Are Markets Rational?Are Markets Rational?

Part 1Part 1

References References

• Reilly & Brown, Ch. 7 – “Efficient Capital Markets”• Haugen, Ch. 15 – “The Wrong 20-Yard Line”• Mauboussin (www.capatcolumbia.com) – “Shift

Happens”• Hagstrom, Ch. 8 – “The Market as a Complex

Adaptive System”• Rubinstein (Financial Analysts Journal, 2001) –

“Rational Markets: Yes or No? The Affirmative Case”• Fortune (3 Dec. 2002) – “Is the Market Rational?”

Forms Of EMTForms Of EMT• Weak Form

– Prices reflect all historical information– Price changes follow a random walk– “Tests of Return Predictability”– Technical Analysis

• Semi-Strong Form– Prices reflect all public information– “Event Studies”– Fundamental Analysis

• Strong Form– Prices reflect all public and private information– “Tests for Private Information”– Insider Trading

Weak Form EMHWeak Form EMH

• Supported by:– Studies on Autocorrelation– Tests of Filter Rules

• Contradicted by:– Seasonality

• January Effect

• Day-of-the-Week Effect

– Long-term overreaction/reversal patterns

Semi-Strong Form EMHSemi-Strong Form EMH

• Supported by: – Most Event Studies

• Contradicted by:– Various Accounting Anomalies

• Size Effect

• M/B Effect

– Neglected Firm Effect

Summary on Summary on Semi-Strong Form EMHSemi-Strong Form EMH

• Market seems to do a relatively good job at adjusting a stock’s valuation for certain types of new information• Determining how much the new info. will change the stock’s

value and then adjusting the price by an equivalent amountThis is what event studies examine

• But it seems to have problems developing an overall valuation for a stock in the first place • E.g., What is the correct value for IBM as a whole is a very

difficult question to answer, but how much IBM’s value should change if it is awarded a specific new contract is much easier to determine

Strong Form EMHStrong Form EMH

• Supported by: – Under-performance of most fund managers

• Most are beaten by the market averages

• Contradicted by:– Returns following insider purchases

– Value Line effect

– Consistent outperformance of some fund managers • Notably, Warren Buffett and the “Superinvestors of Graham-

and-Doddsville”

Fund ManagersFund Managers

• Trained professionals, working full time at investment management

• If any investor can achieve above-average returns, it should be this group

• If any non-insider can obtain inside information, it would be this group, due to the extensive management interviews that they conduct

• But, Peter Lynch criticism:– “have blinders on”

• Also …

Fund ManagersFund Managers

• Quote from “Wall Street:”– “Do you want to know why fund managers can’t beat

the S&P 500? Because fund managers are sheep … and sheep get slaughtered.”

• Problems Fund Managers Face:– Administrative expenses and trading costs

– Agency problems that contribute to poor performance

– Compensation structure that encourages “sheep-like” behavior

Tests and Results of EMHTests and Results of EMH

• Many results tend to support EMH– Event studies– Performance of most fund managers

• But many other results tend to contradict EMH– Performance of Buffett– Numerous anomalies & long-run overreaction/reversals

• So, are markets efficient (or rational) or not?– Need to examine whether markets can be beaten, after

adjusting for risk– But, how should you model and measure risk? CAPM? APT?

Tests and Results of EMHTests and Results of EMH

• Tests face a joint hypothesis problem – Results are dependent on both of two factors: – Market efficiency

• Is the stock’s price equal to its true value?

– Asset pricing model used (CAPM, APT, etc.)• What is the stock’s true value?

• So, are the markets efficient or rational?– Ultimately, can never answer definitively– Mauboussin’s view (“Shift Happens”): stock market as a

chaotic or complex adaptive system– Haugen’s view follows …

Haugen’s TrilogyHaugen’s Trilogy

““The New Finance”The New Finance”““Beast on Wall Street”Beast on Wall Street”““The Inefficient Stock Market”The Inefficient Stock Market”

““The New Finance”The New Finance”

• Focuses on the market’s major systematic error:– Fails to appreciate the strength of competitive forces in a market

economy– Over-estimates the length of the “short run”– Over-reacts to records of success and failure for individual

companies– Drives the prices of successful companies too high– Drives the prices of unsuccessful companies too low

• So:– Successful firms tend to experience negative earnings surprises

down the road– Unsuccessful firms tend to benefit from positive earnings surprises

Changing Investor Opinion as to the Changing Investor Opinion as to the Length of the Short RunLength of the Short Run

• Prior to 1924 Prior to 1924 - Stock valuation based on Stock valuation based on current normalizedcurrent normalized earnings. earnings.

