Fina 2802 Investments and Portfolio Analysis Spring 2010

Fina 2802: Investments and Portfolio Analysis Spring, 2010 Dragon Tang Lecture 10 The Efficient Market Hypothesis February 11, 2010 Readings: Chapter 11 Practice Problem Sets: 2, 3, 4, 7, 9, 15, 16, 19, 20 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 1

Efficient Markets and Critique Objectives 1. Define the concept of Market Efficiency and its implication for security prices. 2. Demonstrate why if market are efficient security price movements should be essentially unpredictable. 3. Cite evidence that supports and contradicts the efficient market hypothesis. 4. Formulate investment strategies that make sense in informationally efficient markets. Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 2

Where Are We? Pricing: Risk vs. Return Investment Securities Investment Companies Trading Market Efficiency Trading Behavior Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 3

Stock Return Predictability If we know stock prices follows: Pt+1 = a + b Xt + et with enough historical observations, we can find a and b. Given the current market condition Xt, we can predict future return Pt+1 with high precision. What happens next? Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 4

Market Efficiency Definition: Markets are efficient if prices of securities fully reflect all available information about securities. The belief in market efficiency is called Efficient Market Hypothesis (EMH). Market efficiency Fin 2802, Spring 10 - Tang Prices change only due to new information Stock price changes are random and unpredictable (Random Walk) Chapter 11: Market Efficiency 5

Random Walk with Positive Trend Security Prices Time Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 6

Why market efficiency? Many highly paid analysts are searching for ways to improve investment performance. Competition among these analysts make mispriced securities difficult to find. Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 7

Cumulative Abnormal Returns Surrounding Takeover Attempts Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 8

Returns Following Earnings Announcements Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 9

Three Versions of EMH • Weak-form EMH: prices reflect all past info • Semistrong-form EMH: prices reflect all public (past&current) info • Strong-form EMH: prices reflect all (past&current, public&private) info Strong Form Fin 2802, Spring 10 - Tang Semistrong Weak Form Chapter 11: Market Efficiency 10

Implications of EMH for Investment Policy • Technical Analysis: useless • Fundamental Analysis: adds little value • Active versus Passive Portfolio Management: passive wins EMH Fin 2802, Spring 10 - Tang You can’t “Beat the Market” Chapter 11: Market Efficiency 11

The Role of Portfolio Management in an Efficient Market • Need for a well-diversified portfolio • Tax considerations • Individual considerations • Age considerations Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 12

But Are Markets Efficient? Hard question! • The Magnitude Issue • The Selection Bias Issue • The Lucky Event Issue Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 13

Short Horizon Tests of Weak-form EMH Confirming EMH: • Patterns in stock prices cannot be exploited • Runs of stock prices cannot be used to predict the next price movement • Filter rules cannot generate trading profits • Momentum: Serial correlation may exist over short periods (Jegadeesh & Titman, 1993) Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 14

Long Horizon Tests of the Weak-form EMH • Reversal: Serial correlation may be negative over long horizons (“Overreaction”) • Excess volatility may result when market prices are compared to “fundamentals” Short-run overreaction Fin 2802, Spring 10 - Tang Short-run momentum Long-run reversal Chapter 11: Market Efficiency 15

Evidence Against EMH: Predictors of Broad Market Movements • Dividend yield • Earnings yield • Bond yield spreads Q: Are these proxies for a change in Market risk premium? Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 16

Problems in Testing EMH • Most tests require risk adjustments • Risk adjustment require a model of risk (typically uses CAPM) • Tests of risk-adjusted returns are joint tests of the EMH and the risk adjustment procedure • Rejecting risk-adjustment procedure leaves no conclusions about EMH is essentially untestable. Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 17

Tests of the Semistrong-form EMH Anomalies (evidence against EMH): • P/E Effect: low P/E, High returns • Small-firm-in-January effect: Small firm, High return, in January • Neglected-Firm Effect: Less known firms have higher return • Book-to-Market effect: high B/M high returns • Postearnings effect: sluggish response of price to earnings announcements Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 18

The Size Effect from 1926 to 2003 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 19

Average Rate of Return as a Function of Book to Market Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 20

Cumulative Abnormal Returns in Response to Earnings Announcements Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 21

Tests of the Strong-form EMH Against strong-form EMH: • Inside information SEC regulations Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 22

Interpreting the Evidence Why Anomalies? • Risk premiums or inefficiencies? • Anomalies or data mining? • Behavioral interpretation: — Inefficiencies exist — Caused by human behavior Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 23

The Behavioral Critique • Information Processing • Behavioral Biases • Limits to Arbitrage Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 24

Reality Check of the Semistrong-form EMH Mutual fund performance Skilled equity investment professionals do not consistently beat the market. Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 25

Estimates of Individual Mutual Fund Alphas Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 26

Persistence of Mutual Fund Performance Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 27

Search for Abnormal Returns Trading rule becomes less valuable once exploited • Markets are made more efficient as new techniques are used • If you find a rule that work, don’t tell anybody…markets might be efficient! Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 28

Are Markets Efficient? • Search for underpriced securities continues • Several anomalies have not been adequately explained • Markets generally are very efficient but rewards may be available to the gifted (not only the lucky!). Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 29

Summary • Research shows stock prices tend to follow a random walk • Three forms of the efficient market hypothesis • Technical analysis (violation of Weak form) • Fundamental analysis (violation of Semistrong form) • Empirical studies have generally shown that technical analysis does not generate trading profits • Several anomalies exist regarding fundamental analysis • Professionally managed funds generally cannot consistently beat the market Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency 30