The Efficient Market Hypothesis CHAPTER 11 EFFICIENT MARKET

The Efficient Market Hypothesis CHAPTER 11

EFFICIENT MARKET HYPOTHESIS (EMH) Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 2

FIGURE 11. 1 CUMULATIVE ABNORMAL RETURNS BEFORE TAKEOVER ATTEMPTS: TARGET COMPANIES BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 3

FIGURE 11. 2 STOCK PRICE REACTION TO CNBC REPORTS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 4

EMH AND COMPETITION Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 5

VERSIONS OF THE EMH Weak Semi-strong Strong BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 6

TYPES OF STOCK ANALYSIS Technical Analysis - using prices and volume information to predict future prices Weak form efficiency & technical analysis Fundamental Analysis - using economic and accounting information to predict stock prices Semi strong form efficiency & fundamental analysis BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 7

ACTIVE OR PASSIVE MANAGEMENT Active Management Security analysis Timing Passive Management Buy and Hold Index Funds BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 8

MARKET EFFICIENCY & PORTFOLIO MANAGEMENT Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 9

EVENT STUDIES Empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price Abnormal return due to the event is estimated as the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 10

HOW TESTS ARE STRUCTURED Returns are adjusted to determine if they are abnormal Market Model approach a. rt = at + brmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = rt - (a + br. Mt) BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 11

ARE MARKETS EFFICIENT Magnitude Issue Selection Bias Issue Lucky Event Issue BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 12

WEAK-FORM TESTS Returns over the Short Horizon Momentum Returns over Long Horizons BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 13

PREDICTORS OF BROAD MARKET RETURNS Fama and French Aggregate returns are higher with higher dividend ratios Campbell and Shiller Earnings yield can predict market returns Keim and Stambaugh Bond spreads can predict market returns BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 14

SEMISTRONG TESTS: ANOMALIES P/E Effect Small Firm Effect (January Effect) Neglected Firm Effect and Liquidity Effects Book-to-Market Ratios Post-Earnings Announcement Price Drift BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 15

FIGURE 11. 3 AVERAGE ANNUAL RETURN FOR 10 SIZE-BASED PORTFOLIOS, 1926 – 2006 BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 16

FIGURE 11. 4 AVERAGE RETURN AS A FUNCTION OF BOOK-TO-MARKET RATIO, 1926– 2006 BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 17

FIGURE 11. 5 CUMULATIVE ABNORMAL RETURNS IN RESPONSE TO EARNINGS ANNOUNCEMENTS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 18

STRONG-FORM TESTS: INSIDE INFORMATION The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon SEC requires all insiders to register their trading activity BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 19

INTERPRETING THE EVIDENCE Risk Premiums or market inefficiencies— disagreement here Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 20

FIGURE 11. 6 RETURNS TO STYLE PORTFOLIO AS A PREDICTOR OF GDP GROWTH BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 21

INTERPRETING THE EVIDENCE CONTINUED Anomalies or Data Mining The noisy market hypothesis Fundamental indexing BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 22

STOCK MARKET ANALYSTS Do Analysts Add Value Mixed evidence Ambiguity in results BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 23

MUTUAL FUND PERFORMANCE Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns Style changes May be risk premiums Hot hands phenomenon BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 24

FIGURE 11. 7 ESTIMATES OF INDIVIDUAL MUTUAL FUND ALPHAS, 1972 - 1991 BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 25

TABLE 11. 1 PERFORMANCE OF MUTUAL FUNDS BASED ON THREE-INDEX MODEL BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 26

FIGURE 11. 8 PERSISTENCE OF MUTUAL FUND PERFORMANCE BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 27

TABLE 11. 2 TWO-WAY TABLE OF MANAGERS CLASSIFIED BY RISKADJUSTED RETURNS OVER SUCCESSIVE INTERVALS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 28

Behavioral Finance and Technical Analysis CHAPTER 12

BEHAVIORAL FINANCE Investors Do Not Always Process Information Correctly Investors Often Make Inconsistent or Systematically Suboptimal Decisions BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 30

