The Market Efficiency Hypothesis (MEH)

Prediction and Timing
Session 10
Outline 10: Market Efficiency The Market Efficiency Hypothesis Can the Stock Market be Predicted? Different Views on Expected Returns Regression Evidence Market Newsletters Evidence Summary of Predictability of Broad Stock Market Readings: Franzoni and Marn (JF06, JPM06). 1. 2. 3. 4. 5. 6. More Evidence against Market Efficiency The Importance of a Joint Test Pricing Anomalies and Superior Performance in Modern Times Application: Pension Funding Mispricing (Franzoni and Marn JF06 and JPM06)
1. The Market Efficiency Hypothesis (MEH)

Suppose you learn that MSFT profits are going to increase in the future. Should you buy today? The answer depends on whether or not the price already reflects this information (this is the idea of market efficiency). The possibility of profiting from your information strongly depends on the way information gets into prices. For instance: o The price may have increased in the recent past and that information is already incorporated in the current price level. In this case, buying today is not a good idea. Youve learned the information too late. o The price may have stayed still or even gone down in the recent past. This may be justified by innovations in other variables such as increases in ex-ante volatility or risk premium that you are not aware of. It is not clear that buying is a good idea here either.
Copyright Jos M. Marn
Portfolio Management
Session 10
There are many definitions of market efficiency. The most widely accepted notion distinguishes between: o Weak form of mkt. efficiency: Prices reflect all information contained in past prices and returns (rules out technical analysis) o Semi-strong form of mkt. efficiency: Prices reflect all public information (past prices, news papers contents, databases, etc. ) o Strong form of mkt. efficiency: Prices reflect all available information, both public and private. In 1970 Fama concluded that US stock prices satisfied the first two forms of market efficiency and that it was not possible to reject the third one (due to the poor performance of management in the mutual fund industry and apparent inexistence of arbitrage opportunities in equity markets). Today we think of asset markets in a very different way. Market efficiency is usually analyzed by addressing two questions: o Can the market be predicted? o Are there strategies that beat the market? In this Chapter we analyze these two questions in the context of the first two forms of Market Efficiency; in the next two Chapters we analyze the third one (by looking at the performance of fund managers)
Copyright Jos M. Marn 2 Portfolio Management
Session 10
2. Can the Stock Market Be Predicted?

It seems predicting the market may produce handsome rewards (Remember the quiz I gave you the first day of class) Stock market prediction: crucial in the development of finance and economics (Cowles; Econometrica, Cowles Foundation, )
Title: Can Stock Market Forecasters Forecast? Abstract: It is doubtful Author: Alfred Cowles Source: Econometrica, July 1933 (3rd issue)
Potential reasons for predictability o Shifts in risk or risk aversion giving rise to higher risk premium; need not provide advantages to rebalancing o Inefficiency, such as investor sentiment; could suggest profitable rebalancing strategies (timing) o Frictions in asset markets: illiquidity, costs, regulation, etc. o Possibly some of the stories hedge fund managers tell There are lots of methods pursued. Few, if any, are associated with strong empirical evidence.
Copyright Jos M. Marn 3
Session 10
One common approach is a dividend-discount model o Forecast the stream of future dividends per share, D1, D2, . . . o Construct a discount rate, k, often as a spread (premium) over an observed long-term bond yield. o Compute the implied current share value
V0 = D1 D2 + +K 1 + k (1 + k ) 2
(1)
o Compare V0 to the current price. Most dividend-discount models are bullish on stocks when dividend yields are high and long-term bond rates are low.
Different Views on Expected Returns on the Broad Market

o Jeremy Siegel, 1994: Stocks for the Long Run (book)
As an illustration, look at views at the end of 2000. Key references:
o Brown, Goetzman and Ross, 1995: Survival (article in JoF) o Glassman-Hassett, 1999: Dow 36.000 (book) o R. Shiller, 2000: Irrational Exuberance (book) The next 6 pages can help you to follow the basic arguments.
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-- Siegels and Glassman-Hassett View
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-- Brown-Goetzman-Ross Counterargument
Market Prediction and Timing

