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Empirics of Financial Markets

Patrick J. Kelly, Ph.D.

Market Efficiency

Market Efficiency
Allocational Operational Informational (also Capital Market Efficiency)

Market Efficiency
Allocational
When marginal rates of return for all producers and lenders are equal

Operational
Transactions cost of transferring funds is zero

Informational (also Capital Market Efficiency)

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2010 Patrick J. Kelly

Aspects of Information Efficiency

I. Type and Quantity of Information Created
1. Past Price 2. Public 3. Private

Type and Quantity of Information

Private Information

Public Information

Past Prices

II. Information Incorporation

1. Speed 2. Correctness 3. Completeness

Information Generated by
Exchanges Investors, Analysts, Companies
Public Private

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Information Incorporation

FedExs Share Price July October 2005

Sept. 21, 2005

Wall Street Journal September 21, 2005

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Market Efficiency and New Information

When news about the value of a security hits the market, its price should react and incorporate this news quickly and correctly.
Quickly: stale information is of no value Correctly: price response should be accurate on average Completely. no systematic over- or underreaction

Market Efficiency Requires Rational Investors

Market needs at least some investors to be rational
Learn and update their beliefs correctly
According to Bayes law
!(#|$)=!($|#)!(#)/!($)

Make choices that are in accordance with our beliefs

Behavioral finance: Some phenomena are best explained if some agents are not rational
But lets stick with the rational for a little longer.
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Maurice Kendall (1953)

In the 1950s a statistician from the London School of Economics set out to examine whether stock prices were predictable. To the surprise of many economists prices behave almost like wandering series.
Does this indicate that prices are driven by psychology or Animal Spirits? Is there a more rational explanation?

Efficient Prices and Competition (assuming rational investors)

Suppose stock X is currently priced at $10 per share But youve developed a model that allows you to predict with confidence that prices will rise to $15 per share in a week. If you were alone in the knowledge that the price will go up, youd slowly buy as much stock as you can so dont affect the price and can earn the biggest profit.

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Efficient Prices and Competition (2)

Suppose other investors also had access to your brilliant model. Youd have to buy the stock quickly before they did and push up the price. Everyone else would realize the same thing and place a large number of orders and push the price up to (nearly) $15. The more investors who know the more orders and the faster the prices will change
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Competition and Efficient Prices

Competition (arbitrage) assures prices reflect information Because prices quickly adjust to new information prices appear to behave almost like wandering series.
Key assumption: Information arrival is random.

Random Walk - stock prices are random

Actually submartingale
Expected price is positive over time Positive trend and random about the trend

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How Quickly Do Prices adjust?

Security Prices Random Walk with Positive Trend
Forsyth, Palfrey and Plott (1982)

Time
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Forms of the EMH

Fama (1970) categorized Information Efficiency with respect to the type of information prices reflect Weak form: Prices reflect all information contained in past prices Semi-strong form: Prices reflect all publicly available information Strong form: Prices reflect all relevant information, even if it is not in the public domain (private information)
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Are Markets Efficient?

Strong Form Efficient?

Semi-Strong?

Weak?

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Tests of Weak Form efficiency

Do prices follow a random walk?
Campbell, Lo, MacKinlay (1997)

Random Walk 2: Technical Analysis

Predict future stock price movements by looking at patterns in past prices: charting
Example: Head and Shoulders, from: http://www.investopedia.com/terms/h/headshoulders.asp 1. Rises to a peak and subsequently declines. 2. Then, the price rises above the former peak and again declines. 3. And finally, rises again, but not to the second peak, and declines once more.

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Head and Shoulders in Actual Data

Technical Analysis (cont)

Technical analysts: Info about a companys prospects is not useless, but unnecessary for successful trading If technical analysis is successful, then prices are NOT weak-form efficient Difficult to believe as price info is available to all investors at a minimal cost
Everyone can try to exploit the patterns, which implies that they should not arise Chartists believe otherwise

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A filter rule proposed in the WSJ

Consider an investor with a $1 million portfolio on Dec. 24, 1998, the first time the Standard & Poor's 500-stock index was at its current level. If the investor had merely held on, he would have seen essentially zero appreciation through Nov. 11 of this year. But if that same investor instead had sold one-tenth of his portfolio every time the stock market gained 20% and allocated one-fifth of his cash to the market when stocks fell more than 10%, he would have gained about $140,000, according to a Wall Street Journal analysis.
I actually got $86,892, assuming I invested the cash in 1 month TBills and completely ignoring transactions costs.
From: How to Play a Market Rally by Ben Jevisohn and Jane J. Kim, WSJ Nov. 13, 2010.

