Lec 7 Security Analysis and Portfolio Management

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Security Analysis and Portfolio

Management

Lec 7


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What is an efficient market?

An efficient capital market is one

in which security prices adjust rapidly to

the arrival of new information and, therefore,

the current prices of securities reflect all

information about the security

this is referred to as an informationally

efficient market


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4 Assumptions for fficiency

fficient market re!uires that

a large number of profit maximizing participants analyze and value securities,

each independently of the others

New information regarding securities

comes to the market in a random fashion, and

the timing of one announcement is generally independent of others

Profit-maximizing investors adjust security prices rapidly to reflect the effect

of new information.

lthough the price adjustment may be imperfect, it is unbiased"

#his means that sometimes the market $ill o%erad&ust and other times it $ill underad&ust,

but you cannot predict $hich $ill occur at any gi%en time


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'inally, because security prices ad&ust to all ne$ information, these security

prices

should reflect all information that is publicly a%ailable at any point in

time"

#herefore, the security prices that pre%ail at any time should be anunbiased reflection of all currently a%ailable information including the

risk in%ol%ed in o$ning the security

#herefore, in an efficient market,

the expected returns implicit in the current price of the security should

reflect its risk,

!hich means that in%estors $ho buy at these informationally efficient

prices should recei%e a rate of return that is consistent $ith the

percei%ed risk of the stock"


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#his scenario implies that informationally

efficient markets re!uire some

minimum amount of trading and that more trading by numerous competing

in%estors should cause a faster price

ad&ustment,

making the market more efficient


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Semistrong-Form

Efficient Market

Hypothesis

#he semistrong-form EMH asserts that security prices adjust rapidly to the

release of all public information" that is, current security prices fully reflect all public information.

#he semistrong hypothesis encompasses the $eak-form hypothesis, because all the market

information considered by the $eak-form hypothesis, such as stock prices, rates of return, and

trading %olume, is public"

Public information also includes all nonmarket information,

such as earnings and di%idend announcements, price-to-earnings (P2* ratios, di%idend-yield (32P* ratios, pricebook

%alue (P21* ratios, stock splits, ne$s about the economy, and political ne$s"

#his hypothesis implies that in%estors $ho base their decisions on any important

ne$ information

after it is public should not derive above-average risk-adjusted profits from their transactions,

considering the cost of trading because the security price already reflects all such ne$ publicinformation"


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Strong-Form

Efficient Market

Hypothesis

#he strong-form EMH contends that stock prices fully reflect all

information from public andprivate sources.

#his means that no group of investors has monopolistic access to

information rele%ant to the formation of prices"

#herefore, this hypothesis contends that no group of in%estors should be able to consistently deri%e abo%e-a%erage risk-ad&usted rates of return"

#he strongform M) encompasses both the $eak-form and the semistrong-

form M)"

'urther, the strongform M) e0tends the assumption of efficient markets, in

$hich prices ad&ust rapidly to the release of ne$ public information, to assume perfect markets, in $hich all

information

is costfree and a%ailable to e%eryone at the same time"


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#$%#% N& '$%()#% *+ $++$N#

'/$# 01P*#0$%$%

Weak-Form Hypothesis: ests and !esults

5esearchers ha%e formulated t$o groups of tests of the $eak-form M)"

#he first category in%ol%es statistical tests of independence bet$een

rates of return"

#he second entails a comparison of risk-return results for trading rulesthat make in%estment decisions based on past market information

relati%e to the results from a simple buy-and-hold policy, $hich assumes

that you buy stock at the beginning of a test period and hold it to the end"


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#he second statistical test of independence is the runs test"

#iven a series of price changes$ each price change is either designated a plus

(>* if it is an increase in price or a minus (* if it is a decrease in price"

#he result is a set of pluses and minuses as follo$s+ >>>>>>>>"

A run occurs $hen t$o consecuti%e changes are the same@

t$o or more consecuti%e positi%e or negati%e price changes constitute one run"

When the price changes in a different direction, such as $hen a negati%e price change is

follo$ed by a positi%e price change, the run ends and a ne$ run may begin"

#o test for independence, you $ould compare the number of runs for a gi%en series

to the number in a table of e0pected %alues for the number of runs that should

occur in a random series"

Studies that ha%e e0amined stock price runs ha%e confirmed the independence of

stock price changes o%er time


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#ests of #rading 5ules

#echnical analysts do not e0pect a set number of

positi%e or negati%e price changes as a signal of a

mo%e to a ne$ e!uilibrium in the market"

