CHAPTER TEN Market Efficiency

Cleary / Jones Investments: Analysis and

Management

Learning 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 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 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

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

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 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 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 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 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-strong Encompasses weak and semi-strong forms as subsetsforms as subsets

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 cannot Assets are priced so that investors cannot exploit any discrepancies and earn exploit any discrepancies and earn unusual returnsunusual returns

Transaction costs matterTransaction costs matter

Weak-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

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 changesAccounting changes– 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 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 markets What should investors do if markets are efficient?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

Market AnomaliesMarket Anomalies Exceptions that appear to be contrary Exceptions that appear to be contrary

to market efficiencyto market efficiency Earnings announcements affect stock Earnings announcements affect stock

pricesprices– Adjustment occurs before announcement, Adjustment occurs before announcement,

but also significant amount afterbut also significant amount 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 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 Anomalies Size effectSize effect

– Tendency for small firms to have higher Tendency for small firms to have higher risk-adjusted returns than large firmsrisk-adjusted returns than large firms

January effectJanuary effect– Tendency for small firm stock returns to Tendency for small firm stock returns to

be higher in January 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 Anomalies Value Line Ranking SystemValue Line Ranking System

– Advisory service that ranks 1700 stocks Advisory service that ranks 1700 stocks from best (1) to worst (5)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

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