Transcript Document

THE EFFICIENT MARKET HYPOTHESIS

Analysis of economic time series in 1950s
◦ Business cycle theorist, evolution of several
economic variables overtime
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What about the behavior of stock market
prices
◦ Maurice Kendall 1953, no predictable patterns in
stock prices
◦ Irrationality?
◦ Random price movements indicate a wellfunctioning or efficient market, no an irrational
one
◦ Why and implications
10.1 RANDOM WALKS AND THE
EFFICIENT MARKET
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Do security prices reflect information ?
Why look at market efficiency?
◦ Implications for business and corporate finance
◦ Implications for investment
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Forecast of a future price increase will lead instead to an
immediate price increase
◦ If it is sure the stock price will increase, then large orders to buy
the stock and no one holding the stock will sell, immediate jump
in stock price
◦ Stock price will immediately reflect the good news implicit in the
model’s forecast
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Any information that could be used to predict stock
performance should already be reflected in stock prices
Increase or decrease only in response to new information,
which is unpredictable; the stock prices that change in
response to new information also must move unpredictably
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Random walk
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Random Walk - stock prices are random
◦ the price changes should be random and unpredictable
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Not irrationality
◦ Randomly evolving stock prices are the consequence of
intelligent investors competing to discover relevant
information
◦ Random walk would be the natural result of prices that
always reflect all current knowledge
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EMH
◦ The stocks already reflect all available information
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Why expect prices to reflect all available information
Grossman and Stiglitz (1980)
◦ Investors have incentive to spend time and resources to
analyze and uncover new information only if higher
returns
◦ Degree of efficiency differs across various markets
 Emerging markets, less intensively analyzed, accounting
disclosure requirements less rigorous, small stocks receive
relatively little coverage
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Competition among the well-backed, highly
paid, aggressive analyst ensures that stock
prices ought to reflect available information
regarding their proper levels
With many well-backed analysts willing to
spend resources on research, easy picking in
the market are rare, incremental return on
research activity may be small that only
largest portfolios will find them worth
pursuing
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Weak
◦ Reflect all information that can be derived by
examining market
◦ trading data, past prices, trading volume, or short
interest
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Semi-strong
◦ All publicly available information regarding the
prospects of a firm
◦ Past prices, fundamental data
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Strong
◦ All information relevant to the firm
◦ Even including information available only to company
insiders
10.2 IMPLICATIONS OF THE EMH
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Technical Analysis - using prices and volume
information to predict future prices.
◦ Weak form efficiency & technical analysis
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Fundamental Analysis - using economic and
accounting information to predict stock prices.
◦ Semi strong form efficiency & fundamental analysis
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Search for recurrent and predictable patterns in stock prices
◦ Prices responds slowly enough
Resistance levels/ supprt levels
◦ Example, XYZ traded at 70 for several months. Once it
declined to 65 then increased, 70 is considered a resistance
level, because investors who bought at 70 will be eager to
sell their shares as soon as they can break even, selling
pressure at 70
EMH implies technical analysis is without merit
◦ Past history of prices and trading volume is publicly
available, any information from analyzing past prices has
already been reflected in stock prices
◦ Price patterns self-destructing, occasionally uncover a
profitable trading rule, then it will be invalidated when the
mass of traders attempts to exploit it
 Market dynamic is one of a continual search for profitable
trading rules
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Dow theory
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Elliott wave theory
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◦ Primary trend
◦ Secondary trends
◦ Minor trends
◦ A set of wave patterns
Moving averages
Relative strength approach
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Use earnings and dividend prospects of the
firm, expectations of future interest rates,
risk evaluation of the firm to determine
proper stock prices
Attempt to determine the present discounted
value of all payments a stockholder will
receive
Past earnings, balance sheets, further
detailed economic analysis (quality of
management, standing within its industry,
prospects for the industry)
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EMH implies most fundamental analysis is
doomed to failure.
Competition of uncovering information
◦ Many well-informed well-financed firms conducting
market research
◦ Difficult to uncover special information
◦ Only analysts with a unique insight will be rewarded
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Not to identify firms that are good, but to
find firms that are better than everyone else’s
estimate
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Competition among investors
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Active Management
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Passive Management
◦ Only serious analysis and uncommon techniques are
likely to generate the differential insight necessary to
yield trading profits
◦ Feasible economically only for managers of large
portfolios
 Security analysis
 Timing
◦ Aims only to establishing a well-diversified portfolio of
securities without attempting to find under-or-overvalued
 Buy and Hold
 Index Funds
 Broad diversification, low management fees
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if the market is efficient, what is the role of portfolio
management?
