chapter ten market efficiency chapter ten market efficiency cleary / jones investments: analysis and...
TRANSCRIPT
CHAPTER TEN
Market Efficiency
CHAPTER TEN
Market Efficiency
Cleary / Jones
Investments: Analysis and Management
Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives
To explain the concept of efficient To explain the concept of efficient marketsmarkets
To describe the three forms of To describe the three forms of market efficiency - weak, semi-market efficiency - weak, semi-strong, and strongstrong, and strong
To discuss the evidence regarding To discuss the evidence regarding the Efficient Market Hypothesisthe Efficient Market Hypothesis
Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives
To state the implications of market To state the implications of market efficiency for investorsefficiency for investors
To outline major exceptions to the To outline major exceptions to the Efficient Market HypothesisEfficient Market Hypothesis
Efficient MarketsEfficient MarketsEfficient MarketsEfficient Markets
How well do markets respond to new How well do markets respond to new information?information?
Should it be possible to decide Should it be possible to decide between a profitable and unprofitable between a profitable and unprofitable investment given current information?investment given current information?
Efficient MarketsEfficient Markets– The prices of all securities quickly and The prices of all securities quickly and
fully reflect all available informationfully reflect all available information
Conditions for an Efficient Conditions for an Efficient MarketMarket
Conditions for an Efficient Conditions for an Efficient MarketMarket
Large number of rational, profit-Large number of rational, profit-maximizing investorsmaximizing investors– Actively participate in the marketActively participate in the market– Individuals cannot affect market pricesIndividuals cannot affect market prices
Information is costless, widely available, Information is costless, widely available, generated in a random fashiongenerated in a random fashion
Investors react quickly and fully to new Investors react quickly and fully to new informationinformation
Consequences of Efficient Consequences of Efficient MarketMarket
Consequences of Efficient Consequences of Efficient MarketMarket
Quick price adjustment in response to Quick price adjustment in response to the arrival of random information the arrival of random information makes the reward for analysis lowmakes the reward for analysis low
Prices reflect all available informationPrices reflect all available information Price changes are independent of one Price changes are independent of one
another and move in a random fashionanother and move in a random fashion– New information is independent of pastNew information is independent of past
Market Efficiency FormsMarket Efficiency FormsMarket Efficiency FormsMarket Efficiency Forms
Efficient market hypothesisEfficient market hypothesis– To what extent do securities markets To what extent do securities markets
quickly and fully reflect different available quickly and fully reflect different available information?information?
Three levels of Market EfficiencyThree levels of Market Efficiency– Weak form - market level dataWeak form - market level data– Semi-strong form - all public informationSemi-strong form - all public information– Strong form - all information, both public Strong form - all information, both public
and privateand private
Weak FormWeak FormWeak FormWeak Form
Prices reflect all past price and Prices reflect all past price and volume datavolume data
Technical analysis, which relies on Technical analysis, which relies on the past history of prices, is of little the past history of prices, is of little or no value in assessing future or no value in assessing future changes in pricechanges in price
Market adjusts or incorporates this Market adjusts or incorporates this information quickly and fullyinformation quickly and fully
Semi-Strong FormSemi-Strong FormSemi-Strong FormSemi-Strong Form
Prices reflect all publicly available Prices reflect all publicly available informationinformation
Investors cannot act on new public Investors cannot act on new public information after its announcement information after its announcement and expect to earn above-average, and expect to earn above-average, risk-adjusted returnsrisk-adjusted returns
Encompasses weak form as a subsetEncompasses weak form as a subset
Strong FormStrong FormStrong FormStrong Form
Prices reflect all information, public Prices reflect all information, public and privateand private
No group of investors should be No group of investors should be able to earn abnormal rates of able to earn abnormal rates of return by using publicly and return by using publicly and privately available informationprivately available information
Encompasses weak and semi-Encompasses weak and semi-strong forms as subsetsstrong forms as subsets
Evidence on Market Evidence on Market EfficiencyEfficiency
Evidence on Market Evidence on Market EfficiencyEfficiency
Keys:Keys:– Consistency of returns in excess of riskConsistency of returns in excess of risk– Length of time over which returns are Length of time over which returns are
earnedearned Economically efficient marketsEconomically efficient markets
– Assets are priced so that investors Assets are priced so that investors cannot exploit any discrepancies and cannot exploit any discrepancies and earn unusual returnsearn unusual returns
Transaction costs matterTransaction costs matter
Weak-Form EvidenceWeak-Form EvidenceWeak-Form EvidenceWeak-Form Evidence
Test for independence (randomness) Test for independence (randomness) of stock price changesof stock price changes– If independent, trends in price changes If independent, trends in price changes
do not existdo not exist– Overreaction hypothesis and evidenceOverreaction hypothesis and evidence
Test for profitability of trading rules Test for profitability of trading rules after brokerage costsafter brokerage costs– Simple buy-and-hold betterSimple buy-and-hold better
Semi-Strong-Form Semi-Strong-Form EvidenceEvidence
Semi-Strong-Form Semi-Strong-Form EvidenceEvidence
Event studiesEvent studies– Empirical analysis of stock price Empirical analysis of stock price
behaviour surrounding a particular eventbehaviour surrounding a particular event– Examine company unique returnsExamine company unique returns
The residual error between the security’s The residual error between the security’s actual return and that given by the index actual return and that given by the index modelmodel
Abnormal return (ArAbnormal return (Aritit) = R) = Ritit - E(R - E(Ritit)) Cumulative when a sum of ArCumulative when a sum of Arit it
Semi-Strong-Form Semi-Strong-Form EvidenceEvidence
Semi-Strong-Form Semi-Strong-Form EvidenceEvidence
Stock splitsStock splits– Implications of split Implications of split
reflected in price reflected in price immediately immediately following the following the announcementannouncement
Accounting Accounting changeschanges– Quick reaction to Quick reaction to
real change in valuereal change in value
Initial public Initial public offeringsofferings– Only issues Only issues
purchased at offer purchased at offer price yield price yield abnormal returnsabnormal returns
Announcements Announcements and newsand news– Little impact on Little impact on
price after releaseprice after release
Strong-Form EvidenceStrong-Form EvidenceStrong-Form EvidenceStrong-Form Evidence
Test performance of groups which Test performance of groups which have access to nonpublic informationhave access to nonpublic information– Corporate insiders have valuable private Corporate insiders have valuable private
informationinformation– Evidence that many have consistently Evidence that many have consistently
earned abnormal returns on their stock earned abnormal returns on their stock transactionstransactions
Insider transactions must be publicly Insider transactions must be publicly reportedreported
Implications of Efficient Implications of Efficient Market HypothesisMarket Hypothesis
Implications of Efficient Implications of Efficient Market HypothesisMarket Hypothesis
What should investors do if What should investors do if markets are efficient?markets are efficient?