Session 10
-- Shillers View
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Robert J. Shiller, Irrational Exuberance, Princeton University Press, 2000
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Robert J. Shiller, Irrational Exuberance, Princeton University Press, 2000
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Regression Evidence
Suppose we estimate the regression
R(t , t + T ) = a + b( D P) t + et
(2)
R(t, t +T) : Value-weighted NYSE excess return from time t to t + T (D / P)t : Dividend-yield on NYSE at time t N : Number of observations (non-overlapping returns)
T 1 mos. 3 mos. 12 mos. 24 mos. 36 mos. 48 mos. a -0.5 -4.2 -3.2 -12.4 -9.4 -21.8 b 0.3 1.5 2.8 6.9 8.2 13.8 t(b) 192697 2.1 3.2 1.6 2.3 1.9 1.9 R2 0.00 0.03 0.03 0.13 0.14 0.18 N 852 248 71 35 23 17 a -0.5 -2.0 -10.4 -20.8 -28.5 -45.6 b 0.3 1.0 4.8 10.1 14.7 21.9 t(b) 194097 2.4 2.5 2.7 3.0 2.5 3.4 R2 0.01 0.03 0.11 0.25 0.26 0.47 N 684 228 57 28 19 14
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A plot of the post-1940 experience

1,6 1,4
Subsequent four-year return
1,2 1 0,8 0,6 0,4 0,2 0 -0,2 0,02
0,03
0,04
0,05
0,06
0,07
0,08
Current dividend yield
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Market Efficiency
Session 10
Market Newsletters Evidence

The Graham-Harvey Study
Market Efficiency
Session 10
Summary of Predictability of the Broad Stock Market

Some evidence in favor of market efficiency: o Newsletters Some evidence of market inefficiency: o Shillers D/P ratio o Others, such as the implied dividend yield (using the put-call parity) Golez (2008). But the general idea is that predicting the market is hard, what explains the simultaneous existence of very different views among experts.
Market Efficiency
Session 10
3. More Evidence against Market Efficiency

Basic approach consists on testing a very weak form of the random walk condition namely that price changes are uncorrelated without excluding the possibility of dependency rather than the strong form of prices being i.i.d. over time. Using this criterion, the hypothesis is rejected. It is important here to note that these tests do not use risk adjusted returns. Consequently, the rejection of the hypothesis does not necessarily imply market inefficiency. The evidence may be due to the existence of some latent factor that is not accounted for. See the discussion in Campbell, Lo and MacKinlay (97). Strictly speaking, the MEH cannot be tested individually but jointly with some asset pricing model. You will see more clearly at the end of this section why this is the case. Evidence 1: using long run returns (5 years) we have: o For stock indexes: positive first order serial correlation (significant) o For individual stocks: negative first order serial correlation (although not significant due to the high idiosyncratic component)
Market Efficiency
Session 10
Return interval
Daily returns IBEX Monthly Returns IGBM Monthly returns equally weighted index
Table 10.2 (Marn and Rubio) STOCK INDEXES AUTOCORRELATION Sample Mean Standard 1 2 3 4 size (%) Dev. 1982 0,079 1,248 0,117 -0,034 -0,037 -0,004 obs. 402 obs. 402 obs. 1,007 1,319 5,351 5,817 0,198 -0,043 -0,060 0,287 -0,009 0,006 0,023 0,073
5 0,002 0,096 0,108
In table 10.2 notice the different results for the value weighted and the equally weighted index where small firms have a relatively larger weight.
Notice also that the simultaneous existence of positive serial correlation (for indexes) and negative (for individual stocks) implies the existence of positive cross serial correlation between individual stocks over time. In other words, there must exist a positive correlation between an asset return and the one period lagged return of the others.
Market Efficiency
Session 10
This evidence is consistent with the overreaction hypothesis (according to which investors overreact on the arrival of news) and can explain the relative success of contrarian strategies, which involve selling winners and buying loser stocks. Why? First, the negative auto-correlation of stocks implies that current losers (have falling prices in the past) will become winners in the future, and vice versa. Second, the positive cross correlation reinforces this effect. Suppose that we have two assets A and B. If As current return is larger than the markets, then the contrarian strategy consists on selling A and buying B. But if there is positive cross correlation, the larger As current return would imply a larger Bs return in the future. Clearly, this effect plays in favor of the contrarian strategy.
Evidence 2: Using short run return (say daily) we obtain positive serial correlation both for indexes and individual stocks. o This evidence is consistent with the under-reaction hypothesis and justifies the relative success of momentum strategies.
Market Efficiency
Session 10
4. The Importance of a Joint Test