#hey typically look for a general consistency in theprice trends o%er time"

Such a trend might include both positi%e and

negati%e changes"

'or this reason, technical analysts belie%ed that their

trading rules $ere too sophisticated and complicated

to be properly tested by rigid statistical tests


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Ad%ocates of an efficient market

hypothesied that in%estors could not

deri%e abnormal profits abo%e a buy-and-

hold policy using any trading rule that

depended solely on past market information"


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5esults of Simulations of Specific #rading

5ules

6n the most popular trading techni!ue, filter rule$ an investor trades a stock when theprice change e%ceeds a filter value set for it"

As an e0ample, an in%estor using a percent filter $ould en%ision a positi%e breakout if the

stock $ere to rise percent from some base, suggesting that the stock price $ould continue

to rise"

A technician $ould ac!uire the stock to take ad%antage of the e0pected continued rise"

6n contrast, a percent decline from some peak price $ould be considered a breakout onthe do$nside, and the technician $ould e0pect a further price decline and $ould sell any

holdings of the stock and possibly e%en sell the stock short


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Studies of this trading rule ha%e used a range of filters from B"

percent to B percent"

#he results indicated that small filters $ould yield abo%e-

a%erage profits before taking account of trading commissions"

)o$e%er, small filters generate numerous trades and, therefore,

substantial trading costs" When these trading commissions $ere

considered, all the trading profits turned to losses"

Alternati%ely, trading using larger filters did not yield returns

abo%e those of a simple buy-and-hold policy #hese results generally support the $eak-form M)


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Semistrong-Form

Hypothesis: ests

and !esults

5ecall that the semistrong-form M) asserts that

security prices ad&ust rapidly to the release of all public information@ that is,

Security prices fully reflect all public information"

Studies that ha%e tested the semistrong-form M) can be di%ided into

the follo$ing sets of studies+ %tudies to predict future rates of return using available public information

beyond pure market information such as prices and trading volume considered

in the weak-form tests

#hese studies can in%ol%e either time-series analysis of returns or the cross-

section distribution of returns for indi%idual stocks" Ad%ocates of the M) $ould contend that

it $ould not be possible to predict future returns using past returns or

to predict the distribution of future returns using public information


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%econd way to test %% $08

$vent studies that examine how fast stock prices adjust to specific

significant economic events.

corollary approach would be to test whether it is possible to invest in

a security after the public announcement of a significant e%ent ande0perience significant abnormal rates of return"

Again, ad%ocates of the M) $ould e0pect security prices to ad&ust

rapidly, such that it $ould not be possible for in%estors to e0perience

superior riskad&usted returns by in%esting after the public

announcement and paying normal transactions costs


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Ad&ustment for Market ffects

'or any of these tests, you need to ad&ust the securityCs rates of return for the

rates of return of the o%erall market during the period considered"

6f one assumed that the indi%idual stocks should e0perience returns

e!ual to the aggregate stock market" #his assumption meant that the market ad&ustment process simply

entailed

subtracting the market return from the return for the indi%idual security to deri%e

its a&normal rate of return$ as follows:

'&normal !eturn ( !eturn from Security ) !eturn from Mkt

1ut each security has a risk factor, $hich has to be considered "

'&normal !eturn ( !eturn from security ) E%pected returns

0pected return+ function of securityCs relationship to market"


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Se%eral studies ha%e considered t$o %ariables

related to the term structure of interest rates+

a default spread,

which is the difference between the yields on lower-grade and Aaa-rated long-term corporate bonds (this spread has been used as a

pro0y for a market risk premium*, and

the term structure spread,

which is the difference bet$een the long-term Aaa yield and theyield on one-month #reasury bills"

#hese %ariables ha%e been used to predict stock

returns and bond returns


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#he reasoning for these empirical results is as follo$s+

When the t$o most significant %ariablesDthe di%idend yield (32P* and the default

spreadDare high,

it implies that in%estors are e0pecting or re!uiring a high return on stocks and bonds"

=otably, this occurs during poor economic en%ironments, as reflected in the gro$th rate of

output"

A poor economic en%ironment also implies a lo$-$ealth en%ironment $herein

in%estors percei%e higher risk for in%estments"

As a result, for in%estors to in%est and shift consumption from the present to the

future, they $ill re!uire a high rate of return"

6t is suggested that, if you in%est during this risk-a%erse period, your subse!uentreturns $ill be abo%e normal"

