How Efficient Is the Market Efficient Market Hypothesis

How Efficient Is the Market? Efficient Market Hypothesis (EMH) Random Walk Hypothesis Forms of EMH Implications of EMH Predictability Anomalies Professional Management

Efficient Market Hypothesis q Definition Ø q Prices of securities fully reflect all available information about these securities Question Ø Is a $20 bill you find while walking down a busy street worth $20? Investments 13 2

Random Walk Hypothesis q q q Tracing the evolution of several economic variables predict stock prices? Kendall (1953) no predictable patterns Random Walk Ø Stock prices are random Ø More precisely Expected return is positive over time q Positive trend and random around the trend q Investments 13 3

Random Walk Hypothesis q Positive Trend with random fluctuation Security Prices Time Investments 13 4

Efficient Markets and Random Walk Stock prices fully and immediately reflect all available information q Once information becomes available, market participants analyze it q Competition assures that prices reflect all available information q Investments 13 5

Forms of EMH q Meaning of all available information Ø Weak Form Information contained in market trading data q Past prices, volumes, interest rate, CPI, etc. q Technical analysis (e. g. trend-chasing or “charting”) is irrelevant q Ø Semi-strong Form All publicly available information q All earnings forecasts, accounting information q Fundamental analysis is irrelevant q Ø Strong Form All information relevant to the firm including insider information q Insider Trading q Investments 13 6

More on Fundamental Analysis q q Stock price should be equal to discounted value of expected future cash flow! Information used Ø Ø Ø q Earnings and dividend forecasts Future interest rate forecasts Firm risk evaluation Process Ø Ø Ø Step 1: examine past earnings and company balance sheets Step 2: evaluation of quality of the firm’s management, firm’s standing in its industry, and prospects of the industry Step 3: determine the present discounted value of all the payments to a shareholder Investments 13 7

Forms of EMH Strong Form Set Investments 13 Semi-strong Form Set Weak Form Set 8

Fundamental vs. Technical Analysis q Is it like astronomy vs. astrology? q Depends if you believe in EMH. . . Investments 13 9

Implications of EMH q Active Management (against EMH? ) Ø Ø q Stock picking (security analysis) Market Timing Economically feasible only for managers of large portfolios Do even large mutual funds have the ability to uncover mispriced securities? Passive Management (for EMH? ) Ø Ø Ø A well-diversified portfolio Buy and hold strategy Index Funds Investments 13 10

Implications of EMH q Role of Portfolio Management Ø Diversification q Ø Appropriate risk level q Ø Provide the systematic risk level that investors can tolerate Tax considerations q Ø Idiosyncratic risk should be diversified away at a minimal cost Growth vs Income stocks, munis vs Treasuries Other considerations Investments 13 11

Are Markets Efficient? q EMH implies Ø Ø Ø q A great deal of portfolio managers’ activities (the search for mispriced securities) is wasted effort Active management may hurt clients because of costs and imperfectly diversified portfolios Not hailed by professional portfolio managers Empirical tests of the hypothesis Ø Ø Ø Tests of predictability in stock returns (weak EMH) Testing some trading rules (weak EMH) Event studies (semi-strong EMH) Studying insider trades (strong EMH) Assessing performance of professional managers Investments 13 12

Predictability – Short-Term q Auto (serial) correlation Ø q Return correlation of two consecutive periods Returns over short horizons (monthly or less) Ø Lo, Mamaysky and Wang (2000, JF) q Ø Technical trading offers excess return Lehman (1990, QJE), Conrad and Kaul (1988, JB), Lo and Mac. Kinlay (1988, RFS) q Investments 13 Positive short-term correlation 13

Predictability – Intermediate-Term q Returns over intermediate horizons (3 -12 mon) Ø Jagadeesh and Titman (1993, JF) q q Stocks exhibit a momentum property in which good or bad recent performance continues Performance of individual stocks Ø Ø Ø Highly unpredictable Portfolios of the past winners appear to outperform portfolios of the past losers. Momentum strategy: q Long on winners and short on losers (still works) Investments 13 14

Predictability – Long-Term q Returns over long horizons (multi-years) Ø De. Bondt and Thaler (1985, JF) q q Ø Stocks exhibit a price-reversal property in which good or bad recent performance reverses Fama and French (1988, JF) q Ø Negative long-term serial correlation over long horizons (5 -year prediction, 3 -year estimation) Contrarian profits reflect time-varying risk premium Contrarian strategy: q Investments 13 Long on losers and short on winners 15

Anomalies q Small-firm-in-January effect Ø q Neglected-firm effect and liquidity effects Ø q The higher the book-to-market ratio, the higher returns P/E effect Ø q The tendency of investments in stock of less wellknown firms to generate abnormal returns Book-to-market ratios Ø q Stocks of small firms have earned abnormal returns, primarily in the month of January Portfolios of low P/E stocks exhibit higher average risk-adjusted returns than high P/E stocks Closed-end fund puzzle: Price < NAV Investments 13 16

Royal Dutch vs. Shell – Where Is Arbitrage? Investments 13 17

Why Do Anomalies Happen? q Limits to arbitrage Ø Ø Ø Fundamental risk in exploiting arbitrage opportunities Implementation costs Models risk (i. e. a model not properly accounting for risk) q q Liquidity issues and non-traded assets Behavioral effects Ø Ø Overconfidence Mental accounting Prospect theory etc… Investments 13 18

Event Studies q Cumulative Abnormal Return (CAR) Ø Market Model approach Non-event time: run rit = ai + bi rmt + eit q Event time: q Excess Return = (Actual - Expected) Ø eit = Actual - (ai + bi rmt) Ø CARt = e-T+1 +…+et Ø CAR -T Investments 13 0 t +T 19

Event Studies – CAR for Target Companies before Takeover Attempts Investments 13 20

Anomalies after Earnings Announcements q Earnings Announcements Ø Foster, Olsen, and Shevlin (1984, Accounting Review) Investments 13 21

Professional Management Some evidence of persistent positive and negative performances q Potential measurement error for benchmark returns q Ø Ø q Style changes Risk premiums Superstar phenomenon Ø or statistical outliers? . . Investments 13 22

Persistence of Mutual Fund Performance Carhart (1997, JF) - not much of a long term persistence! Investments 13 23

Wrap-up What is an efficient market? q What is the weak form of EMH? q What is the semi-strong form of EMH? q What is the evidence of predictability? q What is the relationship between an anomaly and EMH? q Investments 13 24