Stocks, Stock Markets, and Market Efficiency

1
Chapter 8

• Stocks, Stock Markets, and Market Efficiency

2
Essential Characteristics of Common Stock

• Common stock or equity are shares in a firms
  ownership
  
• Stockholder is merely a residual claimant
• Limited liability
• Why Stocks Are Risky
• Stocks are risky because the shareholders are
  residual claimants. Since they are paid last,
  they never know for sure how much their return
  will be.

3
Valuing Stocks

• Fundamental Value and the Dividend-Discount
  Model
  

4
Valuing Stocks

• assume that the firm pays dividends forever,
  then
  

5
Valuing Stocks
Implications of the Dividend-Discount Model with
Risk Stock Prices are High When
Current dividends are high (Dtoday is high)
Dividends are expected to grow quickly (g is
high) The risk-free rate is low (rf is low)
The risk premium on equity is low (rp is low)

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Investing in Stocks For the Long Run
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Investing in Stocks For the Long Run

• Professor Jeremy Siegel of the University of
  Pennsylvanias Wharton School wrote a book titled
  Stocks for the Long Run
  
• investing in stocks is risky only if you hold
  them for a short time. But if you buy them and
  hold them for long enough, they really are not
  very risky.

8
Perfect Capital Markets (PCM)
Perfect Competition Everyone is a price-taker in
both product and securities markets.
? No individual, firm or financial instruction
conveys market power. Commodity markets (corn c
otton) are examples of price taking markets.
No Transaction Costs Frictionless markets ? N
o taxes or regulation (e.g. no bid-ask spreads or
brokerage fees) Assets are perfectly divisible (B
erkshire Hathaway is an example of a stock that
is not perfectly divisible and creates a
liquidity constraint) Rational Expectations
? Investors interpret information the same, and
each investor knows that they share the same
beliefs. Investors maximize utility, they want mo
re than less (unsatiated) Informationally effic
ient Information is costless and received by
everyone simultaneously. ? search costs are zero
(free price discovery)
9
Valuing Stocks

• The Theory of Efficient Markets
• The notion that the prices of all financial
  instruments, including stocks, reflect all
  available information
  
• When markets are efficient, the prices at which
  stocks currently trade reflect all available
  information, so that future price movements are
  unpredictable.

10
Efficient Market Hypothesis

• The notion that the prices of all financial
  instruments, including stocks, reflect all
  available information
  
• So that future price movements are
  unpredictable.
  
• Securities are normally in equilibrium and are
  fairly priced.
  
• Investors cannot beat the market except through
  better information
  
• 3 forms of the EMH
• Weak-form EMH
• Semistrong-form EMH
• Strong-form EMH

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Efficient Market Hypothesis

• Weak-form EMH
• Current share prices reflect all information
  contained in past patterns of prices
  
• Past share prices cannot be used to predict
  future returns
  
• Adjusted for risk, investors cannot earn excess
  returns by developing trading rules on historical
  price information (Technical analysis)
  
• If technical rules worked, everyone would use
  them. As a result they would not work anymore.
  
• A recent decline is no reason to think stocks
  will go up (or down) in the future.
  
• Evidence supports weak-form EMH

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Efficient Market Hypothesis

• Semi-strong-form EMH
• Implies all the conditions of weak-form and
• Current share prices reflect all publicly
  available information
  
• new public information is priced immediately,
  before it can be traded on
  
• Adjusted for risk, investors cannot earn excess
  returns by trading published or common
  knowledge information.
  
• It doesnt pay to pore over info looking for
  undervalued stocks
  
• Largely true, but superior analysts can still
  profit by finding and using new information
  

13
Semi-Strong Form Efficiency

• Implications
• Market reacts to information about companies
  fundamentals
  
• Macroeconomic news.
• News on earnings.
• Price adjustments are fast and appropriate no
  systematic under/overshooting after
  announcement.
  
• Tests
• Event studies of price reactions to news
  announcements.
  
