Market EfficiencyMarket EfficiencyB, K & M Chapter 11B, K & M Chapter 11Group Project 5Group Project 5

Market EfficiencyMarket Efficiency Maurice Kendall in 1953 found that he could identify no Maurice Kendall in 1953 found that he could identify no predictable patterns in stock prices.predictable patterns in stock prices.

Kendall's results were disturbing to some financial Kendall's results were disturbing to some financial economists. economists.

Do "animal spirits" drive the market?Do "animal spirits" drive the market?

Economists came to reverse their interpretation of Economists came to reverse their interpretation of Kendall's studyKendall's study

Random Walks and the Random Walks and the Efficient Market HypothesisEfficient Market Hypothesis

A forecast about favorable future performance leads instead A forecast about favorable future performance leads instead to favorable current performance, as market participants all to favorable current performance, as market participants all try to get in on the action before the price jumptry to get in on the action before the price jump

If prices are bid immediately to fair levels, given all If prices are bid immediately to fair levels, given all available information, it must be that they increase or decrease available information, it must be that they increase or decrease only in response to new information. only in response to new information.

"New" information, by definition, must be unpredictable"New" information, by definition, must be unpredictable

This is the essence of the argument that stock prices should This is the essence of the argument that stock prices should follow a follow a "random walk"random walk""

Random Walks and the Random Walks and the Efficient Market HypothesisEfficient Market Hypothesis

Far from a proof of market irrationality, randomly Far from a proof of market irrationality, randomly evolving stock prices are the necessary consequence of evolving stock prices are the necessary consequence of intelligent investors competing to discover relevant intelligent investors competing to discover relevant informationinformation

Don't confuse randomness in price Don't confuse randomness in price changeschanges with with irrationality in theirrationality in the level level of prices of prices

The notion that stocks already reflect all available The notion that stocks already reflect all available information is referred to as the information is referred to as the efficient market efficient market hypothesis (EMH)hypothesis (EMH)

Competition as the Source of Competition as the Source of EfficiencyEfficiency

Why should we expect stock prices to reflect "all available Why should we expect stock prices to reflect "all available information"?information"?

An investment management fund currently managing a $5 An investment management fund currently managing a $5 billion portfolio can afford to spend up to $50 million on billion portfolio can afford to spend up to $50 million on research that increases the portfolio rate of return by 1 percent research that increases the portfolio rate of return by 1 percent per year. (500 MBA's @ $100,000 / year !)per year. (500 MBA's @ $100,000 / year !)

With so many well-backed analysts willing to spend With so many well-backed analysts willing to spend considerable resources on research, there will be no easy considerable resources on research, there will be no easy pickings in the marketpickings in the market

Versions of the Efficient Versions of the Efficient Market HypothesisMarket Hypothesis

The The weak-formweak-form hypothesis: hypothesis: stock prices already reflect all stock prices already reflect all information that can be derived by examining market trading data information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interestsuch as the history of past prices, trading volume, or short interest

The The semistrong-formsemistrong-form hypothesis hypothesis: all publicly available information : all publicly available information regarding the prospects of a firm must be reflected already in the regarding the prospects of a firm must be reflected already in the stock price. (in addition to past prices, fundamental data on the firm's stock price. (in addition to past prices, fundamental data on the firm's product line, quality of management, balance sheet composition, product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices)patents held, earning forecasts, and accounting practices)

  The The strong-formstrong-form version of the efficient market hypothesis: version of the efficient market hypothesis: stock stock prices reflect prices reflect allall information relevant to the firm (including information relevant to the firm (including information available only to company insiders)information available only to company insiders)

Implications of the EMH for Implications of the EMH for Investment PolicyInvestment Policy

Technical AnalysisTechnical Analysis

- Technical analysis- Technical analysis is essentially the search for recurrent is essentially the search for recurrent and predictable patterns in stock prices.and predictable patterns in stock prices.

- Technical analysts are sometimes called Technical analysts are sometimes called chartistschartists because because they study records or charts of past stock prices, hoping to they study records or charts of past stock prices, hoping to find patterns they can exploit to make a profit.find patterns they can exploit to make a profit.

- The efficient market hypothesis implies that technical The efficient market hypothesis implies that technical analysis is without merit.analysis is without merit.

