Transcript No Slide Title

Chapter 8
The Efficient
Market
Hypothesis
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
8.1 Random Walks and the
Efficient Market
Hypothesis
8-2
Efficient Market Hypothesis (EMH)
• Do security prices accurately reflect information?
– Informational Efficiency
price changes consistently predictable?
 Are
_____________________________________
– Allocational Efficiency
accurately
 Are prices correct in that they ____________
________________________
associated with the
reflect
the cash flows
security?
greater fool theory
 Gold and the _______________________.
 Huge implications concerning the answers to
these questions.
8-3
Implications of Efficiency
• Allocational efficiency
– If markets are not allocationally efficient then
perhaps there is a ________________________
role for greater government
intervention in capital markets.
___________
• Possible rules changes to attempt to improve
allocational efficiency
– Tax on trading activity
– More taxes on short holding period returns
– Changes in corporate compensation
• Direct government involvement in capital
allocation: Industrial Policy
8-4
Implications of Efficiency
• Informational efficiency
– If markets are not informationally efficient
•
–
Investors may not be able to trust that market
prices are up to date and investors should
then conduct their own research (or hire a
researcher) to validate the price.
Privileged groups of investors will be able to
–
consistently take advantage of the general
public.
Active strategies should outperform passive
strategies.
8-5
Implications of Efficiency
• Informational efficiency
– If markets are not informationally efficient
Corporations have to rethink their goals and
•
how best to achieve them.
Maximize shareholder wealth  maximize
–
share price, so how does one go about
maximizing shareholder wealth in this case?
Lack a benchmark to evaluate corporate
–
decisions.
8-6
EMH and Competition
•
•
•
Competition among investors should imply that stock
prices fully and accurately reflect publicly available
information very quickly. Why?
Else there are unexploited profit opportunities.
Once information becomes available, market
participants quickly analyze it & trade on it & frequent,
low cost trading assures prices reflect information.
Questions arise about efficiency due to:
• Unequal access to information
• Structural market problems
• Psychology of investors (Behavioralism)
8-7
Random Price Changes
• Why are price changes random?
–
–
–
In very competitive markets prices should react to
only NEW information
Flow of NEW information is random
Therefore, price changes are random
Idea that stock prices follow a “Random
Walk”
8-8
Random Walk and the EMH
• Random Walk: stock price changes
______________________
are unpredictable
A “pure” random walk implies informational efficiency
process
• Stock prices actually follow a submartingale
____________________
• Expected price change is positive over time
• But random changes are superimposed on the
positive trend
t = time period
• E(pricej,t) > E(pricej,t-1)
8-9
Random Walk with Positive Trend
Security
Prices
Evidence on Random
Walk idea later.
Time
8-10
Forms of the EMH
• Prices reflect all relevant information
information set
• Vary the ________________
– Weak
The relevant information is historical prices and
other trading data such as trading volume.
If the markets are weak form efficient, use of
such information provides no benefit “at the
margin.”
8-11
Forms of the EMH
• Prices reflect all relevant information
• Vary the information set:
– Semi-strong
The relevant information is "all publicly available
information, including past price and volume
data."
If the markets are semi-strong form efficient,
then studying past price and volume data &
studying earnings and growth forecasts
provides no net benefit in predicting price
changes at the margin.
8-12
Forms of the EMH
• Prices reflect all relevant information
• Vary the information set:
– Strong
The relevant information is “all information”
both public and private or “inside” information.
If the markets are strong form efficient, use of
any information (public or private) provides no
benefit at the margin.
SEC Rule 10b-5 limits trading by corporate
insiders, (officers, directors and major
shareholders). Inside trading must be reported.
8-13
Relationships between forms
of the EMH
efficiency implies weak
• Notice that semi-strong
_______________________________
form efficiency holds (but ________________)
NOT vice versa
__________________
• Strong form efficiency would imply that
both semi-strong and weak form efficiency hold
__________________________________________.
8-14
8.2 Implications of the EMH
(for Security Analysis)
8-15
Types of Stock Analysis &
Relationship to the EMH
• Technical Analysis:
Technical Analysis or TA is using prices and volume
information to predict future price changes
TA assumes prices follow predictable trends
– If the markets are weak form efficient or semistrong form efficient or strong form efficient will
technical analysis be able to consistently predict
price changes?
NO
8-16
Basic Types of Technical
Analysis
Identifying common price patterns
One of these patterns is real and one of these is
computer simulated with random price
changes. Can you tell which is which?
