Market Efficiency

Chapter 10

Efficient Markets

• the stock market is efficient if:• stock prices quickly and unbiasedly reflect all information which would affect the value of the stock

• an efficient market does not mean that all stock prices are always correct in that they exactly represent the true value of the stock

• Rather, in an efficient market, stock prices are unbiased estimates of the true intrinsic value

• i.e. the current stock price is the best guess possible about the value of the stock, given the available information

Forms of Efficiency

• Three forms of efficiency, depending on what type of information is thought to be incorporated into stock prices

• Weak Form Efficiency

• Semi-Strong Form Efficiency

• Strong Form Efficiency

Implications of Efficiency

Weak Form: if true, then should not expect to earn excess returns by performing technical analysis as there are no patterns in stock prices

Semi-Strong Form: if true, then should not expect to earn excess returns based upon performing fundamental analysis as public information is already incorporated into stock prices before it can be acted upon

Strong Form: if true, then investing based upon (non-public) inside information will not create excess returns

General Implications of Market Efficiency

If markets are (generally) efficient there are some major implications:(1) For investors, efficient markets are consistent with a passive investment strategy

• active investment strategies not expected to produce excess returns

(2) Changes in a firm’s stock price are rational reflections of new information

• a change in price in reaction to news is an unbiased evaluation of whether that news is good or bad• changes in stock prices are meaningful

Study:Kaplan and Weisbach

Journal of Finance (1992)

• examine a sample of large acquisitions that were eventually divested

• classify them as successful or unsuccessful (based on prices paid and sold for, and on reasons given for sale)

• look at abnormal returns on announcement of acquisition

Kaplan and Weisbach (cont.)

Results: • abnormal returns are negative for acquisitions that eventually turn out to be unsuccessful• abnormal returns for unsuccessful acquisitions are significantly lower than for successful ones

Implication: • the market is able to do a good job predicting whichacquisitions will be successful•changes in stock prices provide a “report card” on actions of the firm

How do markets become efficient?

• If markets are efficient, how do they become efficient?

• How does information get into prices?

• The actions of investors trying to take advantage of information as quickly as possible affects the stock price

• The stock price will then reflect information almost immediately

• “On the Impossibility of Informationally Efficient Markets”- Grossman and Stiglitz (American Economic Review, 1980)

• argue that efficient markets are impossible• if cannot expect to profit from information (since already reflected in the current price), then no one would gather information• no one gathers information, how could it get into stock prices?

• Current view of efficient markets:• not possible for most investors to gain from trading based on information (after including effect of transaction costs)• for an intra-marginal investor, there may be gains to be had from gathering and acting on information• intra-marginal investor is someone who can trade on information before the price has fully reflected it.

How long until prices reflect information?

• How long does it take for stock prices to reflect new information?• or, how quick do you have to be to be intra-marginal?

• May vary by type of information and by stock • widely followed stocks will tend to react more quickly, there may be more of a delay for thinly traded stocks

• Study: Busse and Green (Journal of Financial Economics, 2002)• look at effect of news announcements on trading• have sample of announcements timed to the second• find trading based on the information can make a profit if done within 15 seconds - information is fully reflected within 1 minute

Evidence for Market Efficiency• lots of academic studies which seem to show the market is generally efficient (others that find it isn’t)

• Important evidence that the market may be efficient:• mutual funds do not generally beat the market

• After including the effect of management expense ratio, only 10% of actively managed US equity funds were able to do better than the S&P 500 over the last 5 years• Only 8% were able to beat the market over the last 10 years.

• Further…mutual fund performance is inconsistent

• funds that are the best performers one year tend not to be the best performers the next year

Implication: if mutual fund managers, with all of their expertise and resources, cannot beat the market, maybe the stock is efficient

Market Anomalies• there seem to be certain anomalies in the market• situations that are inconsistent with efficient markets

• certain types of stocks have been found to do better than others• some investors base their investing strategies on trying to take advantage of these

• Important: the following anomalies are not guarantees of excess returns

• studies have shown they hold on average for stocks in the past…no guarantee that they will hold in the future and definitely no guarantee they hold all the time

Size Effect

• stock of small firms (by market cap.) tend to outperform the stock of large firms

• holds after adjusting for risk (using traditional risk measures)

January Effect• January tends to be the best month for stocks

• i.e. stocks tend to jump up a bit at the beginning if the year

• Note: this effect is often explained by tax loss selling in December, with people repurchasing stocks in January

• Note: it turns out the that the January Effect and the Size Effect are related, on average, it is only small stocks that experience excess returns at the beginning of the year

• small stocks on NYSE earn about 8% in January, on average, and less than 1% in each of the other months on average

Value Stocks• Value Stocks: stocks with low price-earnings, and/or high dividend yields, and/or low market-book

• after adjusting for risk, value stocks tend to outperform growth stocks

• this is a long term phenomenon…for some periods of time, growth stocks perform the best. Over the long term, however, value stocks tend to be the best stocks.

Momentum

• the stocks that have performed the best over the previous 6 to 12 months will tend to perform well over the next 6 to 12 months

• there is evidence of momentum in stock returns• stocks that do well tend to keep on doing well

• possible explanation is people “jumping on the bandwagon”

Overreaction(Price Reversals)

• Debondt and Thaler (Journal of Finance, 1985)• 1926 to 1980 data• find that the best performing stocks over the last 3 to 5 years perform badly over the next 3 to 5 years• the worst performing stocks over the last 3 to 5 years perform very well over the next 3 to 5 years• by 3 years after identifying best and worst stocks, the “worst” stocks had outperformed the “best” by 25%

Implication:• the market overreacts• e.g. when a stock does well, it gets pushed up too high, eventually this is corrected

Momentum and Reversals

• momentum and reversals (overreaction) are, in a sense, opposites• momentum says: buy the stocks that have performed well, since this will likely continue• overreaction says: buy the stocks that have performed poorly, since this will likely reverse itself

• Important: • timing for the two effects is different• evidence seems to indicate short term momentum (3 to 12 months) and long term reversals (3 to 5 years)

Volume, Momentum, and Reversals

• study by Lee and Swaminathan (Journal of Finance, 2000)• look at effect of high or low volume trading on momentum and reversals• classify stocks as “winners” and “losers” based on past year’s performance , also look at trading volume over that last year

Results:• High volume “winners” - tend to do badly next year, reversal• Low volume “winners” - tend to do well next year, momentum• High volume “losers” - tend to badly next year, momentum• Low volume “losers” - tend to do well next year, reversal

Anomalies - conclusions

• based, in part, on some of these anomalies, many investors feel the market is not efficient• many investment strategies now based on behavioural finance

• fairly new field that tries to explain the stock market with psychology theories

• Warning: just because a study purports to have found evidence of some way to “beat the market” does not mean that it can or should actually be used

•one of the most accurate predictors of the stock market:

• Super Bowl Effect: market will go up when an NFC team wins Super Bowl, and will go down when AFC wins

• 1967 to 2002, Super Bowl predicted market correctly 29 out of 37 times