FIN5558 INVESTMENTS Prof. Kofi Amoateng Chapter 7.

Stock Price Behavior and Market Efficiency
Commentary: Chapter 7 deals with (a) the foundations of market efficiency, (b) the implications of the forms of market efficiency, (c) Market efficiency and the performance of professional money managers, and (d) What stock market anomalies, bubbles, and crashes mean for market efficiency. Chapter 8 also deals with (a) Prospect theory, (b) the implications of investor overconfidence of misperceptions of randomness, (c) Sentiment-based risk and limits to arbitrage and the wide array of technical analysis methods used by investors. A. Introduction to Market Efficiency: →Relation between stock prices and information available to investors indicating whether it is possible to "beat the market;" if a market is efficient, it is not possible except by luck. 1. Efficient market hypothesis (EMH): Theory asserting that, as a practical matter, the major financial markets reflect all relevant information at a given time. The primary question is: Can you, or can anyone, consistently "beat the market?" (Note that the duck on slide 7-5 is trying to ―beat the market‖ with his hammer. In PowerPoint 2007, the duck is animated (This is the only animated slide in the supplements). The duck attempts to beat the market, but fails. This is intended to provide a bit of levity to the subject.) What does “Beat the Market” Mean? 2. Excess return: A return in excess of that earned by other investments having the same risk. To judge if an investment "beat the market," we need to know if the return was high or low relative to the risk involved. We need to determine if the investment has earned a positive excess return in order to say it "beat the market." B. Foundations of Market Efficiency: →Three economic forces can lead to market efficiency. These conditions are so powerful that any one of them can result in market efficiency. These conditions are: 1. Investor Rationality. If every investor always made perfectly rational investment decisions, earning an excess return would be difficult. If everyone is fully rational, equivalent risk assets would all have the same expected returns. Put differently, no bargains would be there to be had, because relative prices would all be correct. 2. Independent Deviations from Rationality. Even if the investor rationality condition does not hold, the market could still be efficient. Suppose that many investors are irrational, and a company makes a relevant announcement about a new product. Some investors will be overly optimistic, while some will be overly pessimistic, but the net effect might be that these investors cancel each other out. In a sense, the irrationality is just noise that is diversified away. As a result, the market could still be efficient (or nearly efficient). What is important here is that irrational investors do not have similar beliefs. 3. Arbitrage. Suppose there are many irrational traders and further suppose that their collective irrationality does not balance out. In this case, observed market prices can be too high or too low

relative to their risk. Fidelity would be willing to spend up to $90 million to boost the performance of this one fund by as little as one-fifth of 1 percent for a single year only. Public information = future stock prices 3. They have met some irrational people in their lives. if an investor uses inside information to earn an excess return. Strong-form efficiency. public or private. **Why Would a Market Be Efficient? The driving force toward market efficiency is simply competition and the profit motive. with respect to any information. Strong-form efficient market: A market in which information of any kind. Forms of Market Efficiency 1. with respect to any publicly available information. intelligent. Therefore. to improve the performance of this fund by 20 basis points for one year only. with respect to information reflected in past price and volume figures. Semistrong-form efficiency. It is easy for them to think that these irrational people could be representative investors and that market efficiency simply cannot hold because of investor irrationality. is of no use in beating the market. This example shows that even relatively small performance enhancements are worth tremendous amounts of money and thereby create the incentive to unearth relevant information and use it. Thus. look at the world through their own experiences. Public & private information = future stock prices "A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return. Some Implications of Market Efficiency 1. If markets are efficient: 2 . Past prices = future stock prices 2. Consider a large mutual fund such as the Fidelity Magellan Fund (one of the largest equity funds in the United States. How much would this one-time 20-basis point improvement be worth? The answer is 0. Now suppose there are some well-capitalized. if an investor uses past price information to earn an excess return.‖ Lecture Tip. Weak-form efficiency. If these rational arbitrage traders dominate irrational traders. both public and private. the market is not efficient with respect to that information. We sometimes hear the expression ―Market efficiency doesn’t require that everybody be rational. and rational investors. If an investor uses a firm's financial statements to earn an excess return. the market is not semi-strong-form efficient. the market is not strong-form efficient. then the market is not weak-form efficient. just that somebody is. the market will still be efficient. Suppose Fidelity was able. through its research. To be clear. This group of traders would see these high or low market prices as a profit opportunity and engage in arbitrage—buying relatively inexpensive stocks and selling relatively expensive stocks. like all of us. Semistrong-form efficient market: A market in which publicly available information is of no use in beating the market. if the information allows an investor to earn excess returns on an investment." So. D. a market can only be determined to be efficient with respect to specific information. or $90 million. C. with about $45 billion under management). Weak-form efficient market: A market in which past prices and volume figures are of no use in beating the market. Finally.0020 times $45 billion. Students.