Point? • Less than meets the eye
• Data mining
8-17
Basic Types of Technical Analysis
Support and resistance levels
• Support level:
– A price level below which it is supposedly
unlikely for a stock or stock index to fall.
• Resistance level:
– A price level above which it is supposedly
unlikely for a stock or stock index to rise.
A resistance level may arise at say $31.25 if a stock repeatedly rises
to $31.25 and then declines, indicating that investors are reluctant to
pay more than this price for the stock.
A stock price above $31.25 would then indicate a 'breakout' which
would be a bullish signal.
8-18
Types of Stock Analysis &
Relationship to the EMH
• Fundamental Analysis:
using economic and accounting information to
predict stock price changes
– If the markets are weak form efficient or semistrong form efficient or strong form efficient will
fundamental analysis be able to consistently
predict price changes?
If the markets are only weak form efficient?
Fundamental Analysis CAN predict price changes
If the markets are semi-strong or strong form efficient?
Fundamental Analysis CANNOT predict price changes
8-19
Fundamental Analysis
• Fundamental analysis assumes that stock prices
should be equal to
the discounted value of the expected future cash
flows the stock is expected to provide to investors.
• Fundamental analysis is thus the
“art” of identifying over- and undervalued securities
based on an analysis of the firm's financial
statements and future prospects.
8-20
Fundamental Analysis
• Fundamental analysis varies in technique but
generally focuses on
forecasting the firm's future dividends or earnings,
discounting those future cash flows by the required
rate of return (usually obtained from the CAPM),
and comparing the resulting estimated price with the
current stock price.
8-21
Fundamental Analysis
• If the estimated price is greater
______ than the current
price an investor should buy
___ the stock since it is
undervalued
increase to
___________ and since its price should ________
the "true" or "fundamental" value uncovered by the
analyst.
• If the estimated price is less
____ than the current price
the stock should be sold
____ because the stock is
overvalued by the market.
currently __________
• In either case if the analyst is correct the investor
return”
should receive an“abnormal
________________.
8-22
Fundamental Analysis
• Forecasts already exist and for FA to add
value, your forecast must be better than
the consensus forecast.
• Not enough to find a good company, you
must find a company that is better than
others believe, i.e., mispriced.
8-23
Implications of Efficiency for
Active or Passive Management
• Active Management
– Security analysis
– Timing strategies
– Investment Newsletters
• Passive Management
– Buy and Hold portfolios
– Index Funds
Assumes inefficiency,
use technical and/or
fundamental analysis
to pick securities
Consistent with semistrong efficiency
8-24
Market Efficiency and
Portfolio Management
Even if the market is efficient a role exists for
portfolio management
Identify risk & choose appropriate risk level
–
Tax considerations
–
Other considerations such as liquidity needs or
–
diversify away from the client’s industry.
8-25
8.3 Are Markets Efficient?
8-26
Empirical Tests of
Informational Efficiency
• Recall that over time stock prices tend to follow a
submartingale process
____________________
• This has nothing to do with efficiency, per se. It
does however have serious implications for
tests of efficiency
________________.
randomly chosen
• In words this says that a _________________
portfolio of stocks can be expected to have a
______________________________________
positive return
_____________.
8-27
Empirical Tests of
Informational Efficiency
• In practice this means that when trying to figure out
if some portfolio manager is earning abnormal
compare their performance to a
returns we must ____________________________
randomly chosen portfolio
_______________________.
the random portfolio or
• I.E. they must outperform
____________________________,
some benchmark rate
in practice they must beat ____________________
of return
________.
8-28
Empirical Tests of
Informational Efficiency
a.
Can anyone consistently earn an abnormal return?
b.
Do investors systematically misinterpret
information?
This says that investors do not repeat the same
mistakes over and over in an irrational fashion.
For example, sometimes they may overestimate the impact
on earnings of some event and sometimes they
underestimate the impact on earnings but on average the
estimates are unbiased.
8-29
Empirical Tests of Inform. Efficiency
• Event studies
Examine how quickly information is integrated into
prices around an informational event.
EMH suggests rapid assimilation of information into prices.
• Assessing performance of professional managers
Can professional managers, using their resources
and tools, “beat” the market after considering risk?
EMH suggests professionals will not outperform the market.
• Testing a trading rule
Testing whether a rule that uses available
information can earn abnormal returns after
considering the risk and cost of using the rule.
EMH suggests that such rules will not work.
8-30
How Tests Are Structured
1. Examine prices and returns around some
material announcement
8-31
Individual Abnormal Returns Surrounding
the Event in an Efficient
_______________
Market
= abnormal
return
-t
0
+t
Announcement Date
Earnings above forecast for example
8-32
Individual Abnormal Returns Surrounding
the Event in an _______________
Inefficient Market
= abnormal
return
-t
0
+t
Announcement Date
Earnings above forecast for example
8-33
How Tests Are Structured
(cont.)