INFORMATION PROCESSING CRITIQUE Forecasting Errors Overconfidence Conservatism Sample Size Neglect and Representativeness BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 31

BEHAVIORAL BIASES Framing Mental Accounting Regret Avoidance Prospect Theory BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 32

FIGURE 12. 1 PROSPECT THEORY BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 33

LIMITS TO ARBITRAGE Fundamental Risk Implementation Costs Model Risk BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 34

LIMITS TO ARBITRAGE AND THE LAW OF ONE PRICE Siamese Twin Companies Equity Carve-outs Closed-End Funds BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 35

FIGURE 12. 2 PRICING OF ROYAL DUTCH RELATIVE TO SHELL (DEVIATION FROM PARITY) BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 36

EVALUATION OF THE BEHAVIORAL CRITIQUES Bubbles and Behavioral Economics Arguments that the Evidence Does Not Support One Type of Irrationality Relatively New Field BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 37

TECHNICAL ANALYSIS AND BEHAVIORAL FINANCE Trends and Corrections Dow Theory Moving averages Breadth Sentiment Indicators Trin Statistic Confidence Index Put/Call Ratio BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 38

FIGURE 12. 3 DOW THEORY TRENDS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 39

FIGURE 12. 4 DOW JONES INDUSTRIAL AVERAGE IN 1988 BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 40

FIGURE 12. 5 MOVING AVERAGE FOR MICROSOFT BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 41

EXAMPLE 12. 4 MOVING AVERAGES BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 42

FIGURE 12. 6 MOVING AVERAGES BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 43

FIGURE 12. 7 MARKET DIARY BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 44

TABLE 12. 1 BREADTH BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 45

FIGURE 12. 8 ACTUAL AND SIMULATED LEVELS FOR STOCK MARKET PRICES OF 52 WEEKS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 46

FIGURE 12. 9 ACTUAL AND SIMULATED CHANGES IN STOCK PRICES FOR 52 WEEKS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 47

Empirical Evidence on Security Returns CHAPTER 13

OVERVIEW OF INVESTIGATION Tests of the single factor CAPM or APT Model Tests of the Multifactor APT Model Results are difficult to interpret Studies on volatility of returns over time BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 49

THE INDEX MODEL AND THE SINGLEFACTOR APT Expected Return-Beta Relationship Estimating the SCL BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 50

TESTS OF THE CAPM Tests of the expected return beta relationship: First Pass Regression Estimate beta, average risk premiums and unsystematic risk Second Pass: Using estimates from the first pass to determine if model is supported by the data Most tests do not generally support the single factor model BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 51

SINGLE FACTOR TEST RESULTS Return % Predicted Actual Beta BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 52

ROLL’S CRITICISM The only testable hypothesis is on the efficiency of the market portfolio In any sample of observations of individual returns Infinite number of ex post mean-variance efficient portfolios using the sample- period returns and covariances CAPM is not testable unless we know the exact composition of the true market portfolio and use it in the tests Benchmark error BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 53

MEASUREMENT ERROR IN BETA Statistical property If beta is measured with error in the first stage, second stage results will be biased in the direction the tests have supported Test results could result from measurement error BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 54

TABLE 13. 1 SUMMARY OF FAMA AND MACBETH (1973) STUDY (ALL RATES IN BASIS POINTS PER MONTH) BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 55

JAGANATHAN AND WANG STUDY Included factors for cyclical behavior of betas and human capital When these factors were included the results showed returns were a function of beta Size is not an important factor when cyclical behavior and human capital are included BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 56

TABLE 13. 2 EVALUATION OF VARIOUS CAPM SPECIFICATIONS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 57

TABLE 13. 3 PORTFOLIO SHARES RELATIVE TO TOTAL ASSETS BY AGE AND NET WORTH BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 58

TABLE 13. 4 DETERMINANTS OF STOCKHOLDINGS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 59

