Market Efficiency

FNCE 455Class Session #7Lloyd KurtzSanta Clara University

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Topics• The Efficient Market Hypothesis

• How Efficient is the U.S. Market?

• The Curious Case of Bill Miller

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The Efficient Market Hypothesis

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Skill in coin flipping

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Fama on weak-form EMH

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Peter J. Tanous: How did you first get interested in stocks?Fama: As an undergraduate, I worked for a professor at Tufts University. He had a "Beat the Market" service. He figured out trading rules to beat the market, and they always did!

I beg your pardon?They always did, in the old data. They never did in the new data [laughter].

I see. Are you saying that when you back-tested the trading rules on the historic data, the rules always worked, but once you applied them to a real trading program, they stopped working?Right. That's when I became an efficient markets person.

Source: ‘An Interview with Eugene Fama’, Investment Gurus, February 1997. Accessed at Dimensional Fund Advisors’ (DFA) website.

Versions of EMH (as proposed by Fama)

• Weak-Form EMH

• Semistrong-Form EMH

• Strong-Form EMH

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Weak-Form EMH

• In one sentence: Strategies based on analysis of historical prices and market data (‘technicals’) shouldnt work.

• BK&M: “Stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest.”

• This implies that contrarian strategies (‘buying the dip’) and trend-following are fruitless. Variables such as relative price strength should not have investment value.

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Wall Street begs to differ

• Sanford Bernstein analyzed rankings from 21 major quantitative funds.

• Found that “on average, quantitative models’ heaviest exposure is to EV / EBITDA [valuation] and price momentum...”

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Source: Vadim Zlotnikov. “Quantitative Research – January 2007: Survey of Quantitative Models”. Bernstein Research.

Price momentum has worked – a bit

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Academic support for momentum

• Jeegadish and Titman (1993) find a positive momentum effect.• Stocks that perform well (three to 12 month time periods) tend to continue

to perform well.• Stocks that perform poorly (three to 12 month time periods) tend to

continue to perform poorly.• Risk parameters of both groups were comparable.• “The returns of a zero cost portfolio that consists of a long position in past

winners and short position in past losers makes money in every five year period since 1940.”

• Jeegadish and Titman (2001 and 2005) further document this finding.

• Carhart (1997) formally adds a momentum factor to the Fama & French model.

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But longer term...

• BK&M: “DeBondt and Thaler found that if one were to rank order the performance of stocks over a five-year period and then group stocks into portfolios based on investment performance, the base-period‘loser’portfolio would outperform the winner portfolio by an average of 25% in the following three-year period.”

• An open question: does short-term reaction lead to long-term reversals?

• “Fads Hypothesis” – BK&M p. 239

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Semistrong-Form EMH

• Summary: Strategies based on analysis of company fundamentals shouldn’t work.

• BK&M: “All publicly available information regarding the prospects of a firm must be already reflected in the stock price. Such information includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earnings forecasts, accounting practices, and so forth.”

• “Discovery of good firms does an investor no good in and of itself if the rest of the market knows those firms are good.”

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Challenges to Semistrong EMH

• Valuation Effects

• The Size Effect

• Earnings Surprise

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Do value investors win?

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Bodie, Kane, and Marcus (p. 240-41):

“The P/E effect holds up even if returns are adjusted for portfolio beta. Is this a confirmation that the market systematically misprices stocks according to the P/E ratio?

“This would be a surprising and, to us, disturbing conclusion, because analysis of P/E ratios is such a simple procedure...it hardly seems likely that following such a basic technique is enough to generate abnormal returns.”

Lower P/E stocks have done well...

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...as have low EV/EBITDA stocks...

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...although Price/Book has not helped

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Do low P/Es signal higher risk?

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Bodie, Kane, and Marcus:

“One possible interpretation of these results is that the model of capital market equilibrium [the CAPM] is at fault in that returns are not properly adjusted for risk. This makes sense, since if two firms have the same expected earnings, then the riskier stock will sell at a lower price and lower P/E ratio. Because of its higher risk, the low P/E stock will also have higher expected returns. Therefore, unless the CAPM beta fully adjusts for risk, P/E will act as a useful additional descriptor of risk...”

Strong-Form EMH

• Summary: Even strategies based on inside information shouldn’t work.

• BK&M: “Stock prices reflect all information relevant to the firm, even including information available only to company insiders. This version of the hypothesis is quite extreme.”

• If Strong-Form EMH does not hold, it should be possible to earn superior profits by mimicking CEO and CFO trades.

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The stated standard for CFAs is high

“Members and Candidates [for the CFA designation] who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.”

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Source: CFA Institute Code of Ethics and Standards of Professional Conduct

The legal standard is complex• “The term actually includes legal and illegal conduct.” - SEC

• Forbidden in the U.S.(These make insider trading almost always illegal for managers and employees.)• Trading on stolen insider information.• Trading on insider information acquired through a breach of fiduciary duty.

