lecture 8 h08

8/3/2019 Lecture 8 h08

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Albert Lee Chun Portfolio Management 0

CHAPTER 11: EfficientCHAPTER 11: Efficient Market HypothesisMarket Hypothesis

³Past, present, and even discounted future events

are reflected in market price.´ Louis Bachelier

8/3/2019 Lecture 8 h08


Albert Lee Chun Portfolio Management

Introduction

1

One of the early applications of computers in economics in the

1950s was to analyze economic time series:

- prices seem to evolve randomly

- stock market is dominated by erratic market

psychology ?

No, the random price movements indicated a well-functioning

or efficient market, not an irrational one.

We show how competition among analysts leads naturally to

market efficiency and we examine the implications of the

efficient market hypothesys for investment policy, considering

also empirical evidence that support/contradict the notion of

market efficiency.

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8/3/2019 Lecture 8 h08


Albert Lee Chun Portfolio Management

Example:price behavior in efficient market

FCC Corporation is developing a camera that will double thespeed of the auto-focusing system. It is highly profitable andthe NPV will be positive.

Day 0 represents the announcement day. Before theannouncement day, FCC¶s stock sells for $140 per share. The

NPV per share is $40, so the new price will be $180 once thevalue of the new project is fully reflected.

Hence, the solid line represents the path of stock price in anefficient market. The price will adjust immediately and nofurther change in the price of stock will take place later.

The broken line represents a delayed reaction. It takes 8 dayfor the market to fully incorporate the information.

The dotted line indicates an overreaction and subsequentadjustment to the correct price

Broken and dotted line show the path of the stock price if

markets are inefficient.3

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Portfolio Management Strategies

There are 2 principal classes of portfolio managementstrategies.

1. Passive2. Active

Why would an investor choose an active strategy over

a passive strategy, or visa versa?

The answer depends on the beliefs of the investors onwhether or not the market is efficient.

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The 3 EMH and Their Information Sets

Informationset of

past prices

Information setof publicly available

information

All informationrelevant to a stock

Weak

Strong

Semi-

Strong

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Fama (1970): 3 Forms of EMH

Weak form efficiency: The past behavior of pricescannot help us predict future movements in prices.Price changes over time are statisticallyindependent.

Semi-strong form efficiency: There is no publicinformation that can help us predict futuremovements in prices. Prices quickly reflect newvalue-changing information.

Strong form efficiency: Even the µprivate¶information of experts and insiders cannot help us predict future movements in prices. Professionalmanagers are unable to accurately forecast thefuture prices of individual stocks.

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In other words...In other words...

Weak form efficiencyWeak form efficiency::

Past prices are useless!Past prices are useless!

SemiSemi--strong form efficiencystrong form efficiency::Public information is useless!Public information is useless!

Strong form efficiencyStrong form efficiency::

All available information, including µprivate¶All available information, including µprivate¶informationinformation is useless!is useless!

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Efficient Market HypothesisEfficient Market Hypothesis

Assumptions for Efficient Market Hypothesis:Assumptions for Efficient Market Hypothesis:

The number of participants in the market is large andThe number of participants in the market is large and

that they are profit maximizing. Think of large banks,that they are profit maximizing. Think of large banks,hedge funds, institutional investors...hedge funds, institutional investors...

Investors rapidly adjust the prices of securitiesInvestors rapidly adjust the prices of securities

to reflect any new information.to reflect any new information.

New information here is defined as a surprise New information here is defined as a surprise --

something random and unpredictable.something random and unpredictable.

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Implications of Weak Form Efficiency:Implications of Weak Form Efficiency:

Past trading data contains no relevant informationabout future prices.

Best guess of the future price is the current price plus the expected return on the stock.

Consistent with Random Walk Theory:Movements in stock prices from day to day do notreflect any pattern, they are random.

Implications of Weak Form EfficiencyImplications of Weak Form Efficiency

Number RandomReturnExpected1 ! t t

P P

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A Note on the Weak FormA Note on the Weak Form

Technical analysis is useless if this is true!Technical analysis is useless if this is true! TechnicalTechnical

analysisanalysis looks for patterns in past prices, as opposedlooks for patterns in past prices, as opposed

toto fundamental analysisfundamental analysis which looks for fundamentalwhich looks for fundamental

value.value. Even if there are patterns in the market, the presenceEven if there are patterns in the market, the presence

of a few smart investors would be cause them toof a few smart investors would be cause them to

profit from these patterns for a while, but once the profit from these patterns for a while, but once the

market recognizes the pattern it will disappear.market recognizes the pattern it will disappear.