TESTS OF THE MULTIFACTOR MODEL Chen, Roll and Ross 1986 Study Factors Growth rate in industrial production Changes in expected inflation Unexpected Changes in risk premiums on bonds Unexpected changes in term premium on bonds BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 60

STUDY STRUCTURE & RESULTS Method: Two -stage regression with portfolios constructed by size based on market value of equity Fidings Significant factors: industrial production, risk premium on bonds and unanticipated inflation Market index returns were not statistically significant in the multifactor model BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 61

TABLE 13. 5 ECONOMIC VARIABLES AND PRICING (PERCENT PER MONTH X 10), MULTIVARIATE APPROACH BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 62

FAMA-FRENCH THREE FACTOR MODEL Size and book-to-market ratios explain returns on securities Smaller firms experience higher returns High book to market firms experience higher returns Returns are explained by size, book to market and by beta BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 63

TABLE 13. 6 THREE FACTOR REGRESSIONS FOR PORTFOLIOS FORMED FROM SORTS ON SIZE AND BOOK-TO-MARKET RATIOS (B/M) BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 64

INTERPRETATION OF THREEFACTOR MODEL Size is a proxy for risk that is not captured in CAPM Beta Premiums are due to investor irrationality or behavioral biases BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 65

RISK-BASED INTERPRETATIONS Liew and Vassalou Petkova and Zhang BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 66

FIGURE 13. 1 DIFFERENCE IN RETURN TO FACTOR PORTFOLIOS IN YEAR PRIOR TO ABOVE-AVERAGE VERSUS BELOW-AVERAGE GDP GROWTH BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 67

FIGURE 13. 2 HML BETA IN DIFFERENT ECONOMIC STATES BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 68

BEHAVIORAL EXPLANATIONS Market participants are overly optimistic Analysts extrapolate recent performance too far into the future Prices on these glamour stocks are overly optimistic Lower book-to-market on these glamour firms leads to underperformance compared to value stocks Chan, Karceski and Lakonishok La. Port, Lakonishok, Shleifer and Vishny BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 69

FIGURE 13. 3 THE BOOK-TO-MARKET RATIO REFLECTS PAST GROWTH, BUT NOT FUTURE GROWTH PROSPECTS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 70

FIGURE 13. 4 VALUE MINUS GLAMOUR RETURNS SURROUNDING EARNINGS ANNOUNCEMENTS, 19711992 BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 71

LIQUIDITY AND ASSET PRICING Acharya and Pedersen Premiums observed in the three-factor model may be illiquidity premiums Liquidity may explain the size premium but not the book-to-market premium BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 72

TABLE 13. 7 PROPERTIES OF LIQUIDITY PORTFOLIOS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 73

TABLE 13. 8 ESTIMATES OF THE CAPM WITH AND WITHOUT LIQUIDITY FACTORS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 74

TIME-VARYING VOLATILITY Stock prices change primarily in reaction to information New information arrival is time varying Volatility is therefore not constant through time BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 75

STOCK VOLATILITY STUDIES AND TECHNIQUES Volatility is not constant through time Improved modeling techniques should improve results of tests of the risk-return relationship ARCH and GARCH models incorporate time varying volatility BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 76

FIGURE 13. 5 ESTIMATES OF THE MONTHLY STOCK RETURN VARIANCE 1835 - 1987 BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 77

FIGURE 13. 6 IMPLIED VERSUS ESTIMATED VOLATILITY BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 78

EQUITY PREMIUM PUZZLE Rewards for bearing risk appear to be excessive Possible Causes CAPM doesn’t consider the impact of consumption Predicting returns from realized returns Survivorship bias also creates the appearance of abnormal returns in market efficiency studies BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 79

TABLE 13. 9 ANNUAL CONSUMPTION GROWTH, 1954 -2003 (%) BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 80

TABLE 13. 10 ANNUAL EXCESS RETURNS AND CONSUMPTION BETAS BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 81

FIGURE 13. 7 CROSS-SECTION OF STOCK RETURNS: FAMA-FRENCH 25 PORTFOLIOS, 1954 -2003 BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 82