Chapter 10

EFFICIENT CAPITAL MARKETS

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 of them?

Chapter 10 Questions
How does one test the three efficient market subhypotheses, and what are the results of the tests? For each set of tests, which results support the EMH and which indicate an anomaly related to the hypothesis? What are the implications of the results for stock strategies and portfolio managers? What is the evidence related to the EMH for markets in foreign countries?

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

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.

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.

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.

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

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

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.

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

Implications of the SemistrongForm 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.

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

Tests and Results: Weak-Form EMH

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

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

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

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)

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?!

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!

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.

Tests and Results: Semistrong-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

Tests and Results of Semistrong-Form EMH

Another definition of abnormal return is a riskadjusted 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)

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

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.

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

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 riskadjusted returns
These tests include a joint hypothesis of both market efficiency and the asset pricing model used to generate abnormal returns

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

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)

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

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

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.

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 it quickly adjust away in the first day, consistent with the EMH

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

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

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.

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

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

Tests and Results: Strong-Form EMH

Corporate Insiders Mixed results Corporate insiders generally experience aboveaverage 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 insiders may no longer be able to generate abnormal returns

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 aboveaverage returns because of their superior information, and this appears to be the case.

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

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

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

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

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

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

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

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?

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

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

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.

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)

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)

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

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

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