Class Business

Homework Upcoming Midterm

– Review Session• Wed (5/18) 5 – 6 pm 270 TNRB

Predictability of Stock Returns Momentum and reversal might happen due to “fads” and

“bubbles”: – Stocks over-react to news initially and correct to go back to

fundamental value.– ‘Overconfidence’, ‘herding’, and ‘biased self-attribution’

Adjusted Cumulative Returns of Takeover Target Companies

Source: Keown and Pinkerton (1981)

Returns following Earnings Announcements

Source: Patell and Wolfson (1984)

Stock prices fully and accurately reflect available information is a static concept

Once information becomes available, we expect market participants analyze it quickly ( ‘time’ now enters argument)

Competition assures prices quickly reflect information

Most interesting questions deal with how quickly prices adjust to new information or sets of information

There is probably an ‘optimal’ amount of inefficiency– Marginal cost of finding the inefficiency vs. marginal benefit

EMH and Competition

Blind Monkeys Throwing Darts

Some efficient market supporters suggest that it does not matter how you choose stocks in efficient markets.

You can ask some blind monkeys to throw darts on the Wall Street Journal to select stocks.

Blind Monkeys Throwing Darts

However, rational security analysis is still useful:– Monkeys will probably not pick a well-diversified

portfolio with an desired level of risk.– Monkeys do not know the tax considerations of

stock choice.– Monkeys do not take your specific

circumstances into account (job, age, location).

More...Are Markets Efficient?

Magnitude Issue– Some price anomalies are relatively minor, because transactions

costs exceed the profits – Example:

• Suppose you have $10,000 invested• Suppose research will yield a guaranteed increase in return of 0.1%

over the next year with no increase in risk.• You get $10!• Now suppose you have $10 billion invested . .

Selection Bias Issue– Investors will not report the successful strategies.

Lucky Event Issue– If you have enough people doing something, then some people

will always be lucky.

Market Anomalies

Small-Firm Effect– Stocks of small firms have earned abnormal

returns (particularly in January). Book-to-Market Effect

– Stocks with high book-to-market ratios (value stocks) tend to outperform stocks with low book-to-market ratios (growth stocks).

P/E Effect– Stocks with low price-earnings ratio (value

stocks) tend to outperform stocks with high price-earnings ratio (growth stocks).

Small-Firm Effect

Source: Ibbotson Associates (2000)

Value versus Growth Stocks

Source: Fama and French (1992)

Interpretation of Market Anomalies

Market Anomalies are due to:– Risk Premia

• Are we accounting for all the appropriate risk factors, such as in an multifactor framework? (more factors than just market portfolio)

– Irrational Behavior• Investors prefer to purchase large and growth stocks and

neglect small and value stocks.

– Data Mining• By chance, some criteria will appear to predict returns.

The S&P 5001983-1993

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YearSource for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”

Overfitting the S&P 500Butter in Bangladesh

R2=.75

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Overfitting the S&P 500Butter Production in Bangladesh and the United States

R2=.95

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Overfitting the S&P 500Butter Production in Bangladesh and the United States

United States Cheese ProductionSheep Population in Bangladesh and the United States

R2=.99

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Data Mining

Technical Analysis Motley Fool

– Foolish Four– Dow 30

Need good economics to validate a trading strategy, not just an empirical relationship in historical data

EMH – How do we define risk?

It is impossible to determine how efficient markets are by looking at returns.

“Anomalies” depend on which model you believe is correct for expected returns.

If you uncover an anomaly, EMH supporters can always claim you just don’t have the right model or measure of risk.

A better way to test for efficiency is to look at performance of active managers.

Mutual Fund Performance: Alpha

Actively managed mutual funds earn alphas that are slightly negative, but not statistically different from zero.

Some evidence that a few rare managers can earn abnormal returns. (e.g. Warren Buffett)

Evidence indicates that, unless you have confidence (information) in picking a manager, you’re better off in a passive index than chasing the hottest fund manager.