Market Efficiency Lectures

Professor Gordon Phillips 1
Market Efficiency - 1
CAPITAL MARKET EFFICIENCY
IN THIS LECTURE WE WILL DISCUSS:
Efficient Capital Markets:
A. Price Behavior
B. The Hypothesis
C. Forms of Market Efficiency
D. Common Misconceptions about Efficient Capital Markets.
We will take a RANDOM WALK down Wall Street and
discuss: Fundamental Analysis, Technical Analysis, Chartists,
Momentum Players & Contrarians
We will then discuss the evidence on efficient capital markets.
1.0 CAPITAL MARKET EFFICIENCY
Efficient Capital Market - A market in which current market
prices fully reflect available information. That is, one in which
costless trading rules do not consistently beat the market.
A. Price Behavior in an Efficient Market
Stock price reaction in efficient and inefficient markets: NEARLY
INSTANTANEOUS
B. The Efficient Market Hypothesis
Efficient Market Hypothesis (EMH) - asserts that modern U.S.
stock markets are, as a practical matter, efficient.
The important implication of the EMH is securities represent zero
NPV investments - meaning that they are expected to return just
exactly their risk-adjusted rate.
Why Efficient? Competition among investors and traders makes
a market efficient.
CAPITAL MARKET EFFICIENCY
IN THIS LECTURE WE WILL DISCUSS:
Efficient Capital Markets:
A. Price Behavior
B. The Hypothesis
C. Forms of Market Efficiency
D. Common Misconceptions about Efficient Capital Markets.
We will take a RANDOM WALK down Wall Street and
discuss: Fundamental Analysis, Technical Analysis, Chartists,
Momentum Players & Contrarians
We will then discuss the evidence on efficient capital markets.
1.0 CAPITAL MARKET EFFICIENCY
Efficient Capital Market - A market in which current market
prices fully reflect available information. That is, one in which
costless trading rules do not consistently beat the market.
A. Price Behavior in an Efficient Market
Stock price reaction in efficient and inefficient markets: NEARLY
INSTANTANEOUS
B. The Efficient Market Hypothesis
Efficient Market Hypothesis (EMH) - asserts that modern U.S.
stock markets are, as a practical matter, efficient.
The important implication of the EMH is securities represent zero
NPV investments - meaning that they are expected to return just
exactly their risk-adjusted rate.
Why Efficient? Competition among investors and traders makes
a market efficient.
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock
Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and
after (+) announcement
Efficient market
response to bad news
Overreaction to bad
news with reversion
Delayed
response to
bad news
C. The Forms of Market Efficiency
1. Weak Form Efficiency - A form of the theory that suggests you
can't beat the market by knowing past prices.
2. Semi-strong Efficiency - Perhaps the most controversial form of
the theory, it suggests you can't consistently beat the market using
publicly available information. That is, you can't win knowing
what everyone else knows - annual reports etc.
3. Strong Form Efficiency - The form of the theory that states no
information of any kind can be used to beat the market. Evidence
shows this form does not hold.
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock
Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and
after (+) announcement
Efficient market
Overreaction to bad
news with reversion
Delayed
response to
bad news
C. The Forms of Market Efficiency
1. Weak Form Efficiency - A form of the theory that suggests you
can't beat the market by knowing past prices.
2. Semi-strong Efficiency - Perhaps the most controversial form of
the theory, it suggests you can't consistently beat the market using
publicly available information. That is, you can't win knowing
what everyone else knows - annual reports etc.
3. Strong Form Efficiency - The form of the theory that states no
information of any kind can be used to beat the market. Evidence
shows this form does not hold.
Capital market history and the EMH:
1. Prices respond very rapidly to new information.
2. Future prices changes are difficult to predict.
3. Mispriced stocks (those whose future price level can be predicted
accurately) are difficult to identify and exploit.
D. Some Common Misconceptions about the
EMH
- Market efficiency does not mean
it doesn't make a difference how you invest, since the risk/return
trade-off still applies, but
rather that you can't expect to consistently "beat the market" on a
risk-adjusted basis using costless trading strategies.
- Stock price fluctuations are evidence that the market is efficient
since new information is constantly arriving - prices that don't
change are evidence of inefficiency.
- The EMH doesn't say prices are random,
but that price changes in an efficient market are random and
independent. That is, they can't be predicted before they happen.
Capital market history and the EMH:
