Chapter 8 The Efficient Market Hypothesis Mc GrawHillIrwin

Chapter 8 The Efficient Market Hypothesis Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

8. 1 Random Walks and the Efficient Market Hypothesis 8 -2

Efficient Market Hypothesis (EMH) • Do security prices accurately reflect information? – Informational Efficiency price changes consistently predictable? § Are ___________________ – Allocational Efficiency accurately § Are prices correct in that they __________________ associated with the reflect the cash flows security? greater fool theory § Gold and the ____________. § Huge implications concerning the answers to these questions. 8 -3

Implications of Efficiency • Allocational efficiency – If markets are not allocationally efficient then perhaps there is a ____________ role for greater government intervention in capital markets. ______ • Possible rules changes to attempt to improve allocational efficiency – Tax on trading activity – More taxes on short holding period returns – Changes in corporate compensation 8 -4

Implications of Efficiency • Informational efficiency – If markets are not informationally efficient • – Investors may not be able to trust that market prices are up to date and investors should then conduct their own research (or hire a researcher) to validate the price. Privileged groups of investors will be able to – consistently take advantage of the general public. Active strategies should outperform passive strategies. 8 -5

Implications of Efficiency • Informational efficiency – If markets are not informationally efficient Corporations have to rethink their goals and • how best to achieve them. Maximize shareholder wealth maximize – share price, so how does one go about maximizing shareholder wealth in this case? Lack a benchmark to evaluate corporate – decisions. 8 -6

EMH and Competition • • • Competition among investors should imply that stock prices fully and accurately reflect publicly available information very quickly. Why? Once information becomes available, market participants quickly analyze it & trade on it & frequent, low cost trading assures prices reflect information. Questions arise about efficiency due to: • Unequal access to information • Structural market problems • Psychology of investors (Behavioralism) 8 -7

Random Price Changes • Why are price changes random? – – – In very competitive markets prices should react to only NEW information Flow of NEW information is random Therefore, price changes are random Idea that stock prices follow a “Random Walk” 8 -8

Random Walk and the EMH • Random Walk: stock price changes ___________ are unpredictable A “pure” random walk implies informational efficiency process • Stock prices actually follow a submartingale __________ • Expected price change is positive over time • But random changes are superimposed on the positive trend t = time period • E(pricej, t) > E(pricej, t-1) 8 -9

Random Walk with Positive Trend Security Prices Evidence on Random Walk idea Time 8 -10

Forms of the EMH • Prices reflect all relevant information set • Vary the ________ – Weak The relevant information is historical prices and other trading data such as trading volume. If the markets are weak form efficient, use of such information provides no benefit “at the margin. ” 8 -11

Forms of the EMH • Prices reflect all relevant information • Vary the information set: – Semi-strong The relevant information is "all publicly available information, including past price and volume data. " If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin. 8 -12

Forms of the EMH • Prices reflect all relevant information • Vary the information set: – Strong The relevant information is “all information” both public and private or “inside” information. If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin. SEC Rule 10 b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported. 8 -13

Relationships between forms of the EMH efficiency implies weak • Notice that semi-strong ________________ form efficiency holds (but ________) NOT vice versa _________ • Strong form efficiency would imply that both semi-strong and weak form efficiency hold _____________________. 8 -14

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8. 2 Implications of the EMH (for Security Analysis) 8 -17

Types of Stock Analysis & Relationship to the EMH • Technical Analysis: Technical Analysis or TA is using prices and volume information to predict future price changes TA assumes prices follow predictable trends – If the markets are weak form efficient or semistrong form efficient or strong form efficient will technical analysis be able to consistently predict price changes? 8 -18

Basic Types of Technical Analysis Support and resistance levels • Support level: – A price level below which it is supposedly unlikely for a stock or stock index to fall. • Resistance level: – A price level above which it is supposedly unlikely for a stock or stock index to rise. A resistance level may arise at say $31. 25 if a stock repeatedly rises to $31. 25 and then declines, indicating that investors are reluctant to pay more than this price for the stock. A stock price above $31. 25 would then indicate a 'breakout' which would be a bullish signal. 8 -19

Types of Stock Analysis & Relationship to the EMH • Fundamental Analysis: using economic and accounting information to predict stock price changes – If the markets are weak form efficient or semistrong form efficient or strong form efficient will fundamental analysis be able to consistently predict price changes? 8 -20

Fundamental Analysis • Fundamental analysis assumes that stock prices should be equal to the discounted value of the expected future cash flows the stock is expected to provide to investors. • Fundamental analysis is thus the “art” of identifying over- and undervalued securities based on an analysis of the firm's financial statements and future prospects. 8 -21

Fundamental Analysis • Fundamental analysis varies in technique but generally focuses on forecasting the firm's future dividends or earnings, discounting those future cash flows by the required rate of return (usually obtained from the CAPM), and comparing the resulting estimated price with the current stock price. 8 -22

Fundamental Analysis • If the estimated price is greater ______ than the current price buy the stock since it is an investor should ___ undervalued increase to ______ and since its price should ____ the "true" or "fundamental" value uncovered by the analyst. • If the estimated price is less ____ than the current price the stock should be sold ____ because the stock is overvalued by the market. currently _____ • In either case if the analyst is correct the investor return” should receive an“abnormal ________. 8 -23