trading costs generally swamp attempts to build a profitable trading system on the basis of past returns. trading costs matter. Lecture Tip: It may be helpful to restate the implications of market efficiency with respect to the forms of market efficiency. Researchers have been unable to provide evidence of a superior trading strategy that uses only past returns. That is. That is.(i) Security selection is less important. suggesting that there should be no restrictions on insider trading. successful market timing is very difficult to achieve. this means that studying past price movements in the hopes of predicting future stock price movements is really a waste of time. (In fact. then the stock’s price behavior is largely consistent with the notion of a random walk. Does Old Information Help Predict Future Stock Prices? 1.  (iii) Investors should not try to time the market.  (ii) There is little need for professional money managers. it is very difficult to predict stock market prices. E. In short. and most of the financial analysts and mutual fund managers are not providing any value. A random walk is  3 . then fundamental analysis using publicly available information is of no benefit. To their surprise. stock price increases and decreases are equally likely. considerable research has shown that stock prices change through time as if they are random. and the efforts of technical analysts are of no benefit to investors. 2. 3. (iii)Strong-form efficiency: If strong-form efficiency holds. there is no assurance that this relationship will occur again in the future. (ii) Semi-strong-form efficiency: If semi-strong-form efficiency holds. as follows: (i) Weak-form efficiency: If weak-form efficiency holds. In fact. When the path that a stock price follows shows no discernible pattern. In addition. There is also a very subtle prediction at work here. 2. then inside information is of no value. which means that predictability is not sufficient to earn an excess return. Random Walks and Stock Prices 1.) 2. If this is true. That is. In its weakest form. and buy-and-hold strategies involving broad market indexes are extremely difficult to outperform. F. the predicted returns are not economically important. investors may as well hold index funds to minimize their costs. 4. Researchers have used sophisticated statistical techniques to test whether past stock price movements are of any value in predicting future stock price movements. no matter how often a particular stock price path has related to subsequent stock price changes in the past. then technical analysis is of no use. This turns out to be a surprisingly difficult question to answer clearly and without qualification. even ignoring market efficiency. Ask your students whether stock market prices are predictable: many of them will say yes. although some researchers have been able to show that future returns are partly predictable by past returns. the efficient market hypothesis is the simple statement that stock prices fully reflect all past information.