WSJ Strategy Back Tested

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Are markets efficient?

Asking whether markets are efficient is a bit silly. Why?

Do prices follow random walks? Is Weak Form efficiency violated?

Efficient Markets are essentially a Platonic ideal: a perfection toward which we can strive but cant actually be obtained. What we can compare is whether
Some stocks are more efficient than others Some markets in some countries are more efficient than others

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A look at the evidence

Comparing Emerging vs. Developed Markets
[Griffin, Kelly, and Nardari (RFS, 2010)]

Efficiency Around the World

Higher means more persistent returns/less weak-form efficiency and more likely profits to one week strategies: Small: High return Average Absolute 5-Day Variance Ratios persistence or reversal

Statistical Tests
Variance Ratios
Large: Low return persistence or reversal

Economic test
Mid-term momentum Short-term reversal
Griffin, Kelly, Nardari (2010)

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Weak Form Efficiency

Weak form: Prices reflect all information contained in past prices Simple trading strategies based on past returns shouldnt be profitable.
Returns should not be predictable.

Is past price information incorporated correctly?

If information is incorporated correctly and completely, then prices should not systematically overshoot.
Prices should just look random

If prices do overshoot, we ought to see reversals

Prices that drop after just going up OR Prices that rise after just going down In the next slide we look at the profits to simple strategies designed to take advantage of over reaction
Buy long past week losers and Short past week winners

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One week contrarian profits

100 80
(278.4)

Contrarian Profits
Are these profits meaningful?
Note: In the U.S. the contrarian strategy earns 30 basis points per week

Average Weekly Return (basis points)

60 40 20 0
-20 -40

The long-short strategy in the U.S. earns only 30 basis points per week before accounting for the cost of buying and selling stock.
Is 30 basis points of return per week enough to cover the cost of a high turn over strategy that buys, sells, shorts and covers stocks each week? With $1,000,000 in assets, 30 basis points generates $3000 in profit ignoring trading costs.

Cyprus China Taiwan Egypt Turkey Hong Kong Thailand Chile Bangladesh Philippines Poland Brazil Sri Lanka Indonesia Malaysia Singapore India South Africa Israel Pakistan Argentina Zimbabwe South Korea Portugal Italy Spain Denmark Switzerland Netherlands Greece United Kingdom Austria Germany Finland Belgium New Zealand United States Sweden Norway Japan France Australia Canada Developed Emerging Difference

Limits to arbitrage
If it is too costly to trade on an anomaly a seemingly easy way to profit the anomaly will continue to exist

Griffin, Kelly, Nardari (2010)

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One week contrarian profits over time

In the US (in Green) trading costs have decreased over time and so have the profits to these contrarian strategies.

Tests of Market Efficiency - Momentum

Momentum predicts return
Portfolios Long on past six-month winners and short past sixmonth losers earn high returns.
Winners are the 10% of stocks with the highest returns Losers are the worst 10% of stocks with the lowest returns

350

Avg. Weekly Returns (Basis Points)

300 250 200 150 100 50 0 -50

94

95

96

97

98

99

00

01

02

03

04 20

19

19

19

19

19

19

20

20

20

20

Griffin, Kelly, Nardari (2010)

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Six-Month Momentum
Buys past six-month winners, shorts past six-month losers
100 80

05

Market Risk Premia in Recessions and Expansions

Average Weekly Return (basis points)

60 40 20 0 -20 -40 -60

Argentina Turkey Malaysia Cyprus Pakistan Singapore Sri Lanka Indonesia China Brazil Egypt Taiwan Thailand Philippines Israel Hong Kong India Chile Poland South Africa Bangladesh Japan Spain Canada Portugal Austria South Korea Greece Finland Netherlands United States Italy Sweden Switzerland France Australia United Kingdom Belgium Denmark Norway New Zealand Germany Developed Emerging Difference

Henkel, Martin, and Nardari (2011)

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Griffin, Kelly, Nardari (2008)

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Do Fundementals Forecast Future Returns?

