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IPPTChap 007
IPPTChap 007
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-1
Stock Price Behavior and Market Efficiency
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Learning Objectives
• It may surprise you to learn that evidence strongly suggests that the
answer to this question is “probably not.”
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Market Efficiency
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What Does “Beat the Market” Mean?
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Three Economic Forces that Can
Lead to Market Efficiency
• Investors use their information in a rational manner.
― Rational investors do not systematically overvalue or undervalue financial assets.
― If every investor always makes perfectly rational investment decisions, it would
be very difficult to earn an excess return.
• Arbitrageurs exist.
― Suppose collective irrationality does not balance out.
― Suppose there are some well-capitalized, intelligent, and rational investors.
― If rational traders dominate irrational traders, the market will still be efficient.
These conditions are so powerful that any one of them leads to efficiency.
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Forms of Market Efficiency,
(i.e., what information is used?)
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Information Sets for Market Efficiency
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Why Would a Market be Efficient?
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Some Implications of Market Efficiency:
Does Old Information Help Predict Future Stock Prices?
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Some Implications of Market Efficiency:
Random Walks and Stock Prices
• If you were to ask people you know whether stock market prices are
predictable, many of them would say yes.
• In fact, considerable research has shown that stock prices change through
time as if they are random.
• That is, stock price increases are about as likely as stock price decreases.
• When there is no discernible pattern to the path that a stock price follows,
then the stock’s price behavior is largely consistent with the notion of a
random walk.
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Random Walks and Stock Prices, Illustrated
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How New Information Gets into Stock Prices, I.
• In its semi-strong form, the EMH states simply that stock prices fully reflect
publicly available information.
• Stock prices change when traders buy and sell shares based on their view of
the future prospects for the stock.
• But, the future prospects for the stock are influenced by unexpected news
announcements.
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Event Studies, I.
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Event Studies, II.
• On Friday, May 25, 2007, executives of Advanced Medical Optics, Inc. (EYE), recalled
a contact lens solution called Complete MoisturePlus Multi Purpose Solution.
• Advanced Medical Optics took this voluntary action after the Centers for Disease
Control and Prevention (CDC) found a link between the solution and a rare cornea
infection.
• The medical name for this cornea infection is acanthamoeba keratitis, or AK.
• EYE Executives chose to recall their product even though no evidence was found
that their manufacturing process introduced the parasite leading to AK.
• Further, company officials believed that the occurrences of AK were most likely the
result of end users who failed to follow safe procedures when installing contact
lenses.
• On Tuesday, May 29, 2007, EYE shares opened at $34.37, down $5.83 from the
Friday closing price.
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Event Studies, III.
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Event Studies, IV.
• When researchers look for effects of news on stock prices, they must make
sure that overall market news is accounted for in their analysis.
• To separate the overall market from the isolated news concerning Advanced
Medical Optics, Inc., researchers would calculate abnormal returns:
• The expected return is calculated using a market index (like the Nasdaq 100
or the S&P 500 Index) or by using a long-term average return on the stock.
• Researchers then align the abnormal return on a stock to the days relative
to the news announcement.
― Researchers usually assign the value of zero to the news announcement day.
― One day after the news announcement is assigned a value of +1.
― Two days after the news announcement is assigned a value of +2, and so on.
― Similarly, one day before the news announcement is assigned the value of -1.
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Event Studies, V.
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Event Studies, VI.
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Event Studies, VII.
• After the news was released, there was a large, sharp downward
movement in the CAR.
• That is:
― There is a band of cumulative abnormal returns,
― A sharp break in cumulative abnormal returns, and
― Another band of cumulative abnormal returns.
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Informed Traders and Insider Trading, I.
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Informed Traders and Insider Trading, II.
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Informed Trading
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Legal Insider Trading
• When you hear the term insider trading, you most likely think
that such activity is illegal.
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Illegal Insider Trading
• When an illegal insider trade occurs, there is a tipper and a tippee.
― The tipper is the person who has purposely divulged material non-public information.
― The tippee is the person who has knowingly used such information in an attempt to profit.
• Sometimes, people accused of insider trading claim that they just “overheard”
someone talking.
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It’s Not a Good Thing:
What did Martha do? (Part 1)
• The SEC believed that Ms. Stewart was told by her friend, Sam Waksal, who founded
a company called ImClone, that a cancer drug being developed by ImClone had been
rejected by the Food and Drug Administration.
• Martha Stewart sold her 3,928 shares in ImClone on December 27, 2001.
― On that day, ImClone traded below $60 per share, a level that Ms. Stewart
claimed triggered an existing stop-loss order.
― However, the SEC believed that Ms. Stewart illegally sold her shares because she
had information concerning the FDA rejection before it became public.
• The FDA rejection was announced after the market closed on Friday, December 28,
2001.
• This news was a huge blow to ImClone shares, which closed at about $46 per share
on the following Monday (the first trading day after the information became public).
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It’s Not a Good Thing:
What did Martha do? (Part 2)
• In June 2003, Ms. Stewart and her stock broker, Peter Bacanovic, were indicted on nine
federal counts. They both plead not guilty.