6n contrast, $hen these %alues are small, it implies that in%estors ha%e reduced their

risk premium and re!uired rates of return and future returns $ill be belo$ normal


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Quarterly Earnings Reports Studies that address quarterly reports are

considered part of the times-series analysis"

Specifically, these studies !uestion $hether it is possible to predict future

returns for a stock based on publicly a%ailable !uarterly earnings reports"

#he typical test e0amined firms that e0perienced changes in !uarterly

earnings that differed from e0pectations"

#he results generally indicated abnormal returns during the / or .9 $eeks

following the announcement of a large unanticipated earnings changeD

referred to as an earnings surprise"

#hese results suggest that an earnings surprise is not instantaneously

reflected in security prices.

#his implies that earnings surprises and earnings re%isions can be used to

predict returns for indi%idual stocks"

#hese results are e%idence against the M)


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!rice"Earnings Ratios Several studies have e#amined the relationship

bet$een the historical price-earnings *+,E ratios for stocks and the

returns on the stocks"

Some have suggested that lo$ P2 stocks $ill outperform high P2 stocks

because gro$th companies en&oy high P2 ratios,

but the market tends to o%erestimate the gro$th potential and thus

o%er%alues these gro$th companies,

$hile under%aluing lo$-gro$th firms $ith lo$ P2 ratios"

A relationship bet$een the historical P2 ratios and subse!uent risk-ad&usted

market performance $ould constitute e%idence against the semistrong M),

because it $ould imply that in%estors could use publicly a%ailableinformation regarding P2 ratios to predict future abnormal returns


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%eglected &irms

Arbel and Strebel considered an additional influence beyond sieD

attention or neglect"

#hey measured attention in terms of the number of analysts $ho regularly

follo$ a stock and di%ided the stocks into three groups+ (* highly follo$ed,

(.* moderately follo$ed, and

(/* neglected"

#hey confirmed the small-firm effect but also found

a neglected-firm effect caused by the lack of information and limited institutional interest"

#he neglected-firm concept applied across sie classes


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%ent Studies

Stock Splits

6P


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Strong-Form

Hypothesis: ests

and !esults

#he strong-form M) contends that stock prices fully reflect

all information, public and private.

#his implies that no group of in%estors has access toprivate

information that will allow them to consistently e0perience

abo%e-a%erage profits"

#his e0tremely rigid hypothesis re!uires not only that stock

prices must ad&ust rapidly to ne$ public information

but also that no group has access to pri%ate information"


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;onclusions 5egarding the Strong-'orm

M)

#he tests of the strong-form M) generated mi0ed results,

but the bulk of rele%ant e%idence supported the hypothesis"

#he results for t$o uni!ue groups of in%estors (corporate

insiders and stock e0change specialists* did not support the

hypothesis

because both groups apparently ha%e monopolistic access to

important information and

use it to deri%e abo%e-a%erage returns


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P)#*N% *+ $++$N# P#)

'/$#%

Efficient Markets and echnical 'nalysis

#he assumptions of technical analysis directly oppose the notion of efficient

markets"

A basic premise of technical analysis is that stock prices mo%e in trends that

persist"

#echnicians belie%e that $hen ne$ information comes to the market, it is

not immediately a%ailable to e%eryone

but is typically disseminated from the informed professional to the aggressi%e

in%esting public and then to the great bulk of in%estors"

Also, technicians contend that in%estors do not analye information and act

immediately" #his process takes time"

#herefore, they hypothesie that stock prices mo%e to a ne$ e!uilibrium

after the release of ne$ information in a gradual manner, $hich causes

trends in stock prece mo%ements that persist


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6f the capital market is $eak-form efficient as indicated by

most of the results, then prices fully reflect all rele%ant

market information so technical trading systems that

depend only on past trading data cannot have any value.


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Efficient Markets

and Fundamental

'nalysis

'undamental analysts belie%e that, at any time, there is%a basic intrinsic %alue for the

aggregrate stock market, %arious industries, or indi%idual securities

and that these %alues depend on underlying economic factors"

#herefore, in%estors should determine the intrinsic %alue of an in%estment asset at a

point in time by e0amining the %ariables that determine %alue such as current and future

earnings or cash flo$s, interest rates, and risk %ariables"

6n%estors $ho engaged in fundamental analysis belie%e that, occasionally, market price

and intrinsic %alue differ but, e%entually, in%estors recognie the discrepancy and

correct it


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Lec 7 Security Analysis and Portfolio Management

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