• Announcements.
• Leading economic indicators.
• Mergers and acquisitions.

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Macroeconomic Announcements

• Time Content of Announcement
• 9.15 am Industrial Production
• Capacity Utilization
• 10.00 am Business Inventories
• Construction Spending
• Factory Inventories NAPM Survey
• New Single-Family Home Sales
• Personal Income
• 2.00 pm Federal Budget

• Time Content of Announcement
• 8.30 am Consumer Price Index
• Durable Goods Orders
• Employment
• Gross National Product
• Housing Starts
• Merchandise Trade Deficit
• Leading Indicators
• Producer Price Index
• Retail Sales

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Reaction to Macroeconomic Announcements

• Question
• How quickly do markets absorb information? Is
  the reaction appropriate?
  
• Results
• Almost all the price adjustment takes place in
  the first minute after the announcement
  
• CPI between 8.30 and 8.31.
• Later adjustments cannot be predicted from
  earlier reactions
  
• No systematic over or underreaction
• No profitable trading on news.

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Efficient Market Hypothesis

• Strong-form EMH
• Implies all the conditions of semi-strong form
  and
  
• Current share prices reflect all information,
  both public and private.
  
• No investor can earn excess returns, including
  those with insider information
  
• Not true--insiders can gain by trading on the
  basis of insider information, but thats
  illegal.
  

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Can excess returns be earned?

• Q Where do you think markets are in term of
  efficiency?
  
• A We can never know for sure since it is
  impossible to measure, but
  
• 1. Evidence exists that insiders CAN earn excess
  return on inside information, so few experts
  believe that markets are strong-form efficient
  
• 2. There is no definitive evidence that investors
  can earn excess returns by studying past prices
  and implementing trading rules.
  
• Paradox ? If such a trading rule existed, and it
  were known, then investors without wealth
  constraints would trade on it until such time
  that it no longer existed.
• It is well known that it is difficult to beat
  an index if you are a professional fund manager
  
• 90 of all funds under perform a passive index

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Efficient market pricing
Stock price
Violates semi-strong form efficiency
Semi-strong form efficiency
Stock prices over time
time
Public annc 1
Public annc 2
Violates strong form efficiency
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Ability to earn excess returns
Q Who can earn excess returns?
Level of efficiency
Strong form
Semi-strong form
Weak form
Firm insiders Smart investors Day traders
Firm insiders Smart investors
Firm insiders
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How efficient are financial markets?

• Semi-Strong form efficient
• The market adjusts almost instantaneously to new
  information

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Rationale Behind the Hypothesis

• When an unexploited profit opportunity arises on
  a security, investors will rush to buy the
  security
  
• Because people would be earning more than they
  should, given the characteristics of that
  security
  
• The increased demand will cause the price to rise
  to the point that the returns are normal again.

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Rationale Behind the Hypothesis (cont.)

• In an efficient market, all unexploited profit
  opportunities will be eliminated.
  
• Not every investor need be aware of every
  security and situation
  
• As long as a few keep their eyes open for
  unexploited profit opportunities, they will
  eliminate the profit opportunities that appear
  because in so doing, they make a profit.

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Evidence on Efficient Market Hypothesis

• Favorable Evidence
• Investment analysts and mutual funds don't beat
  the market
  
• Stock prices reflect publicly available info
• Anticipated announcements don't affect stock
  price
  
• Example Fed Funds rate changes
• Stock prices and exchange rates close to random
  walk
  
• Future changes in stock prices (its return)
  should be unpredictable
  
• Technical analysis does not outperform market
• Studies past data and patterns in the security or
  overall market to predict returns

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Evidence in Favor of Market Efficiency

• Performance of Investment Analysts and Mutual
  Funds should not be able to consistently beat the
  market
  
• The Investment Dartboard often beats investment
  managers.
  