The previous evidence is not conclusive, as it does not take into account risk. As a pedagogical exercise, we go over a very well known study on the bad performance of companies doing a public offering, PO, (both IPOs and seasonal offerings) by Loughran and Ritter (1995), JoF, 50, 23-51, which illustrates the basic point:
RETURN OF NYSE STOCKS THAT REALIZED A PUBLIC OFFERING BETWEEN 1970 AND 1990 OVER THE 5 YEARS AFTER THE OFFERING
YEARS 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1970-90 Copyright Jos M. Marn PO (In %) -46,3 -31,6 -18,2 0,8 234,4 117,9 259,4 173,8 217,9 52,6 -2,1 14,9 76,7 3,8 44,0 9,5 9,3 6,2 80,8 44,4 22,7 15,7 CONTROL SAMPLE (In %) -20,0 6,1 33,4 104,4 173,0 127,3 205,0 234,0 227,0 193,1 188,0 194,7 137,6 67,2 82,2 58,6 33,4 14,0 60,3 25,3 42,7 66,4 6 RELATIVE WEALTH 0,67 0,64 0,61 0,49 1,22 0,96 1,18 0,82 0,97 0,52 0,34 0,39 0,74 0,62 0,79 0,69 0,82 0,93 1,13 1,15 0,86 0,70 Portfolio Management
Market Efficiency
Session 10
From the study we could deduce that PO firms do much worse (on average a 15.7% vs. 66.4% over a 5year period) than companies of similar size that did not do a PO. Does this mean that there is not market efficiency (since POs do not seem to be priced correctly)? Does this mean that we can build an arbitrage strategy (or a very successful strategy) consisting in going long in the control sample and short in the POs portfolio? The previous study only takes into account size (market capitalization) as an aggregate risk factor. It is possible that this proxy undervalues the true risk of the control sample. To address this issue, lets include also the value factor (book to market ratio). In particular, lets run the following regression:
Rit = a0 + a1 ln VM it + a2 ln(VC / VM ) it + a3OPVit + it , where OPV is the fictitious variable that takes the value 1 if the firm has done an PO and 0 otherwise. 3 = 0.38 (that is, -4.5% annually) that amounts to a 5-year compounded mispricing of The result is that a 25%. This means that 50% of the original mispricing (50,07%) does not come from the bad performance of PO stocks but from a risk factor that we had not considered.
Market Efficiency
Session 10
What about FF?
Market Efficiency
Session 10
These results are consistent with the previous regression and show that the PO underpricing still exists but it is less severe (alphas are always larger than -0.38, except in the small issuers with EW portfolios).
Market Efficiency
Session 10
5. Pricing Anomalies (market inefficiency) AND Strategies that Beat the Market in
Modern Times
Previous analysis makes clear that we need to control for risk. The current convention is to set up the study of market efficiency in the context of factorial models. Anomalies related to the stock market are tested using the three Fama and French model (or the 4FF model which adds a momentum factor long past 12 month winners and short past 12 month losers)
o 3-Factor FF Model:
Ri,t Rf,t = ai + bi(RM,t Rf,t) + si S M Bt + hi H M Lt + i,t.
o 4-Factor FF Model (for checking purposes, we add momentum as this one survives the 3-factor FF model):
Ri,t Rf,t = ai + bi(RM,t Rf,t) + si S M Bt + hi H M Lt + mi MOMt + i,t.
o Corroborating evidence on the anomaly being inefficiency rather than a missing risk factor is welcome: Surprises in analysts forecasts Surprises on returns Etc.
Market Efficiency
Session 10
To test if a strategy beats the market we require the previous test for anomalous returns PLUS positive results in the well-known Sharpes style regression. For instance, for hedge funds, the regression takes the form:
Rt = + bk Fkt + ut
k =1 K
(3)
Here, the Fs are not risk factors, but INVESTMENT STYLES. This means that the regression has a nice interpretation: In this regression, the managers return can only be attributed to a particular style if it is correlated to that style, bk 0. So, bk close to zero and low R2 are good news. On the other hand, the term + ut reflects the managers skill. In particular, a positive alpha is good news. In applications we often use:
o Style analysis with traditional benchmarks (styles). Here the Fs are:
MSCI US equities, MSCI non-US equities, IFC emerging markets equities, JP Morgan US govmt bonds, JP Morgan non US govmt bonds, 1-month Eurodollar deposit, gold price, FED traded weighted dollar index
Market Efficiency
Session 10
o Style analysis with Alternative (investments) benchmarks. Here the Fs are: Two equity-oriented benchmarks: the S&P 500 index (S&P 500) and a portfolio that captures the size risk, the Wilshire 17500 index minus the Wilshire 750 index (SC - LC). Two bond market benchmarks: the month-end to month-end change in the Federal Reserve's ten-year constant maturity yield (lOY); and the month-end to month-end change in the difference between Moody's Baa yield and the Federal Reserve's ten-year constant maturity yield (Cred Spr). Three factors that capture the returns of trend-following managers: a portfolio of look-back straddles on bond futures (Bd Opt); a portfolio of look-back straddles on currency futures (FX Opt); and a portfolio of look-back straddles on commodity futures (Com Opt).
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Market Efficiency
Session 10
6. Application: Franzoni and Marin (JF 2006 and JPM 2006)

