The Essentials of an Efficient Market - Final

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The Essentials of An Efficient Market and Implications for Investors, Firms and Regulators

Presented BySam Mensah, Ph.D SEM Financial Group/African Capital Markets Forum, Ghana

UNECA Workshop on African Capital Markets Development27-29 October, 2003, Johannesburg, SA


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Market Efficiency Concepts

Allocation Efficiency Does capital flow to the projects with the highest

risk-adjusted returns?

Operational Efficiency Are transactions completed on a timely basis,

accurately and at low cost?

Informational Efficiency Does the observed market price of a security reflect

all information relevant to pricing the security?


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Theory of Efficient Markets

Financial economics focuses on informational efficiencyAn efficient market is a market that is

efficient in processing informationPrices of securities observed at any point in

time are based on a correct evaluation all information available at the time, i.e. prices “fully reflect” all available information

Also called “Efficient Markets Hypothesis (EMH)”


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How Prices Adjust to New Information


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Patterns of Market Response

Early Response (anticipated information)Efficient Markets ResponseDelayed Response and ReversionOverreaction


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Why do we need to appreciate EMH?

Fundamental attributes of a capitalist economy Prices are accurate signals for capital allocation Both issuers and buyers of securities expect fair prices Persistence of glaring pricing anomalies erodes market

confidence Examples of pricing anomalies are common on African markets

Share prices unchanged on ex-dividends or ex-rights Share prices remain unchanged after new information is released

African capital markets will not develop unless both issuers and investors believe that securities are fairly priced

Market regulators, policymakers and operators need to focus on improving pricing efficiency


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Economic Foundations of the EMH

EMH is an applications the theory of rational expectations to financial markets

A set of postulates are advanced to justify the EMH

Expectations of future returns are rational, i.e. equal to the optimal forecasts on the basis of the best available information

On average, the expected return will equal the equilibrium return, i.e. the return based on factors such as risk, liquidity, etc

Current prices will be set such that the optimal forecast of a security’s return using all available information will be equal to the security’s equilibrium return

In an efficient market, all unexploited profit opportunities will be eliminated Stock prices follow a “random walk”, i.e. future changes in prices should for all

practical purposes be unpredictable Persistence of inefficiency means that investors are not using all

information at their disposal in setting security prices, i.e. expectations are not “rational”


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Interpreting the EMH


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Efficient Markets and Information Sets


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What is the Empirical Evidence?

Whether markets are efficient or indeed can be efficient has not been fully resolved

Extensive testing has taken place in advanced markets

Research on the efficiency of African capital markets is scanty


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Tests in Advanced Markets Tests generally support weak-form efficiency (i.e.

past prices cannot be used to predict future prices) Public information has been found to incorporated

into and sometimes even anticipated by prices, therefore markets are strong-form efficient

Few portfolio managers are able to beat the market and do not do so with any consistency

But insiders are able to earn above normal returns securities

markets are inefficient at the strong-form level


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The African Evidence

Kofi Osei, 1998) found that stock prices in Ghana did not conform to random walk hypothesis, therefore market was weak-form inefficient

Addo (2001) tested ex-dividend day adjustment; statistically significant price appreciation on ex-dividend

day, contrary to theory Market is weak-form inefficient (persistence of historical

prices)

Olowe (1999) found Nigerian Stock Exchange to be weak-form efficient


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Current State of Knowledge

Advanced markets are largely efficient but anomalies still exist

Seasonalities Day of the week effects (returns are higher on

average on the last trading day (Friday) and lower on the first (Monday)

High returns to stocks in January A small group of portfolio managers (US

mutual funds) seem to consistently earn above normal profits


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The Controversy Continues

Can markets be efficient – inefficiency is what propels markets towards efficiency as investors seek out profit opportunities

Behavioral approach suggests that markets don’t just trade on available news and rational response; they reflect irrational impulses (Greenspan’s “irrational exuberance”)


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Implications for Investors

If EMH holds:Published reports of financial Analysts may

not be valuableMarket tips are not valuableTechnical analysis is worthless with weak-

form efficiencyFundamental analysis is worthless with

semi-strong efficiency There should be low returns to active

portfolio management


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What should Investors Do?

For the vast majority, public information cannot be used to beat market Select diversified portfolio and avoid costs of analysis

and transaction Many investors place their funds with managers who

merely replicate an index thus lowering costs

Investors groups (institutional investors, shareholders associations, etc) need to press for greater volume of timely information to move markets closer to the semi-strong efficient markets level, thus boosting market confidence


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Market Efficiency

• The value of investment advice– Forbes’ Magazine’s monkey portfolio

Not all financial theory is good for the financial profession!


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Implications for Corporate Finance

Key Corporate Finance Decisions: Should firms try to time their security issues or is

market timing a hopeless venture? How do markets react to different security issues?

How can firms use this information to decide which securities they should issue to raise funds?

What happens if firms are inefficient? Can firms exploit these inefficiencies in their financing decisions?

Can financial managers “fool” the market by “cooking their books”?


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The Corporate Finance Evidence

Persistence of January effect means firms can take advantage

Mean reverting interest rates means that when interest rates are high based on historical levels they are likely to come down

Stock prices at historical lows are likely to go up BUT

Advantages are only reasonable at the margins. Gains are too low and noise is too high

Financial managers should not ignore important considerations of funding to take advantage of market inefficiencies


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Can Financial Managers Cook the Books?

Change in accounting methods to boost profit (e.g. depreciation methods, pooling versus purchase) tend to elicit negative to neutral market reaction

Stock splits/Bonus shares – Neutral Profit announcements: Delays create negative

market reaction Lesson: Financial managers are unlikely to

“fool” market; but regulatory firmness is essential (ENRON cooked its books for over 4 years before the market caught up with it)


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Implications of Regulators

Regulators accept efficient markets as normative model; IOSCO Objectives and Principles of Securities Regulation stress:The protection of investorsEnsuring that markets are fair, efficient and

transparentThe reduction of systemic risk


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Quote

“In an efficient market, the dissemination of relevant information is timely and widespread and is reflected in the price formation process. Regulation should promote efficiency” (IOSCO Principles and Objectives of Securities Regulation)


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Regulatory Prescriptions

There should be full, timely and accurate disclosure of financial results and other information that is material to investors’ decisions

Holders of securities in a company should be treated in a fair and equitable manner

Accounting and auditing standards should be of a high and internationally acceptable quality

The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers.


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Market Efficiency and Stages of Market Development

Recent research relates market efficiency to stage of market developmentPre-emergingEmergingAdvanced markets


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The Five Phases of Market Maturity


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Stages of market Development (Contd)

Pre-emerging (Most sub-Saharan Africa excl. SA) Immature market, market efficiency is low Low market professionalism Market inefficiencies not fully exploited Low returns to active management

Emerging Markets starts to professionalize More analysis Returns to active management are high Market becomes more efficient


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Market Efficiency and Stages of Market Development (Contd)

Advanced markets (3 stages) Too much active management

No more unexploited market opportunities Returns to active management fall Market efficiency peaks

Indexation penetration increasing (UK, Continental Europe, US)

Increasing reliance on indexation Some market opportunities go unexploited Returns to active management increase again but levels off

Equilibrium Market is not fully efficient Some returns to active management still exist but at a lower level

than earlier phase


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What should Africa do to improve market efficiency?

Need for more professionalism Better regulatory enforcement


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Building Professionalism and market Capacity

Extensive training needed Larger and strong investment houses with capability to

organize information Participation by investment houses from advanced

markets will be a plus for market efficiency (partnerships between SA and other sub-Saharan Africa investment houses may be a good start)

More technical know-how is needed in our stock markets ASEA should build technical know-how of members Formalized collaboration between ASEA, ACMF and

development agencies (e.g. UNECA, ADB, etc) is needed to lift capacity and build professionalism)


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The Importance of Regulatory Enforcement

Without strong regulatory enforcement, market efficiency will be elusive

Major regulatory agencies such as US SEC have failed to detect major inaccuracies in company accounts and nondisclosure (ENRON, Worldcom)

African regulators are poorly resourced Poor market surveillance Limited analytical and investigative capacities

The Essentials of an Efficient Market - Final

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