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Chapter 10


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Chapter 10

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