chapter ten market efficiency chapter ten market efficiency cleary / jones investments: analysis and...

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


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



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


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



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


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


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


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


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



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

chapter ten market efficiency chapter ten market efficiency cleary / jones investments: analysis and...

Documents

market efficiencykeys

market pricesinformation

new public information

current information

arrival of random information

random fashionnew information

past price

public informationstrong