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Empirical Evidence on EMHEmpirical Evidence on EMH

Tests on aggregate stock indices (TSX and NYSE)support weak form efficiency.

However, momentum strategies provide acounterexample to the weak form of the EMH.Momentum strategies are based on the momentumof stock returns, i.e. past performers wouldoutperform past losers.

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Implications of SemiImplications of Semi--Strong Form EfficiencyStrong Form Efficiency

Implications of SemiImplications of Semi--Strong Form Efficiency:Strong Form Efficiency:

Analysis of financial statements such as income

statements and balance sheets will not reveal any

relevant information about future prices. Financial analysts cannot identify mis-priced

stocks from financial statements.

Fund managers who try to beat the market by

selecting stocks could do no better than earn anaverage return.

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Research has found that fund managers on average

do not beat the market. It is really hard to find a

fund manager who beats the market consistently.

Passive index-tracking funds perform as well asmanaged funds.

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Implications of Strong Form EfficiencyImplications of Strong Form Efficiency

Implications of Strong Form EfficiencyImplications of Strong Form Efficiency

Insider information and insider trading is not

useful.

There will be no gradual information leakage.

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Insider trading is the trading of a corporation's

stock or other securities by corporate insiders such

as officers, directors, or holders of more than ten

percent of the firm's shares. Illegal insider tradingrefers to trading a security based on nonpublic

information about the security.

Research has shown that insider information is

valuable and one can profit from insider trading.

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Insider Trading ExampleInsider Trading Example

In 2002, a Martha Stewart was charged with

insider trading regarding the sale of 3,928 shares in

pharmaceutical company ImClone, days before its

application for a new drug was denied. Accordingto SEC allegations, she avoided a loss of $45,673

by selling all 3,928 shares of her ImClone stock.

Stewart was a friend of ImClone cofounder

Samuel Waksal. The day following her sale, thestock value fell 16%. Over the next month, the

price of the shares dropped 70%.

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Quick Review of Market EfficiencyQuick Review of Market Efficiency

Weak Form Efficiency: Prices reflect the informationWeak Form Efficiency: Prices reflect the information

set comprisingset comprising past market trading datapast market trading data (i.e. prices,(i.e. prices,

volume, dividends, etc.)volume, dividends, etc.)

SemiSemi--Strong Form Efficiency: Prices reflect theStrong Form Efficiency: Prices reflect theinformation set comprising past market trading datainformation set comprising past market trading data

plus all other currently available plus all other currently available public information.public information.

Strong Form Efficiency: Prices reflect allStrong Form Efficiency: Prices reflect all public andpublic and

privateprivate information.information.

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Is the Market Efficient?Is the Market Efficient?

There is little reason to believe markets are strongThere is little reason to believe markets are strong

form efficient.form efficient.

There seems to be compelling reason to believe thatThere seems to be compelling reason to believe that

markets are weak markets are weak--form efficient.form efficient. A compromise: some prices, some of the time, mightA compromise: some prices, some of the time, might

not reflect all publicly available information, but mostnot reflect all publicly available information, but most

assets, most of the time, do reflect this information.assets, most of the time, do reflect this information.

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Implication of EMHImplication of EMH

Competitive forces in the capital markets drive theCompetitive forces in the capital markets drive the

market prices of securities to their fundamentalmarket prices of securities to their fundamental

values.values.

The more competitive a market, the more efficient itThe more competitive a market, the more efficient itis.is.

If the markets are efficient, the price of a securityIf the markets are efficient, the price of a security

today is the best predictor of its fundamental value.today is the best predictor of its fundamental value.

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Implication of EMHImplication of EMH

Efficiency does not imply that the observed pricesEfficiency does not imply that the observed prices

reflect the fundamental value of the stock at all times.reflect the fundamental value of the stock at all times.

It implies only that deviations from it's fundamentalIt implies only that deviations from it's fundamental

value are random and unpredictable.value are random and unpredictable. If the markets are not efficient, security prices mayIf the markets are not efficient, security prices may

deviate from their fundamental value. This impliesdeviate from their fundamental value. This implies

that there exist strategies for beating the market.that there exist strategies for beating the market.