1. Prices respond very rapidly to new information.
2. Future prices changes are difficult to predict.
3. Mispriced stocks (those whose future price level can be predicted
accurately) are difficult to identify and exploit.
D. Some Common Misconceptions about the
EMH
- Market efficiency does not mean
it doesn't make a difference how you invest, since the risk/return
trade-off still applies, but
rather that you can't expect to consistently "beat the market" on a
risk-adjusted basis using costless trading strategies.
- Stock price fluctuations are evidence that the market is efficient
since new information is constantly arriving - prices that don't
change are evidence of inefficiency.
- The EMH doesn't say prices are random,
but that price changes in an efficient market are random and
independent. That is, they can't be predicted before they happen.
2.0 A RANDOM WALK DOWN WALL STREET
(STRONG FORM OF MARKET EFFICIENCY DOES NOT HOLD)
A. FUNDAMENTAL ANALYSIS: Important Factors
(OR FIRM FOUNDATION THEORY)
1. EXPECTED GROWTH RATE OF EARNINGS
Longer growth rate ==> higher price
Growth does not go on forever
2. EXPECTED DIVIDEND PAYOUT
Higher price the more paid out.
Stock splits: Why? Small shareholders
3. DEGREE OF RISK
Higher price the less risky
4. LEVEL OF INTEREST RATES
Higher price the lower the interest rates
CAVEATS / PROBLEMS:
1. EXPECTATIONS
2. PRECISE Calculations cannot be made from imprecise decisions-
Don't Justify buy or sell decisions.
3. Information / Analysis may be incorrect
4. Market may not converge to "true value"
Premiums change over time: Growth, Risk etc.
2.0 A RANDOM WALK DOWN WALL STREET
(STRONG FORM OF MARKET EFFICIENCY DOES NOT HOLD)
A. FUNDAMENTAL ANALYSIS: Important Factors
(OR FIRM FOUNDATION THEORY)
1. EXPECTED GROWTH RATE OF EARNINGS
Longer growth rate ==> higher price
Growth does not go on forever
2. EXPECTED DIVIDEND PAYOUT
Higher price the more paid out.
Stock splits: Why? Small shareholders
3. DEGREE OF RISK
Higher price the less risky
4. LEVEL OF INTEREST RATES
Higher price the lower the interest rates
CAVEATS / PROBLEMS:
1. EXPECTATIONS
2. PRECISE Calculations cannot be made from imprecise decisions-
Don't Justify buy or sell decisions.
3. Information / Analysis may be incorrect
4. Market may not converge to "true value"
Premiums change over time: Growth, Risk etc.
B. TECHNICAL ANALYSIS: MARKET IS
INEFFICIENT!!!
CASTLES IN THE AIR:
Tulip bulb craze in 1634
South sea trade in 1711
1929 stock price valuation: INVESTMENT POOLS
Growth stocks in 1961
NIFTY 50 in 1972
Internet stocks in 2000-2001
==> Can we predict the start of stopping of the above
castles? Stick to your fundamentals
Technical analysts do not adhere exclusively to the view
that prices reflect fundamental values. Adopt the view that
prices are driven by prevailing sentiments.
C. SOME OF THE MIS-INFORMATION
1. CHARTISTS: PREDICT PRICE FROM PAST PRICES.
Special class of mechanical trading rules:
/Filters /Head and Shoulders/flags, pennants, support and resistance
Levels, accumulation levels, corrections, waves, and
breakthroughs.
SLOGANS
"Hold the winners, sell the losers"
"Switch into 'Strong' stocks
"Don't fight the tape"
COMPUTERS JAZZ THIS "ANALYSIS" UP.
The technician relies on prices and, perhaps, volume to reveal
information.
Presuming that prices react slowly over long periods of time to new
information or changes in investor sentiment.
B. TECHNICAL ANALYSIS: MARKET IS
INEFFICIENT!!!
CASTLES IN THE AIR:
Tulip bulb craze in 1634
South sea trade in 1711
1929 stock price valuation: INVESTMENT POOLS
Growth stocks in 1961
NIFTY 50 in 1972
Internet stocks in 2000-2001
==> Can we predict the start of stopping of the above
castles? Stick to your fundamentals
Technical analysts do not adhere exclusively to the view
that prices reflect fundamental values. Adopt the view that
prices are driven by prevailing sentiments.
C. SOME OF THE MIS-INFORMATION
1. CHARTISTS: PREDICT PRICE FROM PAST PRICES.
Special class of mechanical trading rules:
/Filters /Head and Shoulders/flags, pennants, support and resistance
Levels, accumulation levels, corrections, waves, and
breakthroughs.
SLOGANS
"Hold the winners, sell the losers"
"Switch into 'Strong' stocks
"Don't fight the tape"
COMPUTERS JAZZ THIS "ANALYSIS" UP.
The technician relies on prices and, perhaps, volume to reveal
information.
Presuming that prices react slowly over long periods of time to new
information or changes in investor sentiment.
2. MOMENTUM PLAYERS:
==> SELL THE LOSERS, KEEP THE WINNERS -
Past trends up or down will continue as the information is slowly
absorbed by the market, or as the wave of optimism or pessimism
spreads through the market.
This suggests that the series of returns should show positive
autocorrelation. Price increases should tend to be followed by
price increases, and price decreases should tend to be followed by
price decreases.
EVIDENCE: Shows that this is not the case in the long run. Some