Fundamental Analysis • Forecasts already exist and for FA to add value, your forecast must be better than the consensus forecast. • Not enough to find a good company, you must find a company that is better than others believe, i. e. , mispriced. 8 -24

Implications of Efficiency for Active or Passive Management • Active Management – Security analysis – Timing strategies – Investment Newsletters • Passive Management – Buy and Hold portfolios – Index Funds Assumes inefficiency, use technical and/or fundamental analysis to pick securities Consistent with semistrong efficiency 8 -25

Market Efficiency and Portfolio Management Even if the market is efficient a role exists for portfolio management Identify risk & choose appropriate risk level – Tax considerations – Other considerations such as liquidity needs or – diversify away from the client’s industry. 8 -26

8. 3 Are Markets Efficient? 8 -27

Average Annual Returns for 10 size-based portfolios, 1926 -2007 • Results are driven by returns in the first two weeks of January • May be related to higher ESTIMATION risk of smaller firms • Extra return may be more apparent than real due to higher trading costs and illiquidity 8 -28

Average Returns as a Function of the Book-To Market Ratio, 1926 to 2007 • Value Stock premium return • Distressed and out of favor stocks? 8 -29

Bubbles and Market Efficiency Periodically stock prices appear to undergo a ‘speculative bubble. ’ A speculative bubble is said to occur if prices do not equal the intrinsic value of the security. Does this imply that markets are not efficient? – Very difficult to predict if you are in a bubble and when the bubble will burst. – Stock prices are estimates of future economic performance of the firm and these estimates can change rapidly. – Risk premiums can change rapidly and 8 -30 dramatically.

Summary: What Does the Evidence Show? • Technical Analysis (TA) Stocks do not follow a pure random walk, so there is hope for technical trading strategies. Most TA rules utilize short term trading strategies that generate excessive transaction costs and are not profitable. There appears to be some long term trend reversals. 8 -31

Summary: What Does the Evidence Show? • Fundamental Analysis Appears to be difficult to consistently generate abnormal returns using fundamental analysis. This is because the analysis/investment industry is so competitive and volatility is high. May help you avoid seriously overvalued investments. 8 -32

Summary: What Does the Evidence Show? • Fundamental Analysis The Conundrum: Without fundamental analysis the markets would surely be inefficient, & Abnormal profit opportunities would exist, Leading to profitable fundamental analysis Grossman & Stiglitz AER, 1980 8 -33

Summary: What Does the Evidence Show? • Anomalies Exist Small Firm in January Effect – Book to Market Ratios – Long Term Reversals – Post-Earnings Announcement Drift (Momentum) – 8 -34

Behavioralism bias • Motivation Stock prices in the 1990 s did not appear to match “fundamentals, ” e. g. , high price earnings ratios Evidence of refusal to sell losers Economics discipline is exploring behavioral aspects of decision making 8 -35

What does it all mean? • Technical Analysis: It may be an item in your toolkit but be careful relying on it too much. • Your choices – Pick stocks yourself, based on fundamental analysis, but diversify Beat and/or avoid the competition. • – Pick one or more mutual funds Unlikely to consistently earn + abnormal returns • Pros paying attention to market and firm conditions • – Index or otherwise passively diversify. 8 -36

Selected Problems 8 -37

Problem 1 • Zero, otherwise returns from the prior period could be used to predict returns in the subsequent period. 8 -38

Problem 2 • No. Why? • One would have to show that Intel investors earned a higher rate of return than they should have for the risk taken. – Many investors bought Intel only after its success was evident. – By chance some stocks will perform extremely well. 8 -39

Problem 3 • No, Why? • It does not indicate investors are failing to consider current information in the price, nor does it present an abnormal return opportunity. • It could indicate information leakage or it could indicate that splits occur during price runups. 8 -40

Problem 4 • No, Why? • You won’t get + abnormal returns if the economic cycle is predictable, the news will already be incorporated in the stock’s price. 8 -41

Problem 5 • Buy it • This is a “Value Investment” where you believe the stock will perform better than the market and if you are correct you will earn a positive abnormal return. 8 -42

Problem 6 a. The small firm in January effect b. Might work, but it might not i. Doesn’t hold every year ii. Would lead to “underdiversification” iii. Higher trading costs of these stocks might wipe out any gains iv. Since there is no solid theoretical reasoning for this the ‘extra return’ might just be a risk premium. 8 -43

Problem 7 a. Consistent, expect about half to outperform the market by chance b. Violation, earn + AR by investing with last year’s winners c. Probably consistent, but it depends. I might be able to use an option strategy to take advantage of this. 8 -44

Problem 7 d. e. Violation, you have exploitable price momentum persisting into February Violation, the reversal offers an exploitable opportunity, namely buy last week’s losers 8 -45

Problem 8 The market expected earnings to increase by more than they actually did. 8 -46

Problem 10 a. – The prices of growth stocks may be consistently bid too high due to investor overconfidence. – Investors/analysts may extrapolate recent earnings (and dividend) growth too far into the future and thereby inflate stock prices, forcing poor returns eventually on growth portfolios. – At any given time, historically high growth firms may revert to lower growth and value stocks may revert to higher growth, changing return patterns, this may happen over an extended time horizon. 8 -47

Problem 10 b. Enough investors should prefer value stocks to growth stocks and bid up the prices of value stocks and drive down the prices of growth stocks until the “extra” return on the value stocks was eliminated. 8 -48