chapter 10

Chapter 10

EFFICIENT CAPITAL MARKETS

Chapter 10 Questions

What do we mean when we say that capital markets are efficient?Why should capital markets be efficient?What factors contribute to an efficient market?Given the overall efficient market hypothesis (EMH), what are the three subhypotheses and what are the implications of each of them?

Chapter 10 Questions

How does one test the three efficient market subhypotheses, and what are the results of the tests?For each set of tests, which results support the EMH and which indicate an anomaly related to the hypothesis?What are the implications of the results for stock strategies and portfolio managers?What is the evidence related to the EMH for markets in foreign countries?

Efficient Capital Markets

In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices reflect all information about the security

Whether markets are efficient has been extensively researched and remains controversial

Why does it matter?

If prices do fully reflect all current information, it would not be worth an investor’s time to use information to find undervalued securities.

If prices do NOT fully reflect information, FIND AND USE THAT INFORMATION, and perhaps you will be able to make a killing in the market.

Investing and Market Efficiency

Would stock selection amount to throwing darts at a wall in an efficient market?

Hardly! Risk still matters. We would still want to research the risk-return properties of securities.

Why Should Capital Markets Be Efficient?

What would be the ingredients of an “informationally” efficient market? A large number of profit-maximizing participants

analyze and value securities New information regarding securities comes to the

market in a random fashion Profit-maximizing investors adjust security prices

rapidly to reflect the effect of new information Price adjustments are unbiased – correct on average.

Under these conditions, a security’s price would be appropriate for its level of risk.

Alternative Efficient Market Hypotheses

The various forms of the efficient market hypothesis differ in terms of the information that security prices should reflect.

Weak-form EMH

Semistrong-form EMH

Strong-form EMH

Weak-Form EMH

Current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information

This implies that past rates of return and other market data should have no relationship with future rates of return

Implications of the Weak-From EMH

Examining recent trends in price and other market data in order to predict future price changes would be a waste of time if the market is weak-form efficient.A lot of people do price charting and other forms of “technical analysis.”

Semistrong-Form EMH

Current security prices reflect all public information, including market and non-market information

This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions

Implications of the Semistrong-Form EMH

If the market is efficient in this sense, information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.

Strong-Form EMH

Stock prices fully reflect all information from public and private sources

This would require perfect markets in which all information is cost-free and available to everyone at the same time (which is clearly not the case)

Implication: Not even “insiders” would be able to “beat the market” on a consistent basis

Tests and Results: Weak-Form EMH

Two Approaches

Tests of “statistical memory” in security prices and returns

Tests of trading rules


Statistical tests of independence between rates of returnAutocorrelation tests

Mostly support the weak-form EMH and indicate that price changes are random

Some studies using more securities and more complicated tests cast some doubt

Runs tests Indicate randomness in prices


Comparison of trading rules to a buy-and-hold policy Some filter rules seem yield above-

average profits with small filters, but only before taking into account the substantial transactions costs involved

Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy


Problems with testsCannot be definitive since trading rules can be complex and there are too many to test them allTesting constraints Use only publicly available data Should include all transactions costs Should adjust the results for risk (an apparently

successful strategy may just be a very risky strategy)

Conclusions: Weak-Form EMH

Results generally support the weak-form EMH, but results are not unanimousSome strategies too subjective to testNot all trading rules are disclosed

If you had a trading strategy that worked, would you reveal it?!

Reality Check!

If someone writes a book on how to “beat the market,” you can bet that book sales are more lucrative than the trading strategy!Even if it once worked, if it’s widely known, it won’t work any more!Don’t quit your day job to trade on-line using a published strategy!

Tests and Results: Semistrong-Form EMH

Three different groups of tests:Time series analysis using public informationEvent studies examine how fast stock prices adjust to significant economic eventsCross-sectional analysis of returns based on public information

Tests involve the estimation of “abnormal returns,” where expected abnormal returns are zero in an efficient market.

Tests and Results:Semistrong-Form EMH

Tests often involve “market-adjusted returns,” created by subtracting the market return from the security’s return, thereby defining a security’s “abnormal return:”

ARit = Rit - Rmt

where: ARit = abnormal return on security i during period t

Rit = return on security i during period t

Rmt = return on a market index during period t

Tests and Results ofSemistrong-Form EMH

Another definition of abnormal return is a “risk-adjusted return” or “market model” which adjusts for the security’s own required rate of return, given its systematic risk (as measured by beta):

ARit = Rit - E(Rit)where: E(Rit) = the expected rate of return for stock i during

period t based on the market rate of return and the stock’s normal relationship with the market (its beta)


Time series tests for predictability of returns and profit opportunitiesShort-horizon returns have shown very limited predictabilityLong-horizon returns analysis shown some predictability of returns based on: Dividend yield (D/P) Default spread Term structure spread


Time series tests for predictability of returns and profit opportunitiesQuarterly earnings reports information Unanticipated earnings changes or “earnings

surprises” are not immediately reflected in security prices

The January Anomaly (A “calendar” effect) Large returns in January present opportunities to

purchase in December, and sell in January and earn abnormal returns.


Time series tests for predictability of returns and profit opportunities

Other calendar effectsMonthly effectDay-of-the-week effects

Monday returns were significantly negative


Predicting cross-sectional returns

In an efficient market, all securities should have equal risk-adjusted returns

Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns These tests include a joint hypothesis of both

market efficiency and the asset pricing model used to generate abnormal returns



Price-earnings ratios Examine historical P/E ratios and returns Low P/E stocks had higher risk-adjusted returns

than high P/E stocks Publicly available P/E ratios could be used for

abnormal returns

Price-earnings/Growth ratios Mixed results



The size effect The risk-adjusted returns for extended periods

indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms

Abnormal returns could occur because either markets are inefficient or the market model is not properly specified and provides incorrect estimates of risk and expected returns (joint test)


Predicting cross-sectional returnsThe size effect Adjustments for riskiness of small firms did not

explain the large differences in rate of return The impact of transactions costs of investing in

small firms is substantial (takes away the differential with a short-term trading strategy)

Even after risk and transaction costs, small firms outperform large firms with annual trading

The small-firm effect is not stable Firm size is an important anomaly



Neglected firms and trading activity Is there an effect related to the number of

analysts following a stock and how frequently a stock trades?

Mixed results, mostly any apparent effects explained by taking the size effect into consideration



Book value-market value (BV/MV) ratio Significant positive relationship between the

current values for this ratio and future stock returns

Although various measures including the P/E ratio seem to help predict future returns, the size effect and BV/MV ratio have the greatest predictive ability.


Event studiesEvent studies examine abnormal returns surrounding various eventsThe EMH is that abnormal returns are zeroStock split studies Mostly show no positive impact on returns

because of a stock split

Initial public offerings Significant IPO underpricing, but it quickly adjust

away in the first day, consistent with the EMH


Event studies

Exchange listings Some evidence of short-term profit potential

following the “listing announcement”

Unexpected world events and economic news Quickly reflected in security prices, do not provide

opportunities


Event Studies

Announcements of accounting changes Quickly reflect in security prices and do not seem

to provide abnormal profit opportunities

Corporate events Prices react quickly to announcements of mergers,

financing decisions, etc. No systematic profit opportunities

Summary on the Semistrong-Form EMH

Evidence is mixed

Strong support of the EMH from numerous event studies with the exception of exchange listing studies

Strong evidence against the EMH from both time series and cross-sectional studies Dividend yields, earnings surprises, calendar

effects The size effect, BV/MV, P/E ratios, etc.

Tests and Results: Strong-Form EMH

Testing Groups of InvestorsTests usually center on whether any group of investors consistently earn abnormal profits.Corporate insidersStock exchange specialistsSecurity analystsProfessional money managers


Corporate Insiders

Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities

Insiders must report to the SEC each month on their transactions as insiders

These insider trades are made public about six weeks later and allow for study


Corporate InsidersMixed resultsCorporate insiders generally experience above-average profits especially on purchase transactions This implies that many insiders had private

information from which they derived above-average returns on their company stock

Later studies indicate that insiders may no longer be able to generate abnormal returns


Stock Exchange Specialists

Specialists have monopolistic access to information about unfilled limit orders

You would expect specialists to derive above-average returns because of their superior information, and this appears to be the case.