evidence that within the year momentum strategies produce profits
Jegadesh and Titman (Journal of Finance, 1993) (the losers are
where it holds perhaps reluctance to recognize losses,
overconfidence..
3. CONTRARIANS
Some technical analysts argue investors overreact to good and bad
news.
Advice is to buy on bad news and sell on good news.
This implies that returns should exhibit negative serial dependence
because price reversals are more likely than continuances of price
changes.
We do not observe this statistically.
2. MOMENTUM PLAYERS:
==> SELL THE LOSERS, KEEP THE WINNERS -
Past trends up or down will continue as the information is slowly
absorbed by the market, or as the wave of optimism or pessimism
spreads through the market.
This suggests that the series of returns should show positive
autocorrelation. Price increases should tend to be followed by
price increases, and price decreases should tend to be followed by
price decreases.
EVIDENCE: Shows that this is not the case in the long run. Some
evidence that within the year momentum strategies produce profits
Jegadesh and Titman (Journal of Finance, 1993) (the losers are
where it holds perhaps reluctance to recognize losses,
overconfidence..
3. CONTRARIANS
Some technical analysts argue investors overreact to good and bad
news.
Advice is to buy on bad news and sell on good news.
This implies that returns should exhibit negative serial dependence
because price reversals are more likely than continuances of price
changes.
We do not observe this statistically.
3.0 EVIDENCE ON THE EMH
Which forms, if any, are supported by examination of the data?
Remember the two adjustments that need to be made:
1. Risk adjustment
Concomitant problem of incorrect risk adjustment.
2. Transaction costs
Need to subtract costs from dollar returns.
A. Evidence on EMH: Weak form
Technical Analysis
vs. THE RANDOM WALK: Market is Semi-strong efficient
RANDOM WALK: Price changes should be uncorrelated
and prices should look like a random walk.
EVIDENCE: PLOTS/CORRELATIONS
NO evidence in support of Technical Analysis
3.0 EVIDENCE ON THE EMH
Which forms, if any, are supported by examination of the data?
Remember the two adjustments that need to be made:
1. Risk adjustment
Concomitant problem of incorrect risk adjustment.
2. Transaction costs
Need to subtract costs from dollar returns.
A. Evidence on EMH: Weak form
Technical Analysis
vs. THE RANDOM WALK: Market is Semi-strong efficient
RANDOM WALK: Price changes should be uncorrelated
and prices should look like a random walk.
EVIDENCE: PLOTS/CORRELATIONS
NO evidence in support of Technical Analysis
B. Semi-Strong form, evidence
CAN WE MAKE RISK ADJUSTED PROFITS FROM PUBLIC INFO?
Accounting changes:
Should we buy firm that announces change of accounting policy or
based on their choice of choice of LIFO versus FIFO
If prices (inflation) are rising, LIFO accounting leads to higher cash
flows because of lower taxes.
But it produces lower net income.
Are investors fooled by accounting changes? Not this one.
Stock splits
Should you buy the stock of firm that has just split?
NO: Plot of stock returns before and after show that could only make
excess returns by being able to predict beforehand what stocks will
split.
Stock repurchases
Should you buy stock of firm that announces share repurchases by
tender offers? NO - Again need to be able to have information
beforehand.
Dividend changes (see next slide for omissions)
Should you buy stock of firm that makes Announcements of changes
in firm's dividend policy, I.e. buy on dividend increase or sell if
decrease/cut dividend.
NO evidence of violation of semi-strong form.
B. Semi-Strong form, evidence
CAN WE MAKE RISK ADJUSTED PROFITS FROM PUBLIC INFO?
Accounting changes:
Should we buy firm that announces change of accounting policy or
based on their choice of choice of LIFO versus FIFO
If prices (inflation) are rising, LIFO accounting leads to higher cash
flows because of lower taxes.
But it produces lower net income.
Are investors fooled by accounting changes? Not this one.
Stock splits
Should you buy the stock of firm that has just split?
NO: Plot of stock returns before and after show that could only make
excess returns by being able to predict beforehand what stocks will
split.
Stock repurchases
Should you buy stock of firm that announces share repurchases by
tender offers? NO - Again need to be able to have information
beforehand.
Dividend changes (see next slide for omissions)
Should you buy stock of firm that makes Announcements of changes
in firm's dividend policy, I.e. buy on dividend increase or sell if
decrease/cut dividend.
NO evidence of violation of semi-strong form.
Efficient Market Hypothesis And Behavioral FinanceIs A Compromise In Sight?
6
What FFJR found is that, on average, stock prices around the date of the split behaved as
shown in Figure 5.