• Just days before the jury began to deliberate, however, Judge Miriam Cedarbaum dismissed
the most serious charge of securities fraud.
• Ms. Stewart, however, was convicted on all four counts of obstructing justice.
― Judge Cedarbaum fined Ms. Stewart $30,000 and sentenced her to five months in prison, two
years of probation, and five months of home confinement.
― The fine was the maximum allowed under federal rules while the sentence was the minimum
the judge could impose.
― Peter Bacanovic, Ms. Stewart's broker, was fined $4,000 and was sentenced to five months in
prison and two years of probation.
So, to summarize:
Martha Stewart was accused, but not convicted, of insider trading.
Martha Stewart was accused, and convicted, of obstructing justice.
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Are Financial Markets Efficient (Part 1)?
• But, market efficiency is difficult to test for these four basic reasons:
― The risk-adjustment problem
― The relevant information problem
― The dumb luck problem
― The data snooping problem
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Are Financial Markets Efficient (Part 2)?
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Some Implications if Markets are Efficient
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Market Efficiency and the Performance
of Professional Money Managers, I.
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Market Efficiency and the Performance
of Professional Money Managers, III.
• The previous slide shows the number of these funds that beat the
performance of the Vanguard 500 Index Fund.
• You can see that there is much more variation in the dashed blue line
than in the dashed red line.
• What this means is that in any given year, it is hard to predict how many
professional money managers will beat the Vanguard 500 Index Fund.
• But, the low level and variation of the dashed red line means that the
percentage of professional money managers who can beat the
Vanguard 500 Index Fund over a 10-year investment period is low and
stable.
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Market Efficiency and the Performance
of Professional Money Managers, IV.
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Market Efficiency and the Performance
of Professional Money Managers, V.
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Market Efficiency and the Performance
of Professional Money Managers, VI.
― In only 9 of the 26 years (1986—2011) did more than half beat the
Vanguard 500 Index Fund for a year.
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Market Efficiency and the Performance
of Professional Money Managers, VII.
• Using data from 1986 through 2011, we divide this time period into:
― 1-year investment periods
― Rolling 3-year investment periods
― Rolling 5-year investment periods
― Rolling 10-year investment periods
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Market Efficiency and the Performance
of Professional Money Managers, IX.
• Some factors that influence portfolio choice include the investor’s age, tax
bracket, risk aversion, and even employer. Employer?
― Suppose you work for Starbucks and part of your compensation is stock options.
― Like many companies, Starbucks offers its employees the opportunity to purchase company
stock at less than market value.
― You can imagine that you could wind up with a lot of Starbucks stock in your portfolio, which
means you are not holding a diversified portfolio.
― The role of your portfolio manager would be to help you add other assets to your portfolio so
that it is once again diversified.
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Anomalies
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The Day-of-the-Week Effect:
Mondays tend to have a Negative Average Return
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The Amazing January Effect, I.
• The January effect refers to the tendency for small-cap stocks to have
large returns in January.
• Does the January effect exist for the S&P 500?
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The Amazing January Effect, II.
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The Turn-of-the-Year Effect, I.
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The Turn-of-the-Year Effect, II.
• As you can see, the “Turn of the Year” returns are higher than
the “Rest of the Days” returns.
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The Turn-of-the-Month Effect, I.
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The Turn-of-the-Month Effect, II.
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Bubbles and Crashes
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The Crash of 1929
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The Crash of 1929 — The Aftermath
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The Crash of 1987
• On October 19, 1987, the DJIA lost about 22.6% of its value on a
new record volume (about 600 million shares)
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Circuit Breakers
• The Crash of 1987 led to some significant infrastructure changes that make it
possible for the NYSE to handle much heavier trading volume.
• One of the most interesting changes was the introduction of NYSE circuit breakers
in 1998.
• Different circuit breakers are triggered if the S&P 500 index level drops by 7, 13, or
20 percent. Specifically,
― Level 1 circuit breakers kick in if the S&P 500 Index falls 7% before 3:25 p.m.
― Level 2 circuit breakers kick in if the S&P 500 Index falls 13% before 3:25 p.m.
― Trading halts in all stocks for 15 minutes when the decline triggers a Level 1 or Level 2 circuit breaker.
(Both circuit breakers could be triggered during the same day)
• Level 3 circuit breakers kick in if the S&P 500 index falls 20% at any time during the
day. Trading is halted for the remainder of the day.
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The Asian Crash
• The crash of the Nikkei Index, which began in 1990, lengthened into
a particularly long bear market.
• The Asian Crash started with a booming bull market in the 1980s.
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The Asian Crash — Aftermath
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The “Dot-Com” Bubble and Crash, I.
• By the mid-1990s, the rise in Internet usage and its global growth
potential fueled widespread excitement over the “new economy.”
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The Crash of October 2008
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The Dow Jones Average,
January 2008 through April 2010
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Chapter Review, I.
• Foundations and Forms of Market Efficiency
• Anomalies
― The Day-of-the-Week Effect
― The Amazing January Effect
― Turn-of-the-Year Effect
― Turn-of-the-Month Effect
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