Security Analysts

Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks

This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendation


Security AnalystsThe Value Line Enigma Firms ranked 1 for “timeliness” substantially

outperform the market; firms ranked 5 substantially underperform the market

Prices now adjust quickly to changes in rankings Net of transaction costs, rankings do not appear to

have value in terms of producing abnormal returns

There is some evidence of superior analysts who apparently posses private information


Professional Money ManagersTrained professionals, working full time at investment managementIf any investor can achieve above-average returns, it should be this groupIf any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct


Professional Money Managers

Most tests examine mutual funds

Risk-adjusted returns of mutual funds generally show that most funds did not match aggregate market performance

Summary on the Strong-Form EMH

Mixed results

Some strong support Professional money managers

Some strong evidence against the EMH Tests for corporate insiders and stock exchange

specialists do not support the hypothesis Both groups seem to have monopolistic access to

important information and use it to derive above-average returns

Behavioral Finance

A growing field of study in finance.

Rather than assuming ultra-rational behavior, the area of behavioral finance seeks to incorporate how humans actually behave. Incorporates the ways in which psychology may

impact investment decisions It has been useful for explaining various

“anomalies” that we observe in decision-making that are difficult to reconcile with rationality

Behavioral Finance

Using psychological biases to explain behavior Why do investors persistently “ride” losers and sell

winners? Can be explained by prospect theory

Why do investors display overconfidence in forecasts?

Can be explained by the confirmation bias

Why do investors tend to put more money into failing investments?

Can be explained by the escalation bias

Implications of Market Efficiency

Overall results indicate the capital markets are efficient as related to numerous sets of information

There are substantial instances where the market fails to rapidly adjust to public information So, what techniques will or won’t work? What do you do if you can’t beat the market?

Efficient Markets and Technical Analysis

Assumptions of technical analysis directly oppose the notion of efficient marketsTechnicians believe that stock prices move in patterns that persist and are predictable to the informed investor.Technical analysts develop systems to detect trends and patterns in pricesIf the capital market is weak-form efficient, a trading system that depends on past trading data can have no value

Efficient Markets and Fundamental Analysis

Fundamental analysis involves determining an investment’s intrinsic values based on company and economic “fundamentals” The intrinsic value is compared to the market price

to determine whether the investment is undervalued or overvalued

In an efficient market, prices already reflect public information, so determining “intrinsic value” using that information is not a worthwhile exercise

Efficient Markets and Fundamental Analysis

Past vs. Future The EMH, importantly, considers the incorporation

of available information, which is primarily historic in nature.

Much of what is involved in fundamental analysis, including aggregate market analysis and industry analysis, involves estimating future values.

Superior analysts are those who will be better at predicting this uncertain future.

Efficient Markets and Portfolio Management

Does active portfolio management pay off?Research indicates that most money

managers do keep pace with the market

Certainly with a superior analyst, recommendations should be followedOpportunities may be present in smaller,

neglected stocks (although risk must be taken into account)

Efficient Markets and Portfolio Management

Without superior analysts, passive management may outperform active management Build a globally diversified portfolio with a

risk level matching client preferencesMinimize transaction costs (taxes, trading

turnover, liquidity costs)

The Rationale and Use of Index Funds

Efficient capital markets and a lack of superior analysts imply that many portfolios should be managed passively (so their performance matches the aggregate market, minimizes the costs of research and trading)

Institutions created market (index) funds which duplicate the composition and performance of a selected index series

Insights from Behavioral Finance

There may be trading opportunities created by persistent investor biases and “herd mentality”Supports the notion of contrarian

investment strategiesSome mutual funds employ behavioral

finance strategies

Efficiency in European Equity Markets

Hawawini study indicates behavior of European stock prices is similar to U.S. common stocksDespite market differences, most results

are essentially similarAppropriate to assume a similar level of

efficiency in European markets to those in the United States

chapter 10

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efficient market subhypotheses

securitymarket information

market data

weakform efficient

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nonmarket informationthis

public information

current information