Figure 5. Averaged stock price performance around the split date
According to FFJR findings, the market begins to anticipate a stock split more than two
years before it actually happens and figures out the consequences of the split the day it is
announced.
The event study techniques were further refined by other researchers. Some of the
research designs are quite clever. A bizarre example appeared in a 1985 article in the
Journal of Accounting and Economics by Johnson, Magee, Nagarajan, and Newman.
The title of the article, An Analysis of the Stock Price Reaction to Sudden Executive
Deaths, is self-explaining. The authors found that unexpected CEO deaths are
associated with stock price decreases. However, in cases when the CEO was the
company founder, the stock market tends to react by a price increase, begging the
inference that the ability to create a business is different from the ability to run one.
The efficacy of professional investors is another enduring question. Can they, on
average, provide better investment performance? The research here was focused
primarily on mutual funds. Regrettably, most professional money managers are not able
to provide superior returns.
By 1975, the preponderance of evidence argued that markets were efficient. Statistical
studies showed that technical analysis did not add value (consistent with the weak form
of market efficiency). Event studies found that the market quickly reacts to new
information (consistent with the semi-strong form of market efficiency). And studies of
professional investors performance made a strong case for the strong form market
efficiency.
Tests of Market Efficiency after 1975
As more and more researchers tested the efficient market hypothesis, some rather
controversial evidence began to appear.
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
0.146 0.108
-0.72
0.032
-0.244
-0.483
-3.619
-5.015
-5.411
-5.183
-4.898
-4.563
-4.747
-4.685
-4.49
-6
-5
-4
-3
-2
-1
0
1
-8 -6 -4 -2 0 2 4 6 8
Days relative to announcement of dividend omission
C
u
m
u
l
a
t
i
v
e