• Mutual funds do not outperform the market on
  average
  
• When they are separated into groups according to
  whether they had the highest or lowest profits in
  a chosen period, the mutual funds that did well
  in the first period do not beat the market in the
  second period.
• Investment strategies using inside information is
  the only proven method to beat the market.
  
• In the U.S., it is illegal to trade on such
  information, but that is not true in all
  countries.
  

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Investment Newsletter Performance

• Graham and Harvey (1995) study the performance of
  recommendations of 200 investment newsletters.
  
• Given the evidence on market efficiency, what
  should we expect?
  
• Even if the newsletter writers have inside
  information - should we expect to make money by
  following their recommendations?

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Performance of All Newsletters
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Performance of Long-Lived Newsletters
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Evidence in Favor of Market Efficiency

• Do Stock Prices Reflect Publicly Available
  Information as the EMH predicts they will?
  
• If information is already publicly available, a
  positive announcement about a company will not,
  on average, raise the price of its stock because
  this information is already reflected in the
  stock price.
• Early academic studies confirm favorable
  earnings announcements or announcements of stock
  splits do not, on average, cause stock prices to
  rise.

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Evidence in Favor of Market Efficiency

• Random-Walk Behavior of Stock Prices that is,
  future changes in stock prices should, for all
  practical purposes, be unpredictable
  
• If stock is predicted to rise, people will buy to
  equilibrium level, if stock is predicted to fall,
  people will sell to equilibrium level (both in
  concert with EMH)
• Thus, if stock prices were predictable, thereby
  causing the above behavior, price changes would
  be near zero, which has not been the case
  historically

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Evidence Against Market Efficiency

• Mean Reversion
• Stocks return patterns have a mean that over
  long periods of time it will revert to
  
• Stocks that have done poorly in the past are more
  likely to do well in the future
  
• What goes up must come down
• This predictable positive change in the future
  price, suggests that stock prices are not a
  random walk.
  
• Some researchers have found that stocks with low
  returns today tend to have high returns in the
  future, and vice versa.

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Evidence in Favor of Market Efficiency

• Technical Analysis means to study past stock
  price data and search for patterns such as trends
  and regular cycles, suggesting rules for when to
  buy and sell stocks
• The EMH suggests that technical analysis is a
  waste of time
  
• The simplest way to understand why is to use the
  random-walk result that holds that past stock
  price data cannot help predict changes
  
• Therefore, technical analysis, which relies on
  such data to produce its forecasts, cannot
  successfully predict changes in stock prices

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Evidence on Efficient Market Hypothesis

• Unfavorable Evidence
• Small-firm effect small firms have abnormally
  high returns
  
• January effect high returns in January
• Market overreaction (irrational)
• Mean reversion
• New information is not always immediately
  incorporated into stock prices (drift)

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Evidence Against Market Efficiency

• The Small-Firm Effect is an anomaly. Many
  empirical studies have shown that small firms
  have earned abnormally high returns over long
  periods of time, even when the greater risk for
  these firms has been considered.
• The small-firm effect seems to have diminished in
  recent years but is still a challenge to the
  theory of efficient markets
  
• Various theories have been developed to explain
  the small-firm effect
  
• due to rebalancing of portfolios by institutional
  investors,
  
• tax issues,
• low liquidity of small-firm stocks
• large information costs in evaluating small
  firms
  
• an inappropriate measurement of risk for
  small-firm stocks

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Evidence Against Market Efficiency

• The January Effect
• the tendency of stock prices to experience an
  abnormal positive return in the month of January
  than is predictable
  
• inconsistent with random-walk behavior
• Effect is stronger for smaller value stocks
• Why is there a January Effect?
• Investors have an incentive to sell stocks before
  the end of the year in December because they can
  then take capital losses on their tax return
  (reduce their tax liability)
• Then when the new year starts in January, they
  can repurchase the stocks, driving up their
  prices and producing abnormally high returns.
  
• Although this explanation seems sensible, it does
  not explain why institutional investors such as
  Mutual funