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Chapter 10


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  • 1. Market Efficiency Chapter 10
  • 2. Efficient Markets
    • the stock market is efficient if:
        • stock prices quickly and unbiasedly reflect all
        • information which would affect the value of the stock
    • an efficient market does not mean that all stock prices are
    • always correct in that they exactly represent the true value
    • of the stock
    • Rather, in an efficient market, stock prices are unbiased
    • estimates of the true intrinsic value
        • i.e. the current stock price is the best guess possible
        • about the value of the stock, given the available information
  • 3. Forms of Efficiency
    • Three forms of efficiency, depending on what type of information is thought to be incorporated into stock prices
    • Weak Form Efficiency
    • Semi-Strong Form Efficiency
    • Strong Form Efficiency
  • 4. Implications of Efficiency Weak Form : if true, then should not expect to earn excess returns by performing technical analysis as there are no patterns in stock prices Semi-Strong Form : if true, then should not expect to earn excess returns based upon performing fundamental analysis as public information is already incorporated into stock prices before it can be acted upon Strong Form : if true, then investing based upon (non-public) inside information will not create excess returns
  • 5. General Implications of Market Efficiency
    • If markets are (generally) efficient there are some major implications:
    • (1) For investors, efficient markets are consistent with a passive investment strategy
        • active investment strategies not expected to produce excess returns
    • (2) Changes in a firm’s stock price are rational reflections of new information
        • a change in price in reaction to news is an unbiased
        • evaluation of whether that news is good or bad
        • changes in stock prices are meaningful
  • 6. Study: Kaplan and Weisbach Journal of Finance (1992)
    • examine a sample of large acquisitions that were eventually divested
    • classify them as successful or unsuccessful (based on prices paid and sold for, and on reasons given for sale)
    • look at abnormal returns on announcement of acquisition
  • 7. Kaplan and Weisbach (cont.)
    • Results :
    • abnormal returns are negative for acquisitions that eventually turn out to be unsuccessful
    • abnormal returns for unsuccessful acquisitions are significantly lower than for successful ones
    • Implication :
    • the market is able to do a good job predicting which
    • acquisitions will be successful
    • changes in stock prices provide a “report card” on actions of the firm
  • 8. How do markets become efficient?
    • If markets are efficient, how do they become efficient?
        • How does information get into prices?
    • The actions of investors trying to take advantage of information as quickly as possible affects the stock price
        • The stock price will then reflect information almost immediately
  • 9.
    • “ On the Impossibility of Informationally Efficient Markets”
    • - Grossman and Stiglitz ( American Economic Review , 1980)
        • argue that efficient markets are impossible
        • if cannot expect to profit from information (since
        • already reflected in the current price), then no one
        • would gather information
        • no one gathers information, how could it get into stock prices?
    • Current view of efficient markets :
        • not possible for most investors to gain from trading
        • based on information (after including effect of transaction costs)
        • for an intra-marginal investor , there may be gains to be had
        • from gathering and acting on information
        • intra-marginal investor is someone who can trade on
        • information before the price has fully reflected it.
  • 10. How long until prices reflect information?
    • How long does it take for stock prices to reflect new information?
    • or , how quick do you have to be to be intra-marginal ?
    • May vary by type of information and by stock
    • widely followed stocks will tend to react more quickly, there
    • may be more of a delay for thinly traded stocks
    • Study : Busse and Green ( Journal of Financial Economics , 2002)
      • look at effect of news announcements on trading
      • have sample of announcements timed to the second
      • find trading based on the information can make a profit if done within 15 seconds - information is fully reflected within 1 minute
  • 11. Evidence for Market Efficiency
    • lots of academic studies which seem to show the market is generally efficient (others that find it isn’t)
    • Important evidence that the market may be efficient:
        • mutual funds do not generally beat the market
    • After including the effect of management expense ratio, only 10% of actively managed US equity funds were able to do better than the S&P 500 over the last 5 years
    • Only 8% were able to beat the market over the last 10 years.
  • 12.
    • Further…mutual fund performance is inconsistent
        • funds that are the best performers one year tend not to be the best performers the next year
    • Implication : if mutual fund managers, with all of their expertise and resources, cannot beat the market, maybe the stock is efficient
  • 13. Market Anomalies
    • there seem to be certain anomalies in the market
    • situations that are inconsistent with efficient markets
    • certain types of stocks have been found to do better than others
        • some investors base their investing strategies on trying
        • to take advantage of these
    • Important : the following anomalies are not guarantees of excess
    • returns
        • studies have shown they hold on average for stocks
        • in the past …no guarantee that they will hold in the future
        • and definitely no guarantee they hold all the time
  • 14. Size Effect
    • stock of small firms (by market cap.) tend to outperform the stock of large firms
    • holds after adjusting for risk (using traditional risk measures)
  • 15. January Effect
    • January tends to be the best month for stocks
        • i.e. stocks tend to jump up a bit at the beginning if the year
    • Note : this effect is often explained by tax loss selling in
    • December, with people repurchasing stocks in January
    • Note : it turns out the that the January Effect and the Size Effect
    • are related, on average, it is only small stocks that experience
    • excess returns at the beginning of the year
        • small stocks on NYSE earn about 8% in January,
        • on average, and less than 1% in each of the other months
        • on average
  • 16. Value Stocks
    • Value Stocks : stocks with low price-earnings, and/or
    • high dividend yields, and/or low market-book
    • after adjusting for risk, value stocks tend to outperform growth stocks
    • this is a long term phenomenon…for some periods of time, growth stocks perform the best. Over the long term, however, value stocks tend to be the best stocks.
  • 17. Momentum
    • the stocks that have performed the best over the previous 6 to 12 months will tend to perform well over the next 6 to 12 months
    • there is evidence of momentum in stock returns
        • stocks that do well tend to keep on doing well
    • possible explanation is people “jumping on the bandwagon”
  • 18. Overreaction (Price Reversals)
    • Debondt and Thaler (Journal of Finance, 1985)
        • 1926 to 1980 data
        • find that the best performing stocks over the last 3 to 5 years
        • perform badly over the next 3 to 5 years
        • the worst performing stocks over the last 3 to 5 years
        • perform very well over the next 3 to 5 years
        • by 3 years after identifying best and worst stocks,
        • the “worst” stocks had outperformed the “best” by 25%
    • Implication :
      • the market overreacts
      • e.g. when a stock does well, it gets pushed up too high,
      • eventually this is corrected
  • 19. Momentum and Reversals
    • momentum and reversals (overreaction) are, in a sense, opposites
        • momentum says: buy the stocks that have performed
        • well, since this will likely continue
        • overreaction says: buy the stocks that have performed
        • poorly, since this will likely reverse itself
    • Important :
        • timing for the two effects is different
        • evidence seems to indicate short term momentum
        • (3 to 12 months) and long term reversals (3 to 5 years)
  • 20. Volume, Momentum, and Reversals
    • study by Lee and Swaminathan ( Journal of Finance , 2000)
    • look at effect of high or low volume trading on momentum
    • and reversals
    • classify stocks as “winners” and “losers” based on past year’s
    • performance , also look at trading volume over that last year
    • Results :
      • High volume “winners” - tend to do badly next year, reversal
      • Low volume “winners” - tend to do well next year, momentum
      • High volume “losers” - tend to badly next year, momentum
      • Low volume “losers” - tend to do well next year, reversal
  • 21. Anomalies - conclusions
    • based, in part, on some of these anomalies, many investors feel
    • the market is not efficient
    • many investment strategies now based on behavioural finance
        • fairly new field that tries to explain the stock market
        • with psychology theories
    • Warning : just because a study purports to have found evidence of
    • some way to “beat the market” does not mean that it can or
    • should actually be used
  • 22.
    • one of the most accurate predictors of the stock market:
      • Super Bowl Effect : market will go up when an NFC
      • team wins Super Bowl, and will go down when AFC
      • wins
      • 1967 to 2002, Super Bowl predicted market correctly
      • 29 out of 37 times