• 19251925- E. L. Smith advises stock valuation based on future growth - E. L. Smith advises stock valuation based on future growth -

New Era Theory.New Era Theory.- Growth stocks start to take off, followed by Crash of ’29Growth stocks start to take off, followed by Crash of ’29- Leads to development of Graham & Dodd approachLeads to development of Graham & Dodd approach

• 19341934- Graham and Dodd dispute New Era Theory’s views on growth Graham and Dodd dispute New Era Theory’s views on growth

and valuation.and valuation.- Lessons learned until Go-go years of ’60’sLessons learned until Go-go years of ’60’s

• 1960’s1960’s- Growth stock investing makes comeback.Growth stock investing makes comeback.

But …But …

• Successful growth stock investing requires some Successful growth stock investing requires some degree of persistence in earnings growth,degree of persistence in earnings growth,

• while the speed of mean-reversion in earnings while the speed of mean-reversion in earnings growth appears to be quite fast.growth appears to be quite fast.

• If, in general, it is faster than the market expects, If, in general, it is faster than the market expects, cheap (expensive) stocks should tend to grow cheap (expensive) stocks should tend to grow faster (slower) than expected.faster (slower) than expected.

• If this happens, cheap stocks should tend to out-If this happens, cheap stocks should tend to out-perform expensive stocks.perform expensive stocks.

The Relative Performance of Portfolios Equally-The Relative Performance of Portfolios Equally-weighted in the Cheap and Expensive Quartilesweighted in the Cheap and Expensive Quartiles

• The difference in cumulative return of value stocks relative to growth stocks is measured over rolling 5-year periods.

• The relative performance appears to cycle over time.

• Cheap (value) stocks out-perform more often than not.

Rolling Annualized Average 5-year Difference Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites Between the Returns to Value and Growth Composites

-20%-20%

-10%-10%

0%0%

10%10%

20%20%

30%30%

40%40%

50%50%

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Seasonal Returns to Value and Growth Portfolios Seasonal Returns to Value and Growth Portfolios

11 22 33 44 55 66 77 88 99 1010 1111 1212 1313 1414 1515 1616 1717 1818 1919 2020

0%0%

2%2%

4%4%

6%6%

8%8%

10%10%

12%12%

14%14%

AverageAverage Monthly Monthly

ReturnReturn

Rank based on Previous 5-year Return

Rank based on Previous 5-year Return

Feb. - Dec.Feb. - Dec.

JanuaryJanuaryPrior LosersPrior Losers

Prior Winners

Prior Winners

What has Over-estimation of the Length of the Short Run What has Over-estimation of the Length of the Short Run Done to Risk and Return?Done to Risk and Return?

• Cheap (expensive) stocks tend to have surprisingly Cheap (expensive) stocks tend to have surprisingly high (low) realized returnshigh (low) realized returns

• Cheap (expensive) stocks tend to have low (high) Cheap (expensive) stocks tend to have low (high) volatility, because little (much) is expected of themvolatility, because little (much) is expected of them

• Investors may Investors may expectexpect higher returns from expensive higher returns from expensive stocks but they may be repeatedly stocks but they may be repeatedly surprisedsurprised by by disappointing earnings reportsdisappointing earnings reports

• Thus, the relationship between risk and return Thus, the relationship between risk and return appears to be upside-downappears to be upside-down

How Long Have Risk and Return Been Up-How Long Have Risk and Return Been Up-side Down?side Down?

• If it’s caused by an over-estimation of the If it’s caused by an over-estimation of the short run, it should begin with the short run, it should begin with the renaissance of growth stock investing at renaissance of growth stock investing at the end of the 1950’s.the end of the 1950’s.

• What has been the relative performance What has been the relative performance between the low-volatility stock portfolio between the low-volatility stock portfolio and the market index over time?and the market index over time?

Cumulative Difference in Return Between Cumulative Difference in Return Between Low Volatility Portfolio and S&P 500 Low Volatility Portfolio and S&P 500

19281928 19381938 19481948 19581958 19681968 19781978 19881988

-35%-35%

-25%-25%

-15%-15%

-5%-5%

5%5%

15%15%

25%25%

Cumulative Cumulative DifferenceDifference

The Relationship Between the Perceived and True Growth Horizon The Relationship Between the Perceived and True Growth Horizon and Average Growth Ratesand Average Growth Rates

• Define the growth horizon (or growth Define the growth horizon (or growth duration, see Ch. 20) as the length of time a duration, see Ch. 20) as the length of time a typical stock takes to mean-revert to the typical stock takes to mean-revert to the average rate of earnings growth.average rate of earnings growth.

• The evidence indicates that the The evidence indicates that the perceivedperceived horizon is longer than the horizon is longer than the truetrue horizon. horizon.

The Relationship Between the Perceived and True Growth Horizon The Relationship Between the Perceived and True Growth Horizon and Average Growth Ratesand Average Growth Rates

• The true horizon tends to be relatively The true horizon tends to be relatively constant, but investor constant, but investor perceptionsperceptions may may change.change.

• If investors perceive that relative If investors perceive that relative differences in growth will persist for longer differences in growth will persist for longer periods, growth stocks may out-perform.periods, growth stocks may out-perform.

• Changes in the Changes in the perceivedperceived horizon may horizon may create a cycle in growth/value performance.create a cycle in growth/value performance.

Rolling Annualized Average 5-year Difference Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites Between the Returns to Value and Growth Composites

-20%-20%

-10%-10%

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““Beast on Wall Street”Beast on Wall Street”

22ndnd book in trilogy book in trilogyFocuses on stock volatilityFocuses on stock volatilityThree components of volatilityThree components of volatility

Three Components of Stock VolatilityThree Components of Stock Volatility

Event-driven volatilityEvent-driven volatilityError-driven volatilityError-driven volatilityPrice-driven volatilityPrice-driven volatility

High-wire Act at the Financial CircusHigh-wire Act at the Financial Circus

The wireThe wire The economyThe economy

The aerialistsThe aerialists Different stocksDifferent stocks

Movements inMovements in Movements in Movements in balance barsbalance bars stock pricesstock prices

Components of the Movements Components of the Movements in the Balance Barsin the Balance Bars

Event-drivenEvent-driven

The best moves in the bars humanly possibleThe best moves in the bars humanly possible

Error-drivenError-driven

Over- and under-reactions to shocks in the wireOver- and under-reactions to shocks in the wire

Price-drivenPrice-driven

Aerialists interacting with each other Aerialists interacting with each other

The Types of Volatility ContrastedThe Types of Volatility Contrasted

• Event-driven and error-driven volatility are caused by investors [over]reacting to specific information that could be expected to affect stock values

• Price-driven volatility, on the other hand, works in the opposite direction – it is caused by investors reacting to what is happening in the stock market itself– i.e., there is a reassessment of stock valuations solely as a

consequence of changes in stock prices …

– rather than stock prices changing as a consequence of changes in stock valuations that are being driven by outside information

• This is similar to Keynes’ and Graham’s views

• “We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be.” – Keynes

• “For stock speculation is largely a matter of A trying to decide what B, C, and D are likely to think – with B, C, and D trying to do the same.” – Graham and Dodd

SynthesisSynthesis

The results of many old studies, The results of many old studies, when considered together, point when considered together, point

to startling new conclusions.to startling new conclusions.

ContentionsContentions

Price-driven volatility is the largest of the three components.Price-driven volatility is the largest of the three components. Price-driven volatility is explosive.Price-driven volatility is explosive. Price-driven volatility is an important drag on long-run economic Price-driven volatility is an important drag on long-run economic

growth.growth. Explosions in Price-driven volatility create disruptions in economic Explosions in Price-driven volatility create disruptions in economic

activity.activity.

For example. the Great Crash of 1929 helped cause the Great For example. the Great Crash of 1929 helped cause the Great

Depression.Depression.