2. How do we determine if the returns are abnormal?
Market Model approach
a. rt = a + b(rindex,t) + et
Estimate a and b coefficients
b. Abnormal Return or AR = (Actual - Expected)
ARt = et = Actual return – [a + b(rindex,t)]
8-34
How Tests Are Structured
(cont.)
2. continued:
c. Cumulate the abnormal returns over time:
Add up the ARs over time
-t
0
+t
In this case there appears to be information leakage
before the announcement date (day 0), but markets
adjust quickly to new information.
8-35
Cumulative Abnormal Returns before
Takeover Attempts: Target Companies
In this case there appears to be information leakage before the announcement date
(day 0), but markets adjust quickly.
Keown &
Pinkerton
8-36
Stock Price Reaction to CNBC
Midday Reports
Patell &
Wolfson
8-37
Issues in Examining the Results
• Magnitude Issue
small changes in performance
Even __________________________
___ may be
worthwhile for managers of large investments.
Eg. $5 billion dollar portfolio. Use research to
improve results by 1/10 of a percent per year
= $5 million in value.
small changes in performance
The problem is that these __________________________
virtually impossible to measure since the
would be _________________
is 20% or more
standard deviation of many portfolios ______________.
8-38
Issues in Examining the Results
• Selection Bias Issue
“I have this foolproof new trading scheme that
will make me millions. I want to tell everyone
about it.”
We only learn about the schemes that don’t really
work, or only worked in the past.
• Lucky Event Issue
If 10,000 people flip fair coins 50 times we can
expect 2 people to flip 75% or more heads.
In a large group of stock analysts, some will be correct
most of the time in their picks, and they will look very
smart even though their results are due to pure chance!
8-39
Issues in Examining the Results
• Possible Model Misspecification
Results have to be adjusted for the risk of the
•
given stock or strategy.
•
This means that tests of efficiency are necessarily
joint tests of the model used to measure risk and
market efficiency.
–
Results counter to efficiency may just be saying
researchers aren’t using the right model to
measure risk and hence the expected return.
8-40
Counter Evidence: Some Apparent
Predictors of Broad Market Returns
• Fama and French
Aggregate returns tend to be higher for firms with
–
higher dividend yields
• Campbell and Shiller
Aggregate returns tend to be higher for firms with
–
higher earnings yields
• Keim and Stambaugh
Changes in bond credit spreads can predict
–
market returns
Each of these may also be consistent with
changing risk premiums and may have nothing
to say about market efficiency.
8-41
Average Annual Returns for 10 size-based
portfolios, 1926-2007
• Results are driven
by returns in the
first two weeks of
January
• May be related to
higher ESTIMATION
risk of smaller firms
• Extra return may be
more apparent than
real due to higher
trading costs and
illiquidity
8-42
Average Returns as a Function of the Book-To
Market Ratio, 1926 to 2007
• Value Stock
premium return
• Distressed and out
of favor stocks?
8-43
Cumulative Abnormal Returns in
Response to Earnings Announcements
Short term
momentum
effect that
is counter
to
efficiency.
Rendleman,
Jones & Latane
8-44
Bubbles and Market Efficiency
Periodically stock prices appear to undergo a
‘speculative bubble.’
A speculative bubble is said to occur if prices do not
equal the intrinsic value of the security.
Does this imply that markets are not efficient?
– Very difficult to predict if you are in a bubble and
when the bubble will burst.
– Stock prices are estimates of future economic
performance of the firm and these estimates can
change rapidly.
– Risk premiums can change rapidly and
8-45
dramatically.
Bubbles and Market Efficiency
With hindsight there appear to be times when stock
prices decouple from intrinsic or fundamental value,
sometimes for years.
• Prices eventually conform to intrinsic value.
• Brings into question the allocational efficiency of the
markets more than the informational efficiency.
• What capital allocation mechanism is likely to
perform better than the market based system?
8-46
8.4 Mutual Fund and
Analyst Performance
8-47
Estimates of Individual Mutual
Fund Alphas, 1972 - 1991
Mutual fund returns versus
the S&P500 index; Mean
alpha = 0
8-49
Performance of Mutual Funds
Based on a Four Factor Model
8-50
Persistence of Mutual Fund
Performance
8-51
Mutual Fund and Professional
Manager Performance
• Superstar phenomenon
John Templeton
(Templeton Funds)
Warren Buffet
(Berkshire Hathaway)
Peter Lynch
(Fidelity Magellan)
Bill Miller
(Legg Mason)
Jon Neff
(Vanguard’s Windsor Fund)
8-52
Summary: What Does the Evidence
Show?