Implications of the EMH for Implications of the EMH for Investment PolicyInvestment Policy

Fundamental AnalysisFundamental Analysis

- Fundamental Analysis Fundamental Analysis uses earnings and dividend uses earnings and dividend prospects of the firm, expectations of future interest rates, prospects of the firm, expectations of future interest rates, and risk evaluation to determine proper stock prices.and risk evaluation to determine proper stock prices.

- Ultimately, it represents an attempt to determine the present - Ultimately, it represents an attempt to determine the present discounted value of all the payments a stock holder will discounted value of all the payments a stock holder will receive from each share of stock. receive from each share of stock.

Implications of the EMH for Implications of the EMH for Investment PolicyInvestment Policy

Fundamental AnalysisFundamental Analysis

- - Fundamental analysts usually start with a study of past earnings Fundamental analysts usually start with a study of past earnings and an examination of company balance sheets. They supplement and an examination of company balance sheets. They supplement this analysis with further detailed economic analysis, ordinarily this analysis with further detailed economic analysis, ordinarily including an evaluation of the quality of the firm's management, including an evaluation of the quality of the firm's management, the firm's standing within its industry, and the prospects for the the firm's standing within its industry, and the prospects for the industry as a whole.industry as a whole.

- - The efficient market hypothesis predicts that only analysts with The efficient market hypothesis predicts that only analysts with superior insight will be rewarded.superior insight will be rewarded.

- Fundamental analysis is much more difficult than merely - Fundamental analysis is much more difficult than merely identifying well-run firms with good prospects.identifying well-run firms with good prospects.

The Role of Portfolio Management in The Role of Portfolio Management in an Efficient Marketan Efficient Market

There is a role for rational portfolio management, even in There is a role for rational portfolio management, even in perfectly efficient markets.perfectly efficient markets.

Rational security selection calls for the selection of a well-Rational security selection calls for the selection of a well-diversified portfolio providing the systematic risk level that the diversified portfolio providing the systematic risk level that the investor wants.investor wants.

Rational investment policy also requires that tax consequences be Rational investment policy also requires that tax consequences be consideredconsidered

- High-bracket investors might want to tilt their portfolios in - High-bracket investors might want to tilt their portfolios in the direction of capital gains as opposed to dividend or the direction of capital gains as opposed to dividend or interest income.interest income.

The Role of Portfolio Management in The Role of Portfolio Management in an Efficient Marketan Efficient Market

Rational portfolio management requires attention to the risk Rational portfolio management requires attention to the risk profile of the investor. profile of the investor.

- For example, a GM executive whose annual bonus - For example, a GM executive whose annual bonus depends on GM's profits generally should not invest depends on GM's profits generally should not invest additional amounts in auto stocks.additional amounts in auto stocks.

The role of the portfolio manager in an efficient market is to The role of the portfolio manager in an efficient market is to tailor the portfolio to these needs, rather than to beat the market.tailor the portfolio to these needs, rather than to beat the market.

Evaluating Market Efficiency: Evaluating Market Efficiency: Event StudiesEvent Studies

Cumulative Abnormal Returns Before Takeover Attempts Target Cumulative Abnormal Returns Before Takeover Attempts Target CompaniesCompanies

Are Markets Efficient?Are Markets Efficient?The Magnitude IssueThe Magnitude Issue  

- Consider an investment manager overseeing a $2 billion - Consider an investment manager overseeing a $2 billion portfolio. portfolio.

- If she can improve performance by only 1/10th of 1 - If she can improve performance by only 1/10th of 1 percent per year, that effort will be percent per year, that effort will be worth .001 x $2 billion = $2 million annually. worth .001 x $2 billion = $2 million annually.

- This manager clearly would be worth her salary! Yet can - This manager clearly would be worth her salary! Yet can we, as observers, statistically measure her contribution? we, as observers, statistically measure her contribution?

- Probably not: a 1/10th of 1 percent contribution would be - Probably not: a 1/10th of 1 percent contribution would be swamped by the yearly volatility of the marketswamped by the yearly volatility of the market

Are Markets Efficient?Are Markets Efficient?The Selection Bias IssueThe Selection Bias Issue

- Only investors who find that an investment scheme cannot Only investors who find that an investment scheme cannot generate abnormal returns will be willing to report their findings to generate abnormal returns will be willing to report their findings to the whole world.the whole world.