◦ Selection of a well-diversified portfolio
◦ Tax considerations
◦ Particular risk profile of an investor
Investors’ optimal positions will vary according to factors
such as age, tax bracket, risk aversion and employment, the
role of the portfolio managers in an efficient market is to
tailor the portfolio to these needs, rather than to beat the
market
10.3 EVENT STUDIES
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Event studies
◦ A technique of empirical financial research, assess
the impact of a particular event on a firm’s stock
price
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Assessing performance of professional
managers
Testing some trading rule
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Empirical financial research that enables an
observer to assess the impact of a particular event
on a firm’s stock price
Abnormal return due to the event is estimated as
the difference between the stock’s actual return
and a proxy for the stock’s return in the absence of
the event (benchmark return)
Benchmark return:
◦ broad market index
◦ the stocks matched according to criteria such as firm size,
beta, recent performance, ratio of P/B
◦ Normal returns using CAPM or multifactor model
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Market model to estimate abnormal returns
◦ Single-index Model approach
rt = at + btrMt + et
(Expected Return)
Excess Return = (Actual - Expected)
et = Actual - (at + btrMt)
◦ r is decomposed into market and firm-specific
factors, the firm-specific or abnormal return may be
interpreted as the unexpected return resulting from
the event
◦ et : (component due to the event) Abnormal
return, the return beyond what would be
predicted from market movements alone
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steps
◦ Estimate a and b using data of the prior period
◦ Record the information release date
◦ Abnormal returns surrounding the announcement
Statistical significance and magnitude of the typical abnormal return
assessed to determine the impact of the newly released information
Leakage of information
◦ Released to a small group of investors before official public
release
◦ Cumulative abnormal return
 Sum of all abnormal returns over the time period of interest, capture the
total firm-specific stock movement for an entire period when the
market might be responding to new information
Cumulate the excess returns over time (leakage of
information)
-t
0
+t
10.4 ARE MARKETS EFFICIENT
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Magnitude Issue
◦ Hard to measure the contribution of active research
◦ Actions of intelligent investment managers are the
driving force behind the evolution of prices to fair levels
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Selection Bias Issue
◦ The outcomes we observe have been preselected in favor
of failed attempts
◦ Cannot evaluate the true ability of portfolio managers
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Lucky Event Issue
Possible Model Misspecification
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Could speculators find trends in past prices that
would enable them to earn abnormal profits
◦ Test of the efficacy of technical analysis
◦ Discerning trends by measuring the serial
correlation of stock market returns
 Tendency for stock returns to be related to past
returns
 serial correlation: positive, negative
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Returns over short horizons (Empirical test)
◦ weak price trends over short periods (weekly returns), no
existence of trading opportunities
 Positive serial correlation over short horizons, small correlation
coefficients of weekly returns,
◦ Short-to-intermediate-horizon price momentum in both
the aggregate market and cross-sectionally (3-12 month )
 good or bad recent performance of particular stocks continues
over time
 Portfolios of the best-performing stocks in the recent past
appear to outperform other stocks with enough reliability to
offer profit opportunities
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Returns over long horizons (multiyear periods)–negative
long-term serial correlation in the aggregate market
◦ Fads hypothesis, the stock market might overreact to relevant news
 Overreaction leads to positive serial correlation over short time
horizons
 Subsequent correction leads to poor performance following
good performance
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Not conclusive evidence regarding efficient markets
◦ May be interpreted that the market risk premium varies
over time
◦ Rational response of market prices to changes in discount
rates
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Observable variables to predict market
returns
◦ Fama and French
 Aggregate returns are higher with higher
dividend/price ratios, dividend yield
◦ Campbell and Shiller
 Earnings yield can predict market returns
◦ Keim and Stambaugh
 Bond spreads can predict market returns
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Proxy for variation in the market risk
premium
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Whether publicly available information beyond
trading history of a security can be used to improve
investment performance to test sem-strong form
Market anomalies: findings in the market which are
difficult to reconcile with the EMH
Adjust for portfolio risk before evaluating the success
of an investment strategy
◦ P/E Effect: Portfolios of low price-earnings ratio stocks have
higher returns: higher risk, lower price, lower P/E; higher risk,
higher expected return
◦ Unless CAPM beta fully adjusts for risk, P/E will act as a useful
additional descriptor of risk, associated with abnormal returns
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Small Firm Effect (January Effect)
◦ Dividing the NYSE stocks into 10 portfolios each year
according to firm size.