• Technical Analysis (TA)
Stocks do not follow a pure random walk, so there
is hope for technical trading strategies.
Most TA rules utilize short term trading strategies
that generate excessive transaction costs and are
not profitable.
There appears to be some long term trend
reversals.
8-53
Summary: What Does the Evidence
Show?
• Fundamental Analysis
Appears to be difficult to consistently generate
abnormal returns using fundamental analysis.
This is because the analysis/investment industry is so
competitive and volatility is high.
May help you avoid seriously overvalued
investments.
8-54
Summary: What Does the Evidence
Show?
• Fundamental Analysis
The Conundrum:
Without fundamental analysis the markets would
surely be inefficient, &
Abnormal profit opportunities would exist,
Leading to profitable fundamental analysis
Grossman & Stiglitz
AER, 1980
8-55
Summary: What Does the Evidence
Show?
• Anomalies Exist
Small Firm in January Effect
–
Book to Market Ratios
–
Long Term Reversals
–
Post-Earnings Announcement Drift (Momentum)
–
8-56
Behavioralism bias
• Motivation
Stock prices in the 1990s did not appear to
match “fundamentals,”
e.g., high price earnings ratios
Evidence of refusal to sell losers
Economics discipline is exploring behavioral
aspects of decision making
8-57
What does it all mean?
• Technical Analysis:
It may be an item in your toolkit
but be careful relying on it too
much.
• Your choices
–
Pick stocks yourself, based on fundamental
analysis, but diversify
• Beat and/or avoid the competition.
–
Pick one or more mutual funds
Unlikely to consistently earn + abnormal returns
•
Pros paying attention to market and firm conditions
•
–
Index or otherwise passively diversify.
8-58
Selected Problems
8-59
Problem 1
• Zero, otherwise returns from the prior
period could be used to predict returns in
the subsequent period.
8-60
Problem 2
• No. Why?
• One would have to show that Intel
investors earned a higher rate of return
than they should have for the risk taken.
– Many investors bought Intel only after its
success was evident.
– By chance some stocks will perform extremely
well.
8-61
Problem 3
• No, Why?
• It does not indicate investors are failing to
consider current information in the price,
nor does it present an abnormal return
opportunity.
• It could indicate information leakage or it
could indicate that splits occur during price
runups.
8-62
Problem 4
• No, Why?
• You won’t get + abnormal returns if the
economic cycle is predictable, the news
will already be incorporated in the stock’s
price.
8-63
Problem 5
• Buy it
• This is a “Value Investment” where you
believe the stock will perform better than
the market and if you are correct you will
earn a positive abnormal return.
8-64
Problem 6
a. The small firm in January effect
b. Might work, but it might not
i. Doesn’t hold every year
ii. Would lead to “underdiversification”
iii. Higher trading costs of these stocks might wipe
out any gains
iv. Since there is no solid theoretical reasoning for
this the ‘extra return’ might just be a risk
premium.
8-65
Problem 7
a. Consistent, expect about half to outperform the
market by chance
b. Violation, earn + AR by investing with last
year’s winners
c. Probably consistent, but it depends. I might be
able to use an option strategy to take
advantage of this.
8-66
Problem 7
d.
e.
Violation, you have exploitable price
momentum persisting into February
Violation, the reversal offers an exploitable
opportunity, namely buy last week’s losers
8-67
Problem 8
i. Implicit in the dollar-cost averaging strategy is the
notion that stock prices fluctuate around a “normal”
level. Otherwise, there is no meaning to
statements such as: “when the price is high.”
ii. How do we know, for example, whether a price of
$25 today will be viewed as high or low compared
to the stock price six months from now?
8-68
Problem 9
The market expected earnings to increase
by more than they actually did.
8-69
Problem 10
a. – The prices of growth stocks may be consistently bid too high due to
investor overconfidence.
– Investors/analysts may extrapolate recent earnings (and dividend)
growth too far into the future and thereby inflate stock prices, forcing
poor returns eventually on growth portfolios.
– At any given time, historically high growth firms may revert to lower
growth and value stocks may revert to higher growth, changing return
patterns, this may happen over an extended time horizon.
8-70
Problem 10
b. Enough investors should prefer value stocks to growth
stocks and bid up the prices of value stocks and drive
down the prices of growth stocks until the “extra” return
on the value stocks was eliminated.
8-71