• Allowed (at least in theory) in the U.S.• Trading on insider information acquired where no misappropriation or

breach of fiduciary duty has occurred.• Conversation overheard in a restaurant• Plans found in the street

• Trading on non-material inside information that enhances prior analytical efforts (Mosaic Theory).

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Some CEO insider cases

• Joseph Nacchio, Qwest• Serving 6-year sentence.

• Samuel Waksal, Imclone• Served 7-year sentence.

• Lawrence Ellison, Oracle• Paid $100 mm to charity as part of settlement.

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Support for Strong-Form EMH

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“Steve Jobs in January 2000 received the largest option grant in history: 20 million shares with a present value that I estimated were $471 million. That option grant represented 5.6 percent of the shares outstanding of Apple Computer Inc. The option promptly sank under water, as did a second option covering another 7.5 million shares, which was granted in October 2001.

“Jobs then took an offer in March 2003 to turn in all 27.5 million shares for five million free shares then worth about $75 million. As of the market’s close on Nov. 22, those free shares had a value of $307 million. Had Jobs kept his 27.5 million option shares, they would have contained, again as of the close on Nov. 22, paper profits of $678 million. Bad move, Steve. Some people may perceive you as arrogant, but based on your decision, you really underestimated yourself.”

- Graef Crystal, executive pay columnist for Bloomberg News. “Karmazin Joins Sirius, Gets Welfare”, 11/24/2006

How Efficient is the U.S. Market?

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A matter of degree

Sharpe got up in front of the group and drew a line on the blackboard.

“Here’s the spectrum,” he said: Over here, markets are hyper-efficient. Every piece of information is known and immediately embedded in market prices within seconds. Over on the other end, here’s a market that’s totally crazy. Prices bear no relation to value or anything. We all agree the market isn’t over here, and it isn’t over there, and the thing we need to talk about is, where is it?

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Fox, The Myth of the Rational Market (p. 134-5). HarperCollins. Kindle Edition.

Crazy Hyper-Efficient

Some intuitive questions

• Is it easy to beat the market?

• Are there more successful managers (successful coin flippers) than we would expect due to random chance?

• Are there simple quantitative rules that have beaten the markets for long time periods?

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It’s not easy being average

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Source: “Quantitative Analysis of Investor Behavior [QAIB]”, Dalbar Inc., April 2012.

How many successful managers?

• Most studies show managers with good performance tend to regress to the mean. Very few managers seem able to beat the market over multiple long-term investment horizons. A few have been identified, however:

• Paul Samuelson’s Study• Buffett• Templeton• Lynch• Soros

• Fama’s Mutual Fund Study• Lynch

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Spot the difference…

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Simulated and Actual Cumulative Density Function of Three-Factor t(α) for Gross Returns, 1984-2006

Source: Fama and French, “Luck versus Skill in Mutual Fund Performance”, November 30 2009.

“If we measure fund returns before fees and expenses - in other words, if we add back each fund's expense ratio - the α estimate for the aggregate fund portfolio rises to 0.13% per year, which is only 0.40 standard errors from zero. Thus, even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns.”

Fees make it worse

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Simulated and Actual Cumulative Density Function of Three-Factor t(α) for Net Returns, 1984-2006

Source: Fama and French, “Luck versus Skill in Mutual Fund Performance”, November 30 2009.

“After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.”

Maubossin’s study

Successful managers tend to...

Be based away from major financial centers

Have longer time horizons

Have a value bias

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Source: Michael Maubossin, More Than You Know

Some intuitive questions

• Is it easy to beat the market? • No.

• Are there more successful managers (successful coin flippers) than we would expect due to random chance? • No, but some winners have common characteristics,

notably a focus on valuation.

• Are there simple quantitative rules that have beaten the markets for long time periods?• Yes, buying low P/E stocks, for example.

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The Curious Case of Bill Miller

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But this must be skill, right?Bill Miller’s mutual fund, the Legg Mason Value Trust (LMVTX), beat the S&P 500 (after fees) for 15 consecutive years:

• 1991• 1992• 1993• 1994• 1995• 1996• 1997• 1998• 1999• 2000• 2001• 2002• 2003• 2004• 2005

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“The greatest money manager of our time.”

- Fortune magazine, 11/28/2006

What are the odds?

• Chance of winning 15 coin flips in a row:• p = (0.5)15

• p = 0.0031%• p = 1 in 32,768

• When Bill Miller started there were only 700 equity mutual funds.

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Where have you gone, Bill Miller?

(20.00)

(15.00)

(10.00)

(5.00)

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5.00

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20.00

25.00

30.00

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

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Using Fama & French's measure of market returns instead of the S&P 500, Bill Miller's streak ended in 2004. Miller is trailing the market again in 2008.

Sources: Morningstar, Ken French online Data Library

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And then it got worse...

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The academic consensus

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Bodie, Kane, and Marcus:

“The market is competitive enough that only differentially superior information or insight will earn money; the easy pickings have been picked.”