Mysteries of the Stock MarketMysteries of the Stock Market

Too much stock volatility Too much stock volatility (Shiller, (Shiller, American Economic Review, 1981)American Economic Review, 1981)

Market Price and Perfect Forecast Price: Constant Discount RatesMarket Price and Perfect Forecast Price: Constant Discount Rates

19001900 19101910 19201920 19301930 19401940 19501950 19601960 19701970 19801980 19901990

YearYear

66

1010

1414

1818

2222

2626

3030

3434

P/E

P/E

30

PPt t / E/ Ett3030

PFPFt t / E/ Ett3030

Mysteries of the Stock MarketMysteries of the Stock Market

Too much stock volatilityToo much stock volatility

Volatility too unstable Volatility too unstable (Haugen, Talmor, and Torous, (Haugen, Talmor, and Torous, Journal Journal of Financeof Finance, 1991), 1991)

Volatility Shifts Over 8-week Trading PeriodsVolatility Shifts Over 8-week Trading Periods

HTT find (with 99% confidence) 402 cases where HTT find (with 99% confidence) 402 cases where volatility becomes significantly larger or smaller volatility becomes significantly larger or smaller between the first and second 4-week blocks.between the first and second 4-week blocks.

Realization of Risk Premiums Following the Realization of Risk Premiums Following the Price-level AdjustmentsPrice-level Adjustments

Following the price-adjustments to volatility Following the price-adjustments to volatility changes, subsequent stock returns are, on changes, subsequent stock returns are, on average, 460 basis points higher following average, 460 basis points higher following volatility increases. (The higher required returns volatility increases. (The higher required returns are apparently realized.)are apparently realized.)

Interestingly, only 10% of the shifts have an Interestingly, only 10% of the shifts have an associated cause traceable in the media. associated cause traceable in the media.

Mysteries of the Stock MarketMysteries of the Stock Market

Too much stock volatilityToo much stock volatility Volatility too unstableVolatility too unstable Unconnected market Unconnected market

((Cutler, Poterba, and Summers, Cutler, Poterba, and Summers, Journal of Journal of Portfolio ManagementPortfolio Management, 1989), 1989)

Percentage Changes in Stock Percentage Changes in Stock Prices on 49 Historic DaysPrices on 49 Historic Days

Examples:Examples:

Pearl Harbor AttackedPearl Harbor Attacked -4.37%-4.37%

Roosevelt DiesRoosevelt Dies 1.07%1.07%

Bay of PigsBay of Pigs .47%.47%

John Kennedy AssassinatedJohn Kennedy Assassinated -2.81%-2.81%

Robert Kennedy Assassinated Robert Kennedy Assassinated -.49%-.49%

ChernobylChernobyl -1.06%-1.06%

Percentage Changes in Stock Percentage Changes in Stock Prices on Historic DaysPrices on Historic Days

Average absolute return Average absolute return over 49 historic days over 49 historic days 1.46%1.46%

Average absolute return Average absolute return over all other days over all other days .56%.56% (standard deviation: .82%)(standard deviation: .82%)

““Events” Associated with the Five Largest Events” Associated with the Five Largest One-day Percentage Changes in Stock PricesOne-day Percentage Changes in Stock Prices

Worry over dollar Worry over dollar (10/19/87)(10/19/87) -20.47%-20.47%

Deficit talks in Wash. Deficit talks in Wash. (10/21/87)(10/21/87) 9.10%9.10%

Fear of deficit Fear of deficit (10/26/87)(10/26/87) -8.28%-8.28%

No reason for decline No reason for decline (09/03/46)(09/03/46) -6.73%-6.73%

Roll-back of steel prices Roll-back of steel prices (05/28/62)(05/28/62) -6.68%-6.68%

Haugen vs. MauboussinHaugen vs. Mauboussin

• Note that the previous observation is consistent with Mauboussin’s hypothesis of the financial markets as a complex adaptive system

• Nonlinearity causes stock price movements to bear little relation to specific definable causes

““The Inefficient Stock Market”The Inefficient Stock Market”

• 3rd book in Haugen’s trilogy• Focuses on expected return factor models

– Attempt, in part, to exploit error-driven volatility• Positive payoff to cheapness results from market’s overreaction to

success and failure

• Positive payoff to intermediate term momentum results from the market’s underreaction to positive and negative earnings surprises in individual earnings reports

– Also exploit the distortions in the structure of stock prices brought about by price-driven volatility

It’s Tough to Beat the MarketIt’s Tough to Beat the Market

• It the market is so inefficient, why isn’t beating it “like taking candy from a baby?”