S.J. Henkel et al. / Journal of Financial Economics ] (]]]]) ]]]]]]

60%
Default premium predicts Chen, Roll and Ross (1986)

Cumulative proportion of recession data in CRSP Sample

50%

Keim and Stambaugh (1986) Term premium predicts Campbell (1987), Fama (1984) Keim and Stambaugh (1986) Harvey (1988) Short rate predicts Fama and Schwert (1977) Fama (1981) Geske and Roll (1983) Predictability illusory? Ang and Bekaert (2007) Cochrane (2008) Goyal and Welch (2003, 2008) Valkanov (2003)

Predictive explanatory power in good and bad times

Using : Short Rates, Dividend Yield, Term Premia

40%

30%
Random walk Fama (1965, 1970)

Predictability debatable Goetzmann and Jorion (1993) Hodrick (1992) Kim and Nelson (1993) Richardson and Stock (1989)

20%

Dividend yield predicts

10%

Rozeff (1984), Shiller (1981)

Henkel, Martin and Nardari (2011)

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Fig. 2. The time-series of predictability research. The literature on stock return predictability follows closely the availability of recession data as a cumulative proportion of the total data in CRSP which originally started in 1962. Shown are the percentages of recession data as a percentage of the available data at a given date, as measured by NBER (solid line) and RSVAR (dashed line) dates. Both the NBER and RSVAR samples show similar proles, although RSVAR recession probabilities represent a much larger proportion of the data. Many seminal, and rst, papers on return predictability were published just after the peaking of the proportion of recession data to total available data in 1985 and are followed by a decline in the proportion of recession data thereafter. The citations are representative for expository purposes and are not intended to be indicative of initial research, nor a comprehensive literature survey (Ang and Bekaert, 2007; Campbell, 1987; Chen et al., 1986; Cochrane, 2008; Fama, 1965, 1970, 1981, 1984; Fama and Schwert, 1977; Geske and Roll, 1983; Goetzmann and Jorion, 1993; Goyal and Welch, 2003; Harvey, 1988; Hodrick, 1992; Keim and Stambaugh, 1986; Kim and Nelson, 1993; Richardson and Stock, 1989; Rozeff, 1984; Shiller, 1981; Valkanov, 2003; Welch and Goyal, 2008).

1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Date
37

0%

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DeBondt and Thaler (1985)

The cyclical dynamics of risk premiums and of return predictability need not be synchronous, however. Using the framework of Campbell and Cochrane (1999), Li (2007) shows, counterintuitively, that changes in risk aversion alone are insufcient to induce any return predictability at 2. Background and motivation all. In another example, Mele (2007) demonstrates that countercyclical risk premiums do not necessarily imply 2.1. Dynamics of expected returns higher return volatility in bad times. Nevertheless, we account for the possibility of countercyclical return predictability in two ways. First, we decomEarly empirical evidence of countercyclical risk preThe Journal of Financesources of predictability to control for shifts in 800 pose the miums is in Fama and French (1989) and Ferson and market volatility relative to predictor volatility. Second, we Harvey (1991). The basic intuition for a Average of 16 Three-Year link between Test Periods design December upon professional survey data to better countercyclical risk premiums and return predictability is 1933 and tests based 1980 Between January Period: Length of risk the effects of simple and appealing. If investors demand higher Formation distinguish Three Years current conditions from the effects of expectations regarding future economic conditions. premiums in bad times, and volatility is higher in bad Changes in predictability over time could also result times as well, then overall adjustments to discount rates from infrequent, random structural breaks rather than per unit of change in economic state are larger in bad business cycles. Under different assumptions, Pesaran and times. Crucially, pricedividend ratios become more 0.20Timmermann (2002) and Lettau and Van Nieuwerburgh volatile and prices more sensitive to changing expecta(2008) both identify 1991 as one such structural break. tions as conditions worsen. Predictability might, thereSince there have been further National Bureau of fore, be a countercyclical phenomenon. 0. 15-] expands on our empirical approach and is followed by a description of the data in Section 4. Section 5 reports our empirical ndings. Section 6 concludes. Please cite this article as: Henkel, S.J., et al., Time-varying short-horizon predictability. Journal of Financial Economics Loser Portfolio (2010), doi:10.1016/j.jneco.2010.09.008