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Inefficient MarketsInefficient Markets

Reasons for Inefficient MarketsReasons for Inefficient Markets

1. Market Segmentation1. Market Segmentation

2. Illiquidity2. Illiquidity

3. High Costs of Transaction and Information3. High Costs of Transaction and Information

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Passive Management StrategiesPassive Management Strategies

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Active vs. Passive Strategy and EfficientActive vs. Passive Strategy and Efficient

MarketsMarkets

Investor AInvestor A: Believes the market is: Believes the market is efficientefficient and that itand that it

is not possible to beat the market and finds it optimalis not possible to beat the market and finds it optimal

to follow ato follow a passive passive strategy by holding the marketstrategy by holding the market

index.index.

Investor BInvestor B: Believes the market is: Believes the market is not efficientnot efficient andand

that it is possible to beat the market, and thus seeks tothat it is possible to beat the market, and thus seeks to

follow anfollow an activeactive strategy.strategy.

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Active and Passive StrategiesActive and Passive Strategies

Passive equity portfolio managementPassive equity portfolio management

Long-term buy-and-hold strategy

Usually tracks an index over time

Designed to match market performance

Manager is judged on how well they track the

target index

Active equity portfolio managementActive equity portfolio management Attempts to outperform a passive benchmark

portfolio on a risk-adjusted basis

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Passive StrategyPassive Strategy

1.1. Buy and HoldBuy and Hold: Form a portfolio based on certain: Form a portfolio based on certain

criteria and hold for a predetermined period.criteria and hold for a predetermined period.

2.2. Portfolio IndexationPortfolio Indexation: Replicate the performance of a: Replicate the performance of amarket index. The strategy does not try to look for market index. The strategy does not try to look for

undervalued or overvalued stocks, nor does it try toundervalued or overvalued stocks, nor does it try to

predict movements in the market. predict movements in the market.

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Motivation for IndexingMotivation for Indexing

Theoretical motivationTheoretical motivation: According to the CAPM, the: According to the CAPM, the

market portfolio is the portfolio tangent to themarket portfolio is the portfolio tangent to the

efficient portfolio, and it is not possible obtain higher efficient portfolio, and it is not possible obtain higher returns for any level of risk using another portfolio.returns for any level of risk using another portfolio.

Costs of Active ManagementCosts of Active Management: There are costs of : There are costs of

researching information, costs of analyzingresearching information, costs of analyzinginformation, transaction costs.information, transaction costs.

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Motivation for IndexingMotivation for Indexing

Empirical MotivationEmpirical Motivation::

1. Individual investors under 1. Individual investors under--perform the S&P 500. perform the S&P 500.Barber andBarber and OdeanOdean (1997, 1998, 2000)(1997, 1998, 2000)

2. Institutional investors (who have lowers transactions2. Institutional investors (who have lowers transactionscosts and access to better information) do notcosts and access to better information) do not

outperform the market:outperform the market: Jensen(1968),Jensen(1968), MalkielMalkiel (1995),(1995),CahartCahart (1997). This(1997). This isis alsoalso truetrue whenwhen youyou adjustadjust for for thethe price price of of risk risk usingusing CAPM or aCAPM or a multifactor multifactor model.model.

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Percentage of Managers that Beat the S&P 500

Source: Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/)

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Source: Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/)

Active vs. Passive Index Fund

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Empirical Tests of the EMHEmpirical Tests of the EMH

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Event StudiesEvent Studies

If security prices reflect all available information, thenIf security prices reflect all available information, then

price changes must reflect new information. price changes must reflect new information.

Suppose that the single index model holdsSuppose that the single index model holdsR R tt == a +a + bR bR mtmt + e+ ett

Abnormal returnAbnormal return eett = (= (ActualActual -- ExpectedExpected))et = R t - (at + btR mt)

Abnormal Returns are those beyond what would be predicted

by market movements alone.

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Event StudiesEvent Studies

Examine prices and returns over timeExamine prices and returns over time

0 +t-t

Announcement Date

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Stock Price Reaction to CNBC ReportsStock Price Reaction to CNBC Reports

Response of 172 firms in which a controllingResponse of 172 firms in which a controllingshareholder offered to buy out the minorityshareholder offered to buy out the minorityshareholders.shareholders.

Acquiring shareholders pay a premium over currentAcquiring shareholders pay a premium over current

market prices. So an announcement should causemarket prices. So an announcement should cause prices to jump! prices to jump!

