Transcript TITLE HERE
Market Efficiency
What is an efficient market?
A market is efficient when it uses all available
information to price assets.
Information
is quickly incorporated into prices
Efficiency is the degree to which prices reflect
available information.
2
News, Surprises, and Returns
All news, and announcements contain anticipated
and unexpected components
Efficient markets have already incorporated
expectations into prices
Prices respond to surprises and changes in
expectations, which arrives randomly
Prices
follow a random walk
Price tomorrow = today’s price + random (+/-)
3
Price: Today and Tomorrow
Do you see a pattern
that you want to put
money on?
4
Reactions to Beating Expectations
5
Reaction to Not Meeting Expectations
6
Potential Causes of Efficient
Markets
Investor Rationality
Everyone
is rational → Everyone makes the right
decision
Independent Deviation from Rationality
No
one is rational → Everyone makes the wrong
decision but each makes a different wrong decision
Average out the wrongness
Arbitrage
Only
some people are rational → Smart money takes
7
from less smart money
Types of Efficient Markets
Strong
Semi-Strong
Weak
8
Weak Form Efficiency
Prices reflect all information contained in past
prices and volumes
No
investor is able to form a trading strategy based
on historic prices and volumes and earn an excess
return
9
Disbelievers
Chartists, or Technical Analysts
Analyze
Chartist believe in identifiable and predictable
patterns in these characteristics
Make
“charts” of a stock‘s Price and/or Volume
investment decisions based on these patterns
Brokerage firms tend to love chartists
10
Head and Shoulders
11
Stock Price
Why Technical Analysis Fails
-If there is a profitable
pattern, everyone would do
it
Sell
Sell
Buy
Buy
Time
-If everyone follows the
same strategy competition
will eliminate any
opportunity associated with
the pattern
Semi-Strong Form Efficiency
Security prices reflect all publicly available
information.
Encompasses
weak form efficiency
Publicly available information includes:
Historical price
Published
and volume information
accounting statements
Information
found in the WSJ
13
Disbelievers
Fundamental Analysts
Use
revenues, earnings, future growth forecasts,
return on equity, profit margins, and other data to
determine a company's underlying value and
potential for future growth (Financial Statements)
These guys make more sense than technical
analysts. Why?
14
Strong Form Efficiency
Strong form efficiency says that anything
pertinent to the stock price and known to at
least one investor is already incorporated in the
security’s price.
Public
& Private
Implies:
Insider trading will not earn excess return
Strong form efficiency incorporates weak and
semi-strong form efficiency.
15
Disbelievers
Pretty much everyone
Insiders trading is generally profitable
Galleon
Raj Rajaratnam
Martha
Stewart
16
What EMH Does and Does NOT Say
Investors can throw darts to select stocks.
Kind
of: We still need to consider risk
Prices are random or uncaused.
Prices
reflect information.
Price CHANGES are driven by new information,
which by definition is random
17
Implications of Efficient Markets
Purchase or sale of any security can never be a
positive NPV transaction.
Trust market prices
Stocks with similar risk are substitutes
Mutual fund managers cannot systematically
outperform the market
18
The Evidence
The record on the EMH is extensive,
and generally supportive of the market
being semi-strong form efficient
19
Event Studies
Event
Studies examine returns around
information release dates
EX:
Earnings, Dividend announcements
A test of semi-strong form efficiency
Look
at how quickly prices adjust to the
information
Looking
for under-reaction, over-reaction, early
reaction, or delayed reaction around the event.
20
Event Study Results
The studies generally support the view that the
market is semi-strong form efficient.
Studies suggest that markets may even have
some foresight into the future, i.e., news tends
to leak out in advance of public
announcements.
21
Cumulative abnormal returns
(%)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
1
0.146 0.108
-8
-6
0.032
-4
-0.72
0
-0.244
-2 -0.483 0
-1
2
-2
-3
-3.619
-4
-5
4
6
8
Efficient market
response to “bad news”
-4.563-4.747-4.685-4.49
-4.898
-5.015
-5.183
-5.411
-6
Days relative to announcement of dividend omission
22
The Record of Mutual Funds
If the market is semi-strong form efficient,
then mutual fund managers, should not be able
to consistently beat the average market return
When we compare the record of mutual fund
performance to a market index, we see that
mutual funds are not able to
CONSISTENTLY beat the market.
Consistent
with the market being semi-strong form
efficient
23
Mutual Fund Performance
All funds
Smallcompany
growth
Otheraggressive
growth
-2.13%
Growth
Income
-0.39%
-2.17%
Growth and
Maximum
income
capital gains
Sector
-1.06%
-0.51%
-2.29%
-5.41%
-8.45%
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and
Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
24
Insider trading
Strong
form market efficiency implies
that even insiders trading on private
information cannot earn excess return
A number of studies find that insiders are
able to earn abnormal profits
Violation
of Strong form efficiency
25
Verdict on Market Efficiency
Market is pretty efficient
Opportunities for easy profits are rare.
Financial managers should assume, at least as
a starting point, that security prices are fair and
that it is difficult to outguess the market.
New information is rapidly incorporated into
the prices.
26
EMH Exercises
Indicate whether or not the EMH is contradicted,
if so which form of EMH is contradicted
An
investor consistently earn an abnormal return over
that expected by the market by examining charts of
historical prices
The acquisition of the latest annual report of a company
enables an investor to earn an abnormal return.
A stock which has been fluctuating between $25 and
$27 in the last three months suddenly rises to $40 per
share right after management announces a new project
that has a promising impact on the firm's expected
future cash inflows.
By subscribing to the Value Line Investment Survey, an
investor can earn at least 5% over that earned by the
market on comparable risk investments.
27
Why We Care
Offering several points of view on how the
market works, and the evidence for and against
Using
this you can form your own opinion about
how the market works and invest accordingly
28