say about market efficiency.

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Average Annual Returns for 10 size-based portfolios, 1926-2007

• Results are driven by returns in the first two weeks of January

• May be related to higher ESTIMATION risk of smaller firms

• Extra return may be more apparent than real due to higher trading costs and illiquidity

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Average Returns as a Function of the Book-To Market Ratio, 1926 to 2007

• Value Stock premium return

• Distressed and out of favor stocks?

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Cumulative Abnormal Returns in Response to Earnings

AnnouncementsShort term momentum effect that is counter to efficiency.

Rendleman, Jones & Latane

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Bubbles and Market Efficiency

Periodically stock prices appear to undergo a ‘speculative bubble.’

A speculative bubble is said to occur if prices do not equal the intrinsic value of the security.

Does this imply that markets are not efficient?

– Very difficult to predict if you are in a bubble or not and when the bubble will burst.

– Stock prices are estimates of future economic performance of the firm and these estimates can change rapidly.

– Risk premiums can change rapidly and dramatically.

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Bubbles and Market Efficiency

With hindsight it appears that there are times when stock prices decouple from intrinsic or fundamental value, sometimes for years.

• Prices eventually conform to intrinsic value. => EMH

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8.4 Mutual Fund and Analyst Performance

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Estimates of Individual Mutual Fund Alphas, 1972 - 1991

Mutual fund returns versus the S&P500 index; Mean alpha = 0

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Persistence of Mutual Fund Performance

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Mutual Fund and Professional Manager Performance

• Superstar phenomenon John Templeton (Templeton Funds)

Warren Buffet (Berkshire Hathaway)

Peter Lynch (Fidelity Magellan)

Bill Miller (Legg Mason)

Jon Neff (Vanguard’s Windsor Fund)

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• Technical Analysis (TA)

Summary: What Does the Evidence Show?

Stocks do not follow a pure random walk, so there is hope for technical trading strategies. => However, it should be more than a pure random walk, given some positive return expected.

Most TA rules utilize short term trading strategies that generate excessive transaction costs and are not profitable.

There appears to be some long term trend reversals.

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• Fundamental Analysis

Summary: What Does the Evidence Show?

Appears to be difficult to consistently generate abnormal returns using fundamental analysis.

This is because the analysis/investment industry is so competitive.

May help you avoid seriously overvalued investments.

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• Fundamental Analysis

Summary: What Does the Evidence Show?

Without fundamental analysis the markets would surely be inefficient, &

Abnormal profit opportunities would exist,

Leading to profitable fundamental analysis

Grossman & Stiglitz AER, 1980

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• Anomalies Exist– – – –

Summary: What Does the Evidence show?

Small Firm in January Effect

Book to Market Ratios

Long Term Reversals

Post-Earnings Announcement Drift (Momentum)

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Behavioralism bias• Motivation

Stock prices in the 1990s did not appear to match “fundamentals,” e.g., high price earnings ratios

Evidence of refusal to sell losers (Why?)

Economics discipline is exploring behavioral aspects of decision making

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What does it all mean?

• Technical Analysis:

• Your choices–

–

• •

–

It may be an item in your toolkit but be careful relying on it too much.

Pick stocks yourself, based on fundamental analysis, but diversify

Pick one or more mutual fundsUnlikely to consistently earn + abnormal returns

Pros paying attention to market and firm conditions

Index or otherwise passively diversify.

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Selected Problems

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Problem 1

• Zero, otherwise returns from the prior period could be used to predict returns in the subsequent period.

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Problem 2

• No. Why?– Maybe due to a higher risk?– Maybe due to constant surprises beyond

expected surprise earnings.

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Problem 3

• Not necessarily, Why?

• It could indicate information leakage (=> a violation of EMH) or it could indicate that splits occur during price runups (=> still consistent of EMH).

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Problem 4

• No, Why?

• You won’t get + abnormal returns if the economic cycle is predictable, the news will already be incorporated in the stock’s price.

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Problem 5

• Buy it

• This is a “Value Investment” where you believe the stock will perform better than the market and if you are correct you will earn a positive abnormal return.

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Problem 6

a. The small firm in January effect

b. Might work, but it might noti. Doesn’t hold every year

ii. Would lead to “underdiversification”

iii. Higher trading costs of these stocks might wipe out any gains

iv. Since there is no solid theoretical reasoning for this the ‘extra return’ might just be a risk premium.

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Problem 7

a. Consistent, expect about half to outperform the market by chance

b. Violation, earn + AR by investing with last year’s winners

c. Probably consistent, but it depends. I might be able to use an option strategy to take advantage of this.

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Problem 7

d.

e.

Violation, you have exploitable price momentum persisting into February

Violation, the reversal offers an exploitable opportunity, namely buy last week’s losers

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Problem 8

i. Implicit in the dollar-cost averaging strategy is the notion that stock prices fluctuate around a “normal” level. Otherwise, there is no meaning to statements such as: “when the price is high.”

ii. How do we know, for example, whether a price of $25 today will be viewed as high or low compared to the stock price six months from now?

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Problem 9

The market expected earnings to increase by more than they actually did.

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Problem 10

– The prices of growth stocks may be consistently bid too high due to investor overconfidence.

– Investors/analysts may extrapolate recent earnings (and dividend) growth too far into the future and thereby inflate stock prices, forcing poor returns eventually on growth portfolios.

– At any given time, historically high growth firms may revert to lower growth and value stocks may revert to higher growth, changing return patterns, this may happen over an extended time horizon.

a.

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Problem 10

Enough investors should prefer value stocks to growth stocks and bid up the prices of value stocks and drive down the prices of growth stocks until the “extra” return on the value stocks was eliminated.

b.