a
b
n
o
r
m
a
l

r
e
t
u
r
n
s

(
%
)
Efficient market
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout Do Dividend Omissions Signal Future Earnings or Past Earnings?
Journal of Investing (Spring 1997)
Value Line reclassifications
Should you buy stock of firm after Value line Announcement of
reclassification of firms into higher or lower Value Line group.
Highest rank is 1 (buy recommendation); lowest rank is 5 (sell
recommendation).
==> NO - Again need to be able to have information beforehand.
Earnings announcements
Should we buy stock of firm who suprises the market with stronger
than expected earnings? or sell with weaker than expected?
Look at return versus amount of unexpected earnings change.
Classified into portfolios on basis on magnitude of earnings
"surprise."
YES - It appears that excess returns are possible here even many days
after announcement.
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
0.146 0.108
-0.72
0.032
-0.244
-0.483
-3.619
-5.015
-5.411
-5.183
-4.898
-4.563
-4.747
-4.685
-4.49
-6
-5
-4
-3
-2
-1
0
1
-8 -6 -4 -2 0 2 4 6 8
Days relative to announcement of dividend omission
C
u
m
u
l
a
t
i
v
e

a
b
n
o
r
m
a
l

r
e
t
u
r
n
s

(
%
)
Efficient market
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout Do Dividend Omissions Signal Future Earnings or Past Earnings?
Journal of Investing (Spring 1997)
Value Line reclassifications
Should you buy stock of firm after Value line Announcement of
reclassification of firms into higher or lower Value Line group.
Highest rank is 1 (buy recommendation); lowest rank is 5 (sell
recommendation).
==> NO - Again need to be able to have information beforehand.
Earnings announcements
Should we buy stock of firm who suprises the market with stronger
than expected earnings? or sell with weaker than expected?
Look at return versus amount of unexpected earnings change.
Classified into portfolios on basis on magnitude of earnings
"surprise."
YES - It appears that excess returns are possible here even many days
after announcement.
C. Strong form, evidence
Mutual funds (SEE graph next slide)
Do mutual funds earn excess returns because fund managers are
either better at picking stocks than most people? or because fund
managers have access to private information?
After adjusting for risk and transaction costs, answer seems to be that
fund managers are NOT better at picking stocks on average.
Insider trading
Do insiders earn excess returns?
Yes, if returns are calculated from time of purchase or sale rather than
from time of announcement of purchase or sale.
The Record of Mutual Funds
Annual Return Performance of Different Types of U.S.
Mutual Funds Relative to a Broad-Based Market Index
(1963-1998)
-60.00%
-50.00%
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
All funds Small-
company
growth
funds
Other-
aggressive
growth
funds
Growth
funds
Income
funds
Growth and
income
funds
Maximum
capital
gains
funds
Sector
funds
A
n
n
u
a
l

R
e
t
u
r
n

P
e
r
f
o
r
m
a
n
c
e
Taken from Lubos Pastor and Robert F. Stambaugh, Evaluating and Investing in Equity Mutual Funds, unpublished paper,
Graduate School of Business, University of Chicago (March 2000).
C. Strong form, evidence
Mutual funds (SEE graph next slide)
Do mutual funds earn excess returns because fund managers are
either better at picking stocks than most people? or because fund
managers have access to private information?
After adjusting for risk and transaction costs, answer seems to be that
fund managers are NOT better at picking stocks on average.
Insider trading
Do insiders earn excess returns?
Yes, if returns are calculated from time of purchase or sale rather than
from time of announcement of purchase or sale.
The Record of Mutual Funds
Annual Return Performance of Different Types of U.S.
Mutual Funds Relative to a Broad-Based Market Index
(1963-1998)
-60.00%
-50.00%
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
All funds Small-
company
growth
funds
Other-
aggressive
growth
funds
Growth
funds
Income
funds
Growth and
income
funds
Maximum
capital
gains
funds
Sector
funds
A
n
n
u
a
l

R
e
t
u
r
n

P
e
r
f
o
r
m
a
n
c
e
Taken from Lubos Pastor and Robert F. Stambaugh, Evaluating and Investing in Equity Mutual Funds, unpublished paper,
Graduate School of Business, University of Chicago (March 2000).
CONCLUSIONS
Evidence supports weak and semi-strong forms of market
efficiency but not strong form.
Implication: to make excess profits
Need information no one else has
or
Ability to process available information much better
There are anomalies:
Little evidence that they produce large dollar profits consistently after
adjustments for risk and transaction costs. (Short-run momentum is
one possible exception depends on transaction costs.)
Implications
DIVERSIFY, GET THE INFORMATION FIRST,
Avoid transaction costs, MINIMIZE TAXES
CONCLUSIONS
Evidence supports weak and semi-strong forms of market
efficiency but not strong form.
Implication: to make excess profits
Need information no one else has
or
Ability to process available information much better
There are anomalies:
Little evidence that they produce large dollar profits consistently after
adjustments for risk and transaction costs. (Short-run momentum is
one possible exception depends on transaction costs.)
Implications
DIVERSIFY, GET THE INFORMATION FIRST,
Avoid transaction costs, MINIMIZE TAXES

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Professor Gordon Phillips 1

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