The Lucky Event IssueThe Lucky Event Issue

- If many investors using a variety of schemes make fair bets, - If many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and statistically speaking, some of those investors will be lucky and win a great majority of the bets. win a great majority of the bets.

- The winners, though, turn up in - The winners, though, turn up in The Wall Street JournalThe Wall Street Journal as the as the latest stock market gurus; then they can make a fortune publishing latest stock market gurus; then they can make a fortune publishing market newsletters.market newsletters.

Tests of Predictability In Stock Tests of Predictability In Stock Market ReturnsMarket Returns

Returns Over Long HorizonsReturns Over Long Horizons

- Recent tests of long-horizon returns (that is, returns over - Recent tests of long-horizon returns (that is, returns over multiyear periods) have found suggestions of pronounced multiyear periods) have found suggestions of pronounced negative long-term serial correlation.negative long-term serial correlation.

Tests of Predictability In Stock Tests of Predictability In Stock Market ReturnsMarket Returns

Returns Over Long HorizonsReturns Over Long Horizons

These long-horizon results are dramatic, but the studies offer far These long-horizon results are dramatic, but the studies offer far from conclusive evidence regarding efficient markets:from conclusive evidence regarding efficient markets:

1)1) The study results need not be interpreted as evidence for The study results need not be interpreted as evidence for stock market fads. An alternative interpretation of these stock market fads. An alternative interpretation of these results holds that they indicate only that market risk results holds that they indicate only that market risk premiums vary over time.premiums vary over time.

2)2) These studies suffer from statistical problems. (Based on few These studies suffer from statistical problems. (Based on few observations on long-horizon returns) Much of the statistical observations on long-horizon returns) Much of the statistical support for mean reversion in stock market prices derives support for mean reversion in stock market prices derives from returns during the Great Depression. Other periods do from returns during the Great Depression. Other periods do not provide strong support for the fads hypothesis.not provide strong support for the fads hypothesis.

Predictors of Broad Market ReturnsPredictors of Broad Market Returns Several studies have documented the ability of easily Several studies have documented the ability of easily

observed variables to predict market returns:observed variables to predict market returns:

1)1) Fama and French show that the return on the Fama and French show that the return on the aggregate stock market tends to be higher when the aggregate stock market tends to be higher when the dividend/price ratio, the dividend yield, is high.dividend/price ratio, the dividend yield, is high.

2)2) Campbell and Shiller find that the earnings yield can Campbell and Shiller find that the earnings yield can predict market returns. predict market returns.

3)3) Keim and Stambaugh show that bond market data Keim and Stambaugh show that bond market data such as the spread between yields on high- and low-such as the spread between yields on high- and low-grade corporate bonds also help predict broad market grade corporate bonds also help predict broad market returns.returns.

Predictors of Broad Market ReturnsPredictors of Broad Market Returns On the one hand these results may imply that stock returns can be On the one hand these results may imply that stock returns can be predicted, in violation of the efficient market hypothesis. More predicted, in violation of the efficient market hypothesis. More probably, however, these variables are proxying for variation in the probably, however, these variables are proxying for variation in the market risk premium. market risk premium.

For example, given a level of dividends or earnings, stock prices For example, given a level of dividends or earnings, stock prices will be lower and dividend and earnings yields will be higher when will be lower and dividend and earnings yields will be higher when the risk premium (and therefore the expected market return) is the risk premium (and therefore the expected market return) is larger. Thus, a high dividend or earnings yield will be associated larger. Thus, a high dividend or earnings yield will be associated with higher market returns. with higher market returns.

This does not indicate a violation of market efficiency. The This does not indicate a violation of market efficiency. The predictability of market returns is due to predictability in the risk predictability of market returns is due to predictability in the risk premium, not in risk-adjusted abnormal returns. premium, not in risk-adjusted abnormal returns.

Portfolio Strategies and Market Portfolio Strategies and Market AnomaliesAnomalies

One major problem with these tests is that most require risk One major problem with these tests is that most require risk adjustments to portfolio performance.adjustments to portfolio performance.

Note that tests of risk-adjusted returns are Note that tests of risk-adjusted returns are joint testsjoint tests of the efficient of the efficient market hypothesis and the risk adjustment procedure. market hypothesis and the risk adjustment procedure.