Technical analysisTechnical analysis– Not valuable if weak-form holdsNot valuable if weak-form holds
Fundamental analysis of intrinsic Fundamental analysis of intrinsic valuevalue– Not valuable if semi-strong-form holdsNot valuable if semi-strong-form holds– Experience average resultsExperience average results
For professional money managersFor professional money managers– Less time spent on individual securitiesLess time spent on individual securities
Passive investing favouredPassive investing favoured Otherwise, must believe in superior insightOtherwise, must believe in superior insight
– Tasks if markets informationally efficientTasks if markets informationally efficient Maintain correct diversificationMaintain correct diversification Achieve and maintain desired portfolio riskAchieve and maintain desired portfolio risk Manage tax burdenManage tax burden Control transaction costsControl transaction costs
Implications of Efficient Implications of Efficient Market HypothesisMarket Hypothesis
Implications of Efficient Implications of Efficient Market HypothesisMarket Hypothesis
Market AnomaliesMarket AnomaliesMarket AnomaliesMarket Anomalies
Exceptions that appear to be Exceptions that appear to be contrary to market efficiencycontrary to market efficiency
Earnings announcements affect Earnings announcements affect stock pricesstock prices– Adjustment occurs before Adjustment occurs before
announcement, but also significant announcement, but also significant amount afteramount after
– Contrary to efficient market hypothesis Contrary to efficient market hypothesis because the lag should not exist because the lag should not exist
Market AnomaliesMarket AnomaliesMarket AnomaliesMarket Anomalies
Low P/E ratio stocks tend to Low P/E ratio stocks tend to outperform high P/E ratio stocksoutperform high P/E ratio stocks– Low P/E stocks generally have higher Low P/E stocks generally have higher
risk-adjusted returnsrisk-adjusted returns– But P/E ratio is public informationBut P/E ratio is public information
Should portfolio be based on P/E Should portfolio be based on P/E ratios?ratios?– Could result in an undiversified portfolio Could result in an undiversified portfolio
Market AnomaliesMarket AnomaliesMarket AnomaliesMarket Anomalies
Size effectSize effect– Tendency for small firms to have Tendency for small firms to have
higher risk-adjusted returns than large higher risk-adjusted returns than large firmsfirms
January effectJanuary effect– Tendency for small firm stock returns Tendency for small firm stock returns
to be higher in January to be higher in January – Of 30.5% size premium, half of the Of 30.5% size premium, half of the
effect occurs in January effect occurs in January
Market AnomaliesMarket AnomaliesMarket AnomaliesMarket Anomalies
Value Line Ranking SystemValue Line Ranking System– Advisory service that ranks 1700 Advisory service that ranks 1700
stocks from best (1) to worst (5)stocks from best (1) to worst (5) Probable price performance in next 12 Probable price performance in next 12
monthsmonths
– 1980-1993, Group 1 stocks had 1980-1993, Group 1 stocks had annualized return of 19.3%annualized return of 19.3%
Best investment letter performance overallBest investment letter performance overall
– Transaction costs may offset returnsTransaction costs may offset returns
Conclusions About Market Conclusions About Market EfficiencyEfficiency
Conclusions About Market Conclusions About Market EfficiencyEfficiency
Support for market efficiency is Support for market efficiency is persuasivepersuasive– Much research using different methodsMuch research using different methods– Also many anomalies that cannot be Also many anomalies that cannot be
explained satisfactorilyexplained satisfactorily Markets very efficient, but not totallyMarkets very efficient, but not totally
– To outperform the market, fundamental To outperform the market, fundamental analysis beyond the norm must be doneanalysis beyond the norm must be done
Conclusions About Market Conclusions About Market EfficiencyEfficiency
Conclusions About Market Conclusions About Market EfficiencyEfficiency
If markets operationally efficient, If markets operationally efficient, somesome investors with the skill to investors with the skill to detect a divergence between price detect a divergence between price and semi-strong value earn profitsand semi-strong value earn profits– Excludes the majority of investorsExcludes the majority of investors– Anomalies offer opportunitiesAnomalies offer opportunities
Controversy about the degree of Controversy about the degree of market efficiency still remainsmarket efficiency still remains