EFFICIENT CAPITAL MARKETS

1
Chapter 10

• EFFICIENT CAPITAL MARKETS

2
Chapter 10 Questions

• What do we mean when we say that capital markets
  are 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 the implications of each?

3
Chapter 10 Questions

• How do we test the three efficient market
  subhypotheses, and what are the results of the
  tests?
• For each set of tests, which of the results
  support the EMH and which indicate an anomaly
  related to the hypothesis?
• What is behavioral finance, and how does it
  relate to the EMH?

4
Chapter 10 Questions

• What are some of the major findings of behavioral
  finance, and what are the implications for the
  EMH?
• What are the implications of the efficient market
  test results for
• Technical analysis?
• Fundamental analysis?
• Portfolio managers with superior analysts?
• Portfolio managers with inferior analysts?

5
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

6
Why does it matter?

• If prices do fully reflect all current
  information, it would not be worth an investors
  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 the market.

7
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.

8
Why Should Capital Markets Be Efficient?

• What would be the ingredients of an
  informationally efficient market?
• A large number of profit-maximizing participants
  analyze and value securities
• 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
• Price adjustments are unbiased correct on
  average.
• Under these conditions, a securitys price would
  be appropriate for its level of risk.

9
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

10
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

11
Implications of the Weak-From EMH

• Examining recent trends in price and other market
  data in order to predict future price changes
  would be a waste of time if the market is
  weak-form efficient.
• A lot of people do price charting and other forms
  of technical analysis.

12
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

13
Implications of the Semistrong-Form EMH

• If the market is efficient in this sense,
  information in The Wall Street Journal, other
  periodicals, and even company annual reports is
  already fully reflected in prices, and therefore
  not useful for predicting future price changes.

14
Strong-Form EMH

• Stock prices fully reflect all information from
  public and private sources
• This would require perfect markets in which all
  information is cost-free and available to
  everyone at the same time (which is clearly not
  the case)
• Implication Not even insiders would be able to
  beat the market on a consistent basis

15
Tests and Results Weak-Form EMH

• Two Approaches
• Tests of statistical memory in security prices
  and returns
• Tests of trading rules

16
Tests and Results Weak-Form EMH

• Statistical tests of independence between rates
  of return
• Autocorrelation tests
• Mostly support the weak-form EMH and indicate
  that price changes are random
• Some studies using more securities and more
  complicated tests cast some doubt
• Runs tests
• Indicate randomness in prices

17
Tests and Results Weak-Form EMH

• Comparison of trading rules to a buy-and-hold
  policy
• Some filter rules seem yield above-average
  profits with small filters, but only before
  taking into account the substantial transactions
  costs involved
• Trading rule results have been mixed, and most
  have not been able to beat a buy-and-hold policy

18
Tests and Results Weak-Form EMH

• Problems with tests
• Cannot be definitive since trading rules can be
  complex 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)

19
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?!

20
Reality Check!

• If someone writes a book on how to beat the
  market, you can bet that book sales are more
  lucrative than the trading strategy!
• Even if it once worked, if its widely known, it
  wont work any more!
• Dont quit your day job to trade on-line using a
  published strategy!

21
Tests and Results Semistrong-Form EMH

• Three 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 an efficient market.

22
Tests and ResultsSemistrong-Form EMH

• Tests often involve market-adjusted returns,
  created by subtracting the market return from the
  securitys return, thereby defining a securitys
  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

23
Tests and Results ofSemistrong-Form EMH

• Another definition of abnormal return is a
  risk-adjusted return or market model which
  adjusts for the securitys own required rate of
  return, given its systematic risk (as measured by
  beta)
• ARit Rit - E(Rit)
• where
• E(Rit) the expected rate of return for stock i
  during period t based on the market rate of
  return and the stocks normal relationship with
  the market (its beta)

24
Tests and Results Semistrong-Form EMH

• Time series tests for predictability of returns
  and profit opportunities
• Short-horizon returns have shown very limited
  predictability
• Long-horizon returns analysis shown some
  predictability of returns based on
• Dividend yield (D/P)
• Default spread
• Term structure spread

25
Tests and Results Semistrong-Form EMH

• Time series tests for predictability of returns
  and profit opportunities
• Quarterly earnings reports information
• Unanticipated earnings changes or earnings
  surprises are not immediately reflected in
  security prices
• The January Anomaly (A calendar effect)
• Large returns in January present opportunities to
  purchase in December, and sell in January and
  earn abnormal returns.