Anomalies
Next cross-sectional differences in return
Risk or mispricing? From 1936-1975 Small Firms in the US earned higher returns than explained by CAPM
Banz (1981) and Reinganum (1981)

'.10
C A 0.05-i

0.00

~ ~

--

The January Effect small losing firms have high returns in January
Keim (1983) and Reinganum (1983)

-0.05-r Winner Portfol io

-o
so,-f

s,'u-vq.ej

req p. e e~?~pvi-e

9.,

r sr

v-,

i.e-s

e s-r

r-t

Value Effect (Banz, 1977, 1983)

30 35

10

I5

20

25

MON4TH1S AFTEn PORTFOLID FOIRATION

High E/P firms earn higher returns.

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Figure 1. Cumulative Average Residuals for Winner and Loser Portfolios of 35 Stocks (1-36 months into the test period)

Tests of the EMH Anomalies 1. Small Firm Effects

While not reported here, the results using market model and Sharpe-Lintner residualsare similar. They are also insensitive to the choice of December as the month of portfolio formation (see De Bondt [7]). The overreaction hypothesis predicts that, as we focus on stocks that go throughmore (or less) extreme return experiences (duringthe formationperiod), the subsequentprice reversals will be more (or less) pronounced.An easy way to generate more (less) extreme observations is to lengthen (shorten) the portfolio formationperiod;alternatively, for any given formation period (say, two years), we may compare the test period performance of less versus more extreme portfolios, e.g., decile portfolios (which contain an average 82 stocks) versus portfolios of 35 stocks. Table I confirms the prediction of the overreaction hypothesis. As the cumulative average residuals (during the formation period) for various sets of winner and loser portfolios grow larger, so do the subsequent price reversals, measured by [ACARL,t - ACARw,,] and the accompanying t-statistics. For a formation period as short as one year, no reversal is observed at all. Table I and Figure 2 further indicate that the overreaction phenomenon is qualitativelydifferent from the January effect and, more generally, from season-

Small Firm in January effect

1a. Small Firm in January effect
Return difference occurs almost entirely in January

One of the best known anomalies Returns on small firms are higher than those on large firms after controlling for risk Initial study, smallest 20% of NYSE stocks yield 19.8% higher returns than largest -- huge premium!

Anomaly or Rational Explanation?

Explained by tax-loss selling
Selling losers in December (or earlier) in order to offset profits Buying back winners in January to re-establish desired portfolio diversification

1a. Small Firm in January Effect

1b. Neglected Firm Effect 1c. Illiquidity Effect

Some recent evidence suggests the January effect is a pure anomaly: in the UK says that after the small firm effect was publicized, the pattern has reversed

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Small Firm and Turn of the Year Effects

Small Firm Effect Neglected Firms

1b. The neglected firm effect

Small firms are riskier, more uncertain investments Information about these companies is less available Small firms are neglected by large institutional traders and therefore command higher returns

Empirical tests:
Variation among analyst earnings forecasts or amount of research available about firms was significantly related to strength of small firm effect

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Small Firm Effect Illiquid stock 1c. The liquidity effect:

Small firms have High Trading costs Investors demand a rate-of-return premium for holding stocks which are less liquid Empirical evidence:
Stocks with high bid-ask spreads (% of price) exhibit abnormally high risk-adjusted returns

Tests of the EMH the Book to Market Anomaly 2. Book to Market predicts return:
A seemingly powerful predictor of returns across securities (a role that should be played by ) is book-to-market ratio Fama and French (1992): build 10 groups of stocks by book-tomarket ratio.
Group with highest ratio had return of 1.65% per month Group with lowest ratio had return of 0.72% per month

Why do these returns occur mainly in January?

Puzzle: High book-to-market stocks seem underpriced

Stronger relationship than with CAPMs

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Value Stocks Earn Higher Returns

Week-end-Effects
Returns are reliably negative over weekends from 1953-77 in US (French, 1980)

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