◦ Average annual return are higher on the small-firm
portfolios
◦ Small-firms tend to be riskier, but adjusted for risk
using the CAPM, there is still a consistent premium for
the smaller-sized portfolios
◦ Invest in low-capitalization stocks, earn excess returns
◦ Small-firm-in-January effect
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Interpretation of the small-firm-in-january
effect
◦ Neglected Firm effect and liquidity effect
◦ Book-to-Market Ratios
◦ Post-Earnings Announcement Drift
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Neglected Firm effect and liquidity effect
◦ Small firms tend to be neglected by large institutional
traders, information about smaller firms is less available
◦ Arbel (1985), Divide firms into highly researched,
moderately researched, and neglected groups based on the
number of institutions holding the stock, january effect was
largest for the neglected firms
◦ Merton(1987), neglected firms might be expected to earn
higher equilibrium returns (maybe a type of risk premium)
◦ Amihud(1986), effect of liquidity on stock returns might be
a partial explanation of their abnormal returns. investors
demand return premium to invest in less-liquid stocks that
entail higher trading costs
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Book-to-Market Ratios
◦ A powerful predictor of returns, higher ratio higher
return
◦ Fama and French (1992), divide firms into 10
groups according to book-to-market ratios,
examine the average monthly return
◦ Dependence of returns on b/m ratio is independent
of beta, b/m ratio may serve as a proxy for a risk
factor that affect equilibrium expected return
◦ After control for size and book/market ratio, beta
seemed to have no power to explain average
security returns
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Post-Earnings Announcement Drift
◦ Ball and Brown (1968) , sluggish response of stock prices to firms’
earnings announcements
 News content of an earning announcement be evaluated, by comparing
the announcement of actual earnings to the value previously expected
by market participants. The difference is the earnings surprise.
◦ Rendleman. etc (1982), divide firms into 10 deciles based on the
size of the surprise, calculate CAR.
 Correlation between ranking by earnings surprise and CAR. There is a
large abnormal return on the earnings announcement day
 Market appears to adjust to the earnings information only gradually, a
sustained period of abnormal returns (concerning stock price movement
after the announcement date)
 CAR of positive surprise stocks continue to risk (momentum)
 negative surprise firms continue to suffer negative abnormal
returns
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The ability of insiders to trade profitability in
their own stock has been documented in
studies by Jaffe, Seyhun, Givoly, and Palmon
SEC requires all insiders to register their
trading activity
◦ Once publish the summary of the insider trades, the
trades become public information, if markets are
efficient, fully and immediately processing the
information, should no profit from following the
trades
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How to interpret the ever-growing anomalies
literature (P/E effect, small-firm, market-tobook, momentum, long-term reversal effects)
◦ Related phenomena
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Risk Premiums or market inefficiencies—
disagreement here
◦ Fama and French (1993)argue that these effects can be
explained as manifestations of risk premium ( higher betas,
higher returns), three-factor model
 Size or B/M ratios are not risk factors, but may act as
proxies for more fundamental determinants of risk, there
consistent with an efficient market in which expected
returns are consistent with risk
◦ Lakonishok etc (1995)argue that these effects are evidence
of inefficient markets, systematic errors in the forecast of
stock analysts
 Extrapolate past performance too far into the future,
overprice firms with recent good performance and
underprice firms with recent poor performance
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Anomalies or Data Mining
◦ Rerun the computer database of past returns over
and over and examine stock returns along enough
dimensions:
 Simple chance may cause some criteria to appear to
predict returns
◦ Some anomalies have not shown much staying
power after being reported in the academic
literature, such as small-firm effect, B/M
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EMH, in favor of capitalization-weighted
indexed portfolios that provide broad
diversification with minimal trading costs
Noisy market hypothesis
◦ Market prices may well contain pricing errors or
noise relative to the intrinsic value.
◦ Indexed portfolios invest in proportion to market
capitalization, weights will track the pricing errors,
with greater amounts invested in overpriced stocks
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Fundamental indexing
◦ Invests in proportion to intrinsic value would avoid
the problem
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Technical Analysis
◦ Short horizon
◦ Long horizon
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Fundamental Analysis
Anomalies Exist
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Small Firm Effect (January Effect)
Neglected Firm
Market to Book Ratios
Reversals
Post-Earnings Announcement Drift