26
Tests and Results Semistrong-Form 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

27
Tests and Results Semistrong-Form EMH

• Predicting cross-sectional returns
• In an efficient market, all securities should
  have equal risk-adjusted returns
• Studies examine alternative measures of size or
  quality 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

28
Tests and Results Semistrong-Form EMH

• Predicting cross-sectional returns
• Price-earnings ratios
• Examine historical P/E ratios and returns
• Low P/E stocks had higher risk-adjusted returns
  than high P/E stocks
• Publicly available P/E ratios could be used for
  abnormal returns
• Price-earnings/Growth ratios
• Mixed results

29
Tests and Results Semistrong-Form EMH

• Predicting cross-sectional returns
• The size effect
• The risk-adjusted returns for extended periods
  indicate that the small firms consistently
  experienced significantly larger 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 expected returns (joint
  test)

30
Tests and Results Semistrong-Form EMH

• Predicting cross-sectional returns
• The size effect
• Adjustments for riskiness of small firms did not
  explain the large differences in rate of return
• The impact of transactions costs of investing in
  small firms is substantial (takes away the
  differential with a short-term trading 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

31
Tests and Results Semistrong-Form 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 into
  consideration

32
Tests and Results Semistrong-Form EMH

• Predicting cross-sectional returns
• 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.

33
Tests and Results Semistrong-Form EMH

• Event studies
• Event studies examine abnormal returns
  surrounding various events
• The EMH is that abnormal returns are zero
• Stock split studies
• Mostly show no positive impact on returns because
  of a stock split
• Initial public offerings
• Significant IPO underpricing, but with rapid
  adjustment, consistent with the EMH

34
Tests and Results Semistrong-Form EMH

• Event 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

35
Tests and Results Semistrong-Form EMH

• Event 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

36
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 time
  series and cross-sectional studies
• Dividend yields, earnings surprises, calendar
  effects
• The size effect, BV/MV, P/E ratios, etc.

37
Tests and Results Strong-Form EMH

• Testing Groups of Investors
• Tests usually center on whether any group of
  investors consistently earn abnormal profits.
• Corporate insiders
• Stock exchange specialists
• Security analysts
• Professional money managers

38
Tests and Results Strong-Form EMH

• Corporate 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

39
Tests and Results Strong-Form EMH

• Corporate 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 their company stock
• Later studies indicate that non-insiders who
  trade with insiders may no longer be able to
  generate abnormal returns

40
Tests and Results Strong-Form 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.

41
Tests and Results Strong-Form EMH

• Security 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

42
Tests and Results Strong-Form EMH

• Security Analysts
• The Value Line Enigma
• Firms ranked 1 for timeliness substantially
  outperform the 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 have value in terms of producing abnormal
  returns
• There is some evidence of superior analysts who
  apparently posses private information

43
Tests and Results Strong-Form EMH

• Professional Money Managers
• Trained professionals, working full time at
  investment management
• If any investor can achieve above-average
  returns, it should be this group
• If any non-insider can obtain inside information,
  it would be this group due to the extensive
  management interviews that they conduct

44
Tests and Results Strong-Form 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

45
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

46
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 to reconcile with rationality

47
Behavioral Finance

• Using 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

48
Fusion Investing

• Attempts to integrate two elements of investment
  valuation
• Fundamental value
• Dominant factor
• Investor sentiment
• Additional demand factor related to fads and
  fashions

49
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 wont work?
• What do you do if you cant beat the market?

50
Efficient Markets and Technical Analysis

• Assumptions of technical analysis directly oppose
  the notion of efficient markets
• Technicians believe that stock prices move in
  patterns that persist and are predictable to the
  informed investor.
• Technical analysts develop systems to detect
  trends and patterns in prices
• If the capital market is weak-form efficient, a
  trading system that depends on past trading data
  can have no value

51
Efficient Markets and Fundamental Analysis

• Fundamental analysis involves determining an
  investments intrinsic values based on company
  and economic fundamentals
• The intrinsic value is compared to the market
  price to determine whether the investment is
  undervalued or overvalued
• In an efficient market, prices already reflect
  public information, so determining intrinsic
  value using that information is not a worthwhile
  exercise

52
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.

53
Efficient Markets and Portfolio Management

• Does active portfolio management pay off?
• Research indicates that most money managers do
  keep 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)

54
Efficient Markets and Portfolio Management

• Without superior analysts, passive management may
  outperform active management
• Build a globally diversified portfolio with a
  risk level matching client preferences
• Minimize transaction costs (taxes, trading
  turnover, liquidity costs)

55
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 of
  research and trading)
• Institutions created market (index) funds which
  duplicate the composition and performance of a
  selected index series

56
Insights from Behavioral Finance

• There may be trading opportunities created by
  persistent investor biases and herd mentality
• Supports the notion of contrarian investment
  strategies
• Some mutual funds employ behavioral finance
  strategies

57
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 are
  essentially similar
• Appropriate to assume a similar level of
  efficiency in European markets to those in the
  United States