H. Prices can adjust to news announcements in three ways: i. Overreaction and correction: The price over-adjusts to the new information. executives of Advanced Medical Optics Inc. public or private. Delayed reaction: The price partially adjusts to the new information. Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock. On Friday. You will note that we strove to focus our exposition on the reaction to the news. it overshoots the appropriate new price but eventually falls to the new price. rather than the methods of event studies. To qualify as a true random walk. However. making profits on nonpublic information is illegal. Researchers use a technique known as an event study to test the effects of news announcements on stock prices.related to the weak-form version of the efficient market hypothesis because past knowledge of the stock price is not useful in predicting future stock prices. The company took this voluntary action after the Centers for Disease Control and Prevention (CDC) found a link between the solution and a rare cornea infection called acanthamoeba keratitis. ii. Intel stock price changes would have to be independent and identically distributed. It has been our experience that students really like to get a glimpse of an ―actual‖ technique used by finance researchers. Event Studies: We have included an event study for Advanced Medical Optics.S. The United States Securities and Exchange Commission (SEC) is charged with enforcing laws 4 . G. How Does New Information Get into Stock Prices? 1. Still. new information. May 25. This fact generates an interesting question: Should any of us be able to earn returns based on information that is not known to the public? In the United States (and in many other countries. stock markets. but days elapse before the price completely reflects new information. no information of any kind. iii. These daily price changes are not truly a random walk. There is no tendency for subsequent increases or decreases to occur. The future prospects for the stock are influenced by unexpected news announcements. the efficient market hypothesis is the simple statement that stock prices fully reflect publicly available information. This ban is said to be necessary if investors are to have trust in U. Executives at Advanced Medical Optics chose to recall their product even though they did not find evidence their manufacturing process introduced the parasite that can lead to AK. recalled a contact lens solution called Complete MoisturePlus Multi Purpose Solution. inside information of many types clearly would enable you to earn essentially unlimited returns. I. is useful in beating the market. or AK for short. though not all). Inc. Informed Traders and Insider Trading: Recall that if a market is strong-form efficient. 2007. It is certainly hard to see any pattern in these daily price changes. (EYE) in the text. We illustrate daily price changes for Intel stock in the text. Efficient market reaction: The price instantaneously adjusts to. and fully reflects. the graph of daily price changes for Intel stock is essentially what a random walk looks like. 3. In its semi-strong form.

concerning illegal trading activities.S.  The market reacts quickly and sharply to new information. corporate insiders must declare that trades that they made were based on public information about the company. Lecture Tip. She was accused. Securities and Exchange Commission. In addition. and convicted. of obstructing justice and lying to investigators. You will notice that we do not talk about noise traders here. these trades are reported to the public. The information that an informed trader possesses might come from reading The Wall Street Journal. K. we present the distinctions among informed traders. Such information is both not known to the public and. it is not obvious. (ii) J. It’s Not a Good Thing: What did Martha Stewart Do? Martha Stewart was accused. Talking about noise traders (and their lack of information) could deflect the discussion away from information and the types of informationbased trades. rather than ―inside‖ information. illegal insider trading. reading quarterly reports issued by a company. Some Implications of Market Efficiency 5 . gathering financial information from the Internet. would impact the stock price. or a host of other sources. 2. If the stock market can be beaten. Legal “Insider Trading‖: A company’s corporate insiders can make perfectly legal trades in the stock of their company. There is little evidence that a market under (or over) reaction can be profitably exploited. they must comply with the reporting rules made by the U. To do so. We left them out here because the focus of this section is on information. but not convicted. Insider Trading (i) Illegal Insider Trading: For the purposes of defining illegal insider trading. When they make a trade and report it to the SEC. an insider is someone who possesses material nonpublic information. Are Financial Markets Efficient? (a) There are four reasons why market efficiency is difficult to test:  The risk-adjustment problem  The relevant information problem  The dumb luck problem  The data snooping problem (b) There are three generalities based on research that are relevant to market efficiency:  Short-term stock price and market movements are very difficult to predict with accuracy. Most public companies also have guidelines that must be followed. A person can be charged with insider trading when he or she acts on such information in an attempt to make a profit. Informed Trading: → When an investor makes a decision to buy or sell a stock based on publicly available information and analysis. How Efficient are Markets? 1. and legal insider trading. if it were known. this investor is said to be an informed trader. 1. of insider trading. As a result. talking to other traders. so this implies that the market is not grossly inefficient.

