Econo
Econo
Econo
13-3
The Different Types
of Efficiency
Weak Form
Security prices reflect all historical information.
Strong Form
Security prices reflect all information—public and private.
13-4
Weak Form Market Efficiency
13-5
Semistrong Form Market
Efficiency
Security prices reflect all publicly
available information.
Publicly available information
includes:
Historical price and volume information
Published accounting statements
Information found in annual reports
13-6
Strong Form Efficiency Market
13-7
Information Sets
All information
relevant to a stock
Information set
of publicly available
information
Information
set of
past prices
13-8
What the EMH Does and Does NOT Say
13-9
What the EMH Does and
Does NOT Say
Stockholder Disinterest
◦ Many are skeptical that the market is
efficient because only a fraction of shares
trade each day
◦ But, as long as traders who believe there is a
reason to incur the cost of a trade
participate in the market it remains efficient
◦ Further, stock price reflects available
information (i.e., is efficient) as long as a
number of interested trader use the available
information
13-10
Who Can Beat The Market ?
(In other words: How efficient is the
market?)
13-11
Why Technical Analysis Fails
Time
13-12
Are Changes in Stock
Prices Random?
Serial correlation coefficients small, support weak
form efficiency and randomness
Can we really tell?
◦ Many psychologists and statisticians believe that most people
do not understand what randomness looks like
◦ People claiming to see patterns in stock price movements are
probably seeing optical illusions.
A matter of degree
◦ Even if we can spot patterns, we need to have returns that
beat our transactions costs.
Random stock price changes support weak form
efficiency.
13-13
Who Can Beat The Market ?
Fundamental Analysts ? Fundamental analysts believe that
stock market values reflect economic values, and that there is
publicly available information that will allow them to form a
better estimate of value than is contained in market prices. If
so, the market would not be semi-strong form efficient. If there
is information that will allow an analyst to form a better
estimate of future cash flows than the market's estimate,
reflected in current price, then there may be money to be
made.
• Evidence suggests that, unless you react first, you are
unlikely to reliably earn abnormal returns. (EVENT
STUDIES, PROFESSIONAL MONEY MANAGERS)
13-14
Event Studies
· Event Studies are one type of test of the semi strong form of
market efficiency.
Recall, this form of the EMH implies that prices should
reflect all publicly available information.
· To test this, event studies examine prices and returns over
time—particularly around the arrival of new information.
· Test for evidence of under reaction, overreaction, early
reaction, or delayed reaction around the event.
· Returns are adjusted to determine if they are abnormal by
taking into account what the rest of the market did that
day.
13-15
Event Studies: Dividend Omissions
Efficient market
response to “bad news”
13-16
Event Study Results
Overthe years, event study methodology has been
applied to a large number of events including:
◦ Dividend increases and decreases
◦ Earnings announcements
◦ Mergers
◦ Capital Spending
◦ New Issues of Stock
The studies generally support the view that the
market is semi strong form efficient.
Studies suggest that markets may even have some
foresight into the future, i.e., news tends to leak
out in advance of public announcements.
13-17
The Record of Mutual Funds
Ifthe market is semi-strong form efficient, then
no matter what publicly available information
mutual fund managers rely on to pick stocks,
their average returns should be the same as
those of the average investor in the market as a
whole.
We can test efficiency by comparing the
performance of professionally managed mutual
funds with the performance of a market index.
13-18
Who Can Beat The Market ?
1. Technical Analysts ?
2. Fundamental Analysts ?
3. Insiders?
Insiders can trade on private information.
Often on impending takeover, new product
innovations, or earnings announcement.
Evidence suggests that insiders can and do make
abnormal returns
Thus, strong form efficiency does not seem to be
substantiated by the evidence.
Is this legal?
Answer: Yes and No
13-19
The Behavioral Challenge
Rationality
People are not always rational.
Many investors fail to diversify, trade too much, and
seem to try to maximize taxes by selling winners and
holding losers.
Psychologists argue that people deviate from
rationality in predictable ways:
Representativeness: drawing conclusions from too little data - This
can lead to bubbles in security prices.
Conservativism: people are too slow in adjusting their beliefs to
new information - Security prices seem to respond too slowly to
earnings surprises.
13-20
The Behavioral Challenge
Arbitrage
Suppose that your superior, rational, analysis shows that
company ABC is overpriced.
Arbitrage would suggest that you should short the shares.
After the rest of the investors come to their senses, you make
money because you were smart enough to “sell high and buy
low.”
But what if the rest of the investment community
doesn’t come to their senses in time for you to cover
your short position?
This makes arbitrage risky.
“Markets can stay irrational longer than you can stay solvent.”
John Maynard Keynes 13-21
Empirical Challenges
Limits to Arbitrage
◦ “Markets can stay irrational longer than you can stay
insolvent.” John Maynard Keynes
Earnings Surprises
◦ Stock prices adjust slowly to earnings announcements.
◦ Behavioralists claim that investors exhibit conservatism.
Size
◦ Small cap stocks seem to outperform large cap stocks.
Value versus Growth
◦ High book value-to-stock price stocks and/or high E/P
stocks outperform growth stocks.
13-22
More Behavioral Economics
Cognitive Biases or Heuristic Decision making
Representativeness or categorization
Judgments based on stereotypes, not probabilities
Anchoring Effect
Forming estimates based on arbitrary value
Framing
Mental Accounting – “House Money”
Loss Aversion
13-23
Reviewing the Differences
13-24
Implications for Corporate Finance
Because information is reflected in security prices
quickly, investors should only expect to obtain a
normal rate of return.
Awareness of information when it is released does an investor little
good. The price adjusts before the investor has time to act on it.
13-25
Implications for Corporate
Finance
The EMH has three implications for corporate
finance:
1. The price of a company’s stock cannot be
affected by a change in accounting.
2. Financial managers cannot “time” issues of stocks
and bonds using publicly available information.
3. A firm can sell as many shares of stocks or bonds
as it desires without depressing prices.
There is conflicting empirical evidence on all
three points.
13-26