If it appears that a portfolio strategy can generate superior returns, If it appears that a portfolio strategy can generate superior returns, we must then choose between rejecting the EMH or rejecting the risk we must then choose between rejecting the EMH or rejecting the risk adjustment technique. Usually, the risk adjustment technique is based adjustment technique. Usually, the risk adjustment technique is based on more questionable assumptions than is the EMH.on more questionable assumptions than is the EMH.

Basu finds that portfolios of low price/earnings ratio stocks have Basu finds that portfolios of low price/earnings ratio stocks have higher returns than do high P/E portfolios. The P/E effect holds up higher returns than do high P/E portfolios. The P/E effect holds up even if returns are adjusted for even if returns are adjusted for pp

Portfolio Strategies and Market Portfolio Strategies and Market AnomaliesAnomalies

Is this a confirmation that the market systematically misprices stocks Is this a confirmation that the market systematically misprices stocks according to P/E ratio? This would be extremely surprising and, to us, according to P/E ratio? This would be extremely surprising and, to us, disturbing conclusion, because analysis of P/E ratios is such a simple disturbing conclusion, because analysis of P/E ratios is such a simple procedure.procedure.

One possible interpretation of these results is that the model of One possible interpretation of these results is that the model of capital market equilibrium is at fault in that the returns are not capital market equilibrium is at fault in that the returns are not properly adjusted for risk.properly adjusted for risk.

This makes sense, since if two firms have the same expected This makes sense, since if two firms have the same expected earnings, then the riskier stock will sell at a lower price and lower P/E earnings, then the riskier stock will sell at a lower price and lower P/E ratio. Because of its higher risk, the low P/E stock also will have ratio. Because of its higher risk, the low P/E stock also will have higher expected returns.higher expected returns.

The Small Firm EffectThe Small Firm Effect Banz found that both total and risk-adjusted rates of return tend to Banz found that both total and risk-adjusted rates of return tend to fall with increases in the relative size of the firm, as measured by the fall with increases in the relative size of the firm, as measured by the market value of the firm's outstanding equity.market value of the firm's outstanding equity.

Later studies (Keim, Reinganum, and Blume and Stambaugh) Later studies (Keim, Reinganum, and Blume and Stambaugh) showed that the small-firm effect occurs virtually entirely in January, showed that the small-firm effect occurs virtually entirely in January, in fact, in the first two weeks of January. The size effect is in fact a in fact, in the first two weeks of January. The size effect is in fact a "small-firm-in-January" effect."small-firm-in-January" effect.

Some researchers believe that the January effect is tied to tax-loss Some researchers believe that the January effect is tied to tax-loss selling at the end of the year. (Many people sell stocks that have selling at the end of the year. (Many people sell stocks that have declined in price during the previous months to realize their capital declined in price during the previous months to realize their capital losses before the tax year ends, and do not put the proceeds from losses before the tax year ends, and do not put the proceeds from these sales back into the stock market until after the turn of the year)these sales back into the stock market until after the turn of the year)

The Small Firm EffectThe Small Firm EffectAverage Difference Between Daily Excess Returns of Lowest-Average Difference Between Daily Excess Returns of Lowest-

Firm-Size & Highest-Firm-Size Deciles for Each Month Between Firm-Size & Highest-Firm-Size Deciles for Each Month Between 1963 and 19791963 and 1979

Market-to-Book RatiosMarket-to-Book Ratios Fama and French and Reinganum show that a very powerful Fama and French and Reinganum show that a very powerful predictor of returns across securities is the ratio of the book predictor of returns across securities is the ratio of the book value of the firm's equity to the market value of equity.value of the firm's equity to the market value of equity.

The decile with the highest book-to-market ratio had an The decile with the highest book-to-market ratio had an average monthly return of 1.65% while the lowest-ratio decile average monthly return of 1.65% while the lowest-ratio decile averaged only 0.72 percent per month.averaged only 0.72 percent per month.

Market-to-Book RatiosMarket-to-Book RatiosAverage Rate of Return as a Function of the Average Rate of Return as a Function of the

Book-to-Market RatioBook-to-Market Ratio

ReversalsReversals DeBondt and Thaler, Jegadeesh, and Lehman all find strong DeBondt and Thaler, Jegadeesh, and Lehman all find strong tendencies for poorly performing stocks in one time period to tendencies for poorly performing stocks in one time period to experience sizable reversals over the subsequent period (losers experience sizable reversals over the subsequent period (losers rebound and winners fade back)rebound and winners fade back)

This phenomenon, dubbed the This phenomenon, dubbed the reversal effectreversal effect, is suggestive , is suggestive of overreaction of stock prices to relevant news.of overreaction of stock prices to relevant news.