This is evidence of anThis is evidence of an efficient marketefficient market in that pricesin that pricesfully reflect the new information within minutes of fully reflect the new information within minutes of

the announcement.the announcement. A positive report gets digested by the market withinA positive report gets digested by the market within

5 minutes, whereas a negative report takes on average5 minutes, whereas a negative report takes on average12 minutes to digest.12 minutes to digest.

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Stock Price Reaction to CNBC ReportsStock Price Reaction to CNBC Reports

Minute by minute report of stock prices of firms featured in

CNBC¶s ³Morning´ or ³Midday Call.´

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Leakage of information occurs when information regarding aLeakage of information occurs when information regarding arelevant event is released to a small group of investorsrelevant event is released to a small group of investors before the official public release. before the official public release.

The price might start to increase days or weeks before theThe price might start to increase days or weeks before theannouncement and calculating the abnormal return on theannouncement and calculating the abnormal return on theannouncement date may not best measure the impact of theannouncement date may not best measure the impact of thenew information. One should calculate cumulative returns.new information. One should calculate cumulative returns.

Cumulative abnormal returns over timeCumulative abnormal returns over time

0 +t-t

Cumulative Abnormal ReturnsCumulative Abnormal Returns

10-4010-40

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Cumulative Abnormal ReturnsCumulative Abnormal Returns

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Are the Markets Efficient?Are the Markets Efficient?

Magnitude IssueMagnitude Issue

How efficient are the markets? Stock prices are veryHow efficient are the markets? Stock prices are veryclose to efficient values, and only managers of veryclose to efficient values, and only managers of verylarge portfolios can profit from mislarge portfolios can profit from mis--pricings. pricings.

Selection Bias IssueSelection Bias Issue

Would you publish your successful money makingWould you publish your successful money makingstrategy? No. Only those who fail will publish their strategy? No. Only those who fail will publish their results to the world. Preresults to the world. Pre--selection in favor of failedselection in favor of failedstrategies.strategies.

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The Lucky Event IssueThe Lucky Event Issue

Every take out a coin.Every take out a coin.

Flip the coin 10 times.Flip the coin 10 times.

Heads you win, tails you lose!Heads you win, tails you lose!

Count the number of heads.Count the number of heads.

Who is our big winner?Who is our big winner?

Now let¶s repeat the exercise. Now let¶s repeat the exercise.

Are successful winners able to repeat! Most likely not! Is itAre successful winners able to repeat! Most likely not! Is itskill or merely luck? It is purely luck.skill or merely luck? It is purely luck.

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Weak Form TestsWeak Form Tests

Serial CorrelationSerial CorrelationPositive or negative serial correlation is evidence that stock Positive or negative serial correlation is evidence that stock

returns are related to past returns.returns are related to past returns. Evidence:Evidence: Over very shortOver very shorttime horizons evidence of weak price trends. Not enough totime horizons evidence of weak price trends. Not enough tosuggest the existence of trading opportunities.suggest the existence of trading opportunities.

Momentum EffectMomentum Effect

Good or bad performance continues over time for the best andGood or bad performance continues over time for the best andworst recent performers.worst recent performers. Evidence:Evidence: Over 3Over 3--12 month holding12 month holding

periods, there is some evidence of positive momentum periods, there is some evidence of positive momentum

Returns over Long HorizonsReturns over Long Horizons (over multiyear periods)(over multiyear periods)

Evidence:Evidence: pronounced negative correlation, evidence on pronounced negative correlation, evidence onreversals.reversals. Reversal Effect:Reversal Effect: Winners become losers and losersWinners become losers and losers

become winners. become winners.

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SemiSemi--Strong Form TestsStrong Form Tests

Fundamental analysis calls on a much stronger range of Fundamental analysis calls on a much stronger range of

information than does technical analysisinformation than does technical analysis

Tests of fundamental analysis are more difficult toTests of fundamental analysis are more difficult to

evaluate.evaluate.We will review a number of anomaliesWe will review a number of anomalies ± ± evidence thatevidence that

seems inconsistent with the efficient marketseems inconsistent with the efficient market

hypothesis.hypothesis.

-- Small firm in January EffectSmall firm in January Effect-- Book to Market RatiosBook to Market Ratios

-- Post Earnings Price DriftPost Earnings Price Drift

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Small Firm (January) EffectSmall Firm (January) Effect

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Book Book--toto--Market EffectMarket Effect

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PostPost--EarningsEarnings--Announcement DriftAnnouncement Drift

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Mutual Fund AlphasMutual Fund Alphas

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Mutual Fund PerformanceMutual Fund Performance

lecture 8 h08

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