and. if anybody can. About all we can do is use this in our trading decisions. the Asian Crash. asset allocation is still important because the risk-return tradeoff still holds. international funds were compared to the Morgan Stanley EAFE index. the difference is apparent in the 1984-2009 period. Bubbles and Crashes (including the Market Crashes of 1929. This effect is statistically significant. Anomalies In this section. Figures 7. This is further evidence in favor of market efficiency. Mutual fund managers should be experts in technical and fundamental analysis. the difference was more than twice as large in the 1962-1983 period. This effect exists in most major markets around the world.2 shows the day-of-the-week effect. Apparently the fund managers are able to exploit enough market inefficiencies in the small firm equity market to allow excess returns to accrue. The results of almost every study indicate that the market indices outperform the mutual fund managers.9b show the results of the January effect. Table 7. 6 . L. Turn-of-the-Year Effect: → Researchers have delved deeply into the January effect to see whether the effect is due to returns during the whole month of January or to returns bracketing the end of the year. However. 1. the amazing January effect (and two of its extensions). corporate bond funds were compared to the Lehman Brothers Corporate Bond index. the benchmark indices significantly outperformed the mutual funds for all fund categories but one. purchase a stock late on Monday and sell our stocks late on Friday. The returns in the ―Turn-of-the-Year Days‖ category are higher than returns in the ―Rest-of-the-Days‖ category. Small stocks tend to have much higher returns in January. The one category that the funds outperformed the index was small company equity funds. This study found that.4 shows our calculations concerning this effect. on average. 1987. whereas larger stocks (S&P 500) do not show this result. Two factors are important in explaining the January effect: tax-loss selling and institutional investors rebalancing their portfolios. and they should be able to use these tools to earn excess returns. and small company equity funds were compared to the Wilshire 2000. which indicates that Monday is the only day with a negative average return (Monday Blues). 1. several well-known market anomalies are discussed: the Day-of-the-week effect. February 1999] compares the performance of a large sample of mutual funds categorized by investment objective. 2.9a and 7. but it is difficult to exploit it to earn a positive excess. January effect: This is the term for the tendency for small stocks to have large returns in January. 3. and the ―Dot-Com Bubble and Crash).  Lecture Tip: An interesting study by Fortin and Michelson [Journal of Financial Planning. The effect is more pronounced for stocks that have significant declines. For example.Even if all markets are efficient. The bulk of the return occurs in the first few days of January. growth funds were compared to the S&P 500. Market Efficiency and the Performance of Professional Money Managers There have been a number of studies that compare the performance of mutual fund managers with market indices. to their respective market indexes. Further. Notice that Friday has a high positive return. Day-of-the-week effect: This is the term for the tendency for Monday to have a negative average return. Table 7.

However. However. Crashes. 1932. 1954. Bubbles and Crashes 1. In addition. The same is true with the Tel Avi market in Israel where a day after the Sabbath day is marked by relatively high stock prices. Table 7. On October 19. are sudden. stocks with relatively low P/E ratios outperform stocks with relatively high P/E ratios. the disastrous financial aftermath of a crash can last for years. even after adjusting for other factors. like risk. A crash is a significant and sudden drop in market wide values. Investment bubbles eventually pop because they are not based on fundamental values. on average. on the other hand. months. The Crash of October 1987 (Black Monday): → NYSE circuit breakers: This is the name for rules that kick in to slow trading when the DJIA declines by more than a preset amount in a trading session. some researchers have found that buying stocks after positive earnings surprises is a profitable investment strategy. Typically. the DJIA rebounded about 20 percent following the October 1929 crash. As shown in Figure 7. M. the DJIA then began a protracted fall. trading will halt. investors find themselves holding assets with plummeting values. 2.4.56 on July 8.5 shows the results of our calculations. Researchers have found that. The Crash of 1929: → Although the Crash of 1929 was a large decline. it should already be reflected by stock prices.700 with about $500 billion in losses that day. generally lasting less than a week. N. A bubble can form over weeks. The Earnings Announcement Puzzle Researchers have found that it takes days (or even longer) for a market price to adjust fully to information about earnings surprises. 1987 (Black Monday) the Dow plummeted 500 points to 1. more than 25 years later. 5. Crashes are generally associated with a bubble. By the way.10 on September 3. A bubble occurs when market prices soar far in excess of what normal and rational analysis would suggest. Because a P/E ratio is publicly available information. reaching the bottom at 40. The Holiday-effect in Middle Eastern Equity markets: A day after the Holy Friday Prayer of the Islamic countries is marked by relatively high stock prices. This level represents about a 90 percent decline from the record high level of 386. There are several explanations for what happened: 3. 4. Turn-of-the-Month Effect: →Financial market researchers have also investigated whether a turn-of-the-month effect exists. it pales with respect to the ensuing bear market. 1929. In fact. a bubble lasts much longer than a crash. 7 . purchasing stocks with relatively low P/E ratios appears to be a potentially profitable investment strategy. It appears that this effect was stronger in the 1984-2009 period than in the 1962-1983 period. the DJIA did not surpass its previous high level until November 24. if the DJIA declines far enough. The Price-Earnings (P/E) Puzzle: The P/E ratio is widely followed by investors and is used in stock valuation. However. When a bubble does pop. or even years.11.

