Transcript No Slide Title

Chapter 8
The Efficient
Market
Hypothesis
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 ____________
reflect the cash flows associated with the
_______________________
security?
greater fool theory
 Gold and the _______________________.
 Huge implications concerning the answers to
these questions.
8-2
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
8-3
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.
8-4
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.
8-5
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)
8-6
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
(submartingale process)
Random Walk with Positive Trend
Idea that stock prices follow a “Random
Walk” or Market is Efficient
8-7
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.”
8-8
Forms of the EMH
– 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.
8-9
Forms of the EMH
– 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.
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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 +
However
8-11
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.
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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
________________.
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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
8-14
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.
8-15
8.3 Are Markets Efficient?
8-16
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.
8-17
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 ______________.
8-18
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!
8-19
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.
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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
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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?
8-22
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)
8-23
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.
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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.
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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
8-26
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)
–
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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
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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.
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Problem 1
• Zero, otherwise returns from the prior
period could be used to predict returns in
the subsequent period.
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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.
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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.
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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.
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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.
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Problem 7
a.
Consistent, expect about half to outperform the market by
chance
b. Violation, earn + AR by investing with last year’s winners
• Probably consistent, but it depends. I might be able to use an
option strategy to take advantage of this.
• Violation, you have exploitable price momentum persisting into
February
• Violation, the reversal offers an exploitable opportunity, namely buy
last week’s losers
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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?
8-36
Problem 9
The market expected earnings to increase
by more than they actually did.
8-37