• Two reasons:1. Many professional investors are victims of their

own agency problems

2. More importantly, a gale of unpredictable price-driven volatility stands between investors and the “candy”

It’s Tough to Beat the MarketIt’s Tough to Beat the Market

1. Professional investors are victims of agency problems– Easier to make a “story” for growth stocks than for value stocks– Worry about “benchmark risk” rather than total risk– Portfolio managers need to keep up with market on a fairly steady basis or risk

losing their jobs

2. Gale of unpredictable price-driven volatility stands between investors and consistent profits

– Price-driven volatility is unpredictable, increasing the element of chance in stock returns

– Even after maximizing predictability of stock returns, only 10% of differences in monthly stock returns can be explained by model

– Overvalued growth stocks can always go up even more before finally “coming down to earth”

The Wrong 20-Yard LineThe Wrong 20-Yard Line

• Spectrum of market efficiency equivalent to positions on a football field– At one end zone, perfectly efficient markets– At other end, completely inefficient markets

The Wrong 20-Yard LineThe Wrong 20-Yard Line

Near efficient markets end zone (the left end zone):• All volatility is event-driven• Models based on rational economic behavior do a

good job of explaining and predicting market pricing

• No under- or over-valued stocks, so no role for active investment– No inefficiencies for active managers to exploit– Fact that fund managers tend to underperform the

market taken as evidence that markets are efficient

The Wrong 20-Yard LineThe Wrong 20-Yard Line

Near the other endzone (the right end zone):

• All volatility is price-driven

• Market pays no attention whatsoever to fundamentals

• Market, in the short-term, is in a state of complete and unpredictable chaos

The Wrong 20-Yard LineThe Wrong 20-Yard LineAs we move from the left to the right end zone:• Models based on rational economic behavior begin to

lose power• As you cross midfield, behavioral models begin to

dominate– Note: under these models, markets have biased reactions to

real economic events, but they do still react to real economic events

• As you move to the extreme right, even behavioral models lose power, and the market reacts only to its own events (at least in the short run)– Aerialists pay no attention to the wire whatsoever

The Wrong 20-Yard LineThe Wrong 20-Yard LineActive managers would perform best when the market is

near the 60-yard line:• Too close to the efficient markets end zone, and there are

no inefficiencies for the active managers to exploit• Too close to the inefficient markets end zone, and

unpredictable, price-driven volatility begins to dominate, making it nearly as impossible for active managers to beat the market as at the right end zone– Best way to do well in this case would be by buying future

dividend streams at relatively cheap prices, cf., Warren Buffett

• Lack of clear success by active managers indicates only that we are near one of the end zones, not which one we are near

The Wrong 20-Yard LineThe Wrong 20-Yard LineMost finance professors:• Believe the markets are close to the efficient markets

end zone, maybe at the 20-yard lineHaugen believes:• Price-driven volatility is unstable• When it explodes, the markets may approach the 10-

or even the 5-yard line• When it recedes, the markets may cross the 50-yard

line into the other end of the field• But, on average, the markets are more likely to reside

near the right-end 20-yard line

The TriumphThe Triumph• Finance needs to go back and forth between theory and

empirical findings– Can’t remain stuck on the theory of Modern Finance– Need to move on to a new paradigm

• Haugen’s suggestion – The New Finance– Built on a foundation of statistics, econometrics, and

psychology– Look at what works, not just at what theory says should work– Allows for an integration of evidence contradicting the efficient

markets hypothesis

My OpinionMy Opinion

• As far as their descriptions of how markets work, Haugen and Mauboussin are not inherently that different

• Where they differ is in terms of their interpretation – are the markets efficient or not?

• But, “efficiency” deals with the issue of price vs. value

• This requires an answer to the question, what is the true value of a stock?

My OpinionMy Opinion

• But this question can never be categorically answered :– “The question of value presupposes an answer to the question, of

value to whom, and for what?”

– E.g., the value of Apple stock would be different to Steve Jobs than to any other investor

• Related issue – what is information? – “Information is that which causes changes” – Claude Shannon

(father of information theory)

– So, if something causes the markets to move, then by definition, it must be information, and vice versa

– From this perspective, the market is neither efficient nor inefficient, it just is

My OpinionMy OpinionImportant question:• Not whether or not the markets are efficient – this is a

side issue – but how investors should act, given how the markets work

• Unfortunately, there is a dichotomy between the short run and the long run:– Over the long run, value-type strategies perform best– But, over the short run, growth stocks may rack up stellar

performance records– Key question – can you sit through the sometime short-run

underperformance of value stocks in order to get the long-run benefits they yield?