require payments increased. In April 2003. Irrational investors bid up stock prices and the bubble popped. In three years from December 1986 to the peak in December 1989. many agree that one of the underlying causes of the crash of 2008 was excess liquidity. lengthened into a particularly long bear market. The trading halts vary from 30 minutes. 5. an increase of about 500 percent. which allowed unworthy borrowers to obtain financing. As a result of the crash. Interestingly. The Amex Internet Index soared from a level of 114. and 30 percent declines in the DJIA. much of this was done at low ―teaser rates. the index lost 57 percent of its value. the Nikkei Index stood at a level that was 80 percent off its peak in December 1989. The “Dot-Com” Bubble and Crash: By the mid-1990s. borrowers could have refinanced. to two hours. These circuit breakers required trading halts based upon 10. The market was up in 1987 and the bull market continued for many years after the crash. Many of them suffered huge losses and some folded relatively shortly after their IPOs. Over the next three years.60 on October 1. 8 . which were commonly referred to as ―dot-coms‖ because so many of their names ended in ―. this did not happen. However. Program trading quickly created very large sell orders. to its peak of 688. the Nikkei 225 Index rose 115 percent. Moreover. If house prices had continued to climb. avoiding trouble. By contrast.‖ Of course. Markets were volatile. 7.59 in early October 2002. 20. the rise in Internet use and its international growth potential fueled widespread excitement over the ―new economy. It is quite like the Crash of 1929 in that respect.52 in late March 2000. which began in 1990.‖ When these rates reset.‖ Investors did not seem to care about solid business plans—only big ideas. the S&P 500 Index rallied about 31 percent in the same 1998–2000 time period and fell 40 percent during the 2000–2002 time period. a drop of about 91 The Crash of October 2008: Although still under debate. The Asian Crash: The crash of the Nikkei Index. 1998. to the rest of the trading day. The Amex Internet Index then fell to a level of 58. NYSE circuit breakers were introduced. the market recovered very quickly. Investor euphoria led to a surge in Internet IPOs. the lack of solid business models doomed many of the newly formed companies. the economy was shaky. resulting in bankruptcies for these so-called subprime loans. primarily for mortgages.   6. and Congress was in session considering anti-takeover legislation.

What are some of the key lessons to be learned from historical stock market crashes? Solution: Feedback: Student answers will vary but should display a basic understanding of market crashes. Students can address causes of crashes.1% . Tyler Co.3.7 percent. The following are the daily returns for both the overall market and for Dexter Inc. announced its merger plans on August 25 and had a daily return of 0. 0.(-0.4%] = 1. and the variances in post-crash market behavior.5% 0. The daily market returns for August 25 through August 27 were 0.4.0 % 3. Selected Problems. . announced its merger plans on August 26 and had a daily return of 0. What is the cumulative abnormal return on Dexter. 1.7% . Swenson Co. What should the primary role of portfolio managers be given the research to date on their market performance and based on the assumption that markets are efficient? Solution: Feedback: The role of portfolio managers is the construction and maintenance of a diversified portfolio designed to meet the needs and risk tolerances of their investors.3%)] + [-0. and -0. What is the combined cumulative abnormal return for the announcement date? Solution: Combined cumulative daily abnormal return = [0. stock for these 5 days? Solution: 2..2. 4. the suddenness of crashes. Inc. respectively.5 percent.O.1 percent. The Underwood Co.2%] + [0. announced its merger plans on August 27 and had a daily return of -0.0. 9 .