These tendencies seem pronounced enough to be exploited These tendencies seem pronounced enough to be exploited profitably and so present a strong challenge to market profitably and so present a strong challenge to market efficiency.efficiency.

The Market Crashes of October The Market Crashes of October 1987, and the 1999-2000 1987, and the 1999-2000

Nasdaq bubbleNasdaq bubble

Such fantastic price swings are hard to Such fantastic price swings are hard to reconcile with market fundamentalsreconcile with market fundamentals

Mutual Fund PerformanceMutual Fund Performance We have documented some of the apparent chinks in the armor of We have documented some of the apparent chinks in the armor of efficient market proponents. Ultimately, however, the issue of efficient market proponents. Ultimately, however, the issue of market efficiency boils down to whether skilled investors can make market efficiency boils down to whether skilled investors can make consistent abnormal trading profits. consistent abnormal trading profits.

The best test may be simply to look at the performance of market The best test may be simply to look at the performance of market professionals.professionals.

Casual evidence does not support claims that professionally Casual evidence does not support claims that professionally managed portfolios can beat the market.managed portfolios can beat the market.

The real test of this notion is to see whether managers with good The real test of this notion is to see whether managers with good performance in a given year can repeat that performance in a performance in a given year can repeat that performance in a following year. In other words, is the abnormal performance due to following year. In other words, is the abnormal performance due to skill or luck?skill or luck?

Mutual Fund PerformanceMutual Fund Performance Although the ultimate interpretation of these results is thus Although the ultimate interpretation of these results is thus

to some extent a matter of faith, the most recent studies to some extent a matter of faith, the most recent studies indicate:indicate:

1)1) On average, actively managed funds underperform On average, actively managed funds underperform the marketthe market

2)2) Most persistence in performance is due to Most persistence in performance is due to persistence in the level of expenses and transactions persistence in the level of expenses and transactions costs, and not in the level of gross returnscosts, and not in the level of gross returns

Mutual Fund PerformanceMutual Fund Performance3) 3) Gruber (1996) reports that:Gruber (1996) reports that:

a.a. Mutual funds on average offer a negative risk-Mutual funds on average offer a negative risk-adjusted return relative to low-expense index funds. adjusted return relative to low-expense index funds. Under any reasonable assumptions about holding Under any reasonable assumptions about holding periods, investors in load funds have poorer periods, investors in load funds have poorer performance than investors in no-load fundsperformance than investors in no-load funds

b.b. The biggest puzzle is to explain the survival of high-The biggest puzzle is to explain the survival of high-expense, poor performance funds. He concludes that expense, poor performance funds. He concludes that many investors are unsophisticatedmany investors are unsophisticated

Mutual Fund PerformanceMutual Fund Performance Some previous studies suggest superior performance in any Some previous studies suggest superior performance in any period is more a matter of luck than underlying consistent period is more a matter of luck than underlying consistent ability: (mixed evidence on superior performance)ability: (mixed evidence on superior performance)

The performance of professional managers is broadly The performance of professional managers is broadly consistent with market efficiency. However, a small number of consistent with market efficiency. However, a small number of investment superstars - Peter Lynch, Warren Buffet, John investment superstars - Peter Lynch, Warren Buffet, John Templeton, and John Neff among them - have compiled career Templeton, and John Neff among them - have compiled career records that show a consistency of superior performance hard to records that show a consistency of superior performance hard to reconcile with absolutely efficient markets.reconcile with absolutely efficient markets.

So, Are Markets Efficient?So, Are Markets Efficient? There are enough anomalies in the empirical evidence to There are enough anomalies in the empirical evidence to justify the search for underpriced securities that clearly goes onjustify the search for underpriced securities that clearly goes on

The market is competitive The market is competitive enough enough that only differentially that only differentially superior information or insight will earn money; the easy superior information or insight will earn money; the easy pickings have been pickedpickings have been picked

Conclusion: markets are reasonably efficient, but rewards to Conclusion: markets are reasonably efficient, but rewards to the especially intelligent or creative may in fact be waiting.the especially intelligent or creative may in fact be waiting.