Fama and French Regressions (JF):
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Market Efficiency
Session 10
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Market Efficiency
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Additional Evidence (JF)
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Market Efficiency
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Dynamic Trading Strategy pure alpha strategy (JPM)

o Returns
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Market Efficiency
Session 10
o Style Analysis
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Market Efficiency
Session 10
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Market Efficiency
Session 10
Does the strategy still make money?
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The Market Efficiency Hypothesis (MEH)

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Prediction and Timing

1. The Market Efficiency Hypothesis (MEH)

Copyright Jos M. Marn

Prediction and Timing

Prediction and Timing

2. Can the Stock Market Be Predicted?

Prediction and Timing

Different Views on Expected Returns on the Broad Market

As an illustration, look at views at the end of 2000. Key references:

Prediction and Timing

-- Siegels and Glassman-Hassett View

Copyright Jos M. Marn

Prediction and Timing

Market Prediction and Timing

Market Prediction and Timing

Copyright Jos M. Marn

Market Prediction and Timing

Market Prediction and Timing

Robert J. Shiller, Irrational Exuberance, Princeton University Press, 2000

Copyright Jos M. Marn

Market Prediction and Timing

Market Prediction and Timing

Robert J. Shiller, Irrational Exuberance, Princeton University Press, 2000

Copyright Jos M. Marn

Market Prediction and Timing

Copyright Jos M. Marn

Market Prediction and Timing

A plot of the post-1940 experience

1,2 1 0,8 0,6 0,4 0,2 0 -0,2 0,02

Current dividend yield

Copyright Jos M. Marn

Market Newsletters Evidence

Copyright Jos M. Marn

Summary of Predictability of the Broad Stock Market

Copyright Jos M. Marn

3. More Evidence against Market Efficiency

Copyright Jos M. Marn

5 0,002 0,096 0,108

Copyright Jos M. Marn

Copyright Jos M. Marn

4. The Importance of a Joint Test

Copyright Jos M. Marn

What about FF?

Copyright Jos M. Marn

Copyright Jos M. Marn

6. Application: Franzoni and Marin (JF 2006 and JPM 2006)

Copyright Jos M. Marn

Copyright Jos M. Marn

Additional Evidence (JF)

Copyright Jos M. Marn

Dynamic Trading Strategy pure alpha strategy (JPM)

Copyright Jos M. Marn

Copyright Jos M. Marn

Copyright Jos M. Marn

Does the strategy still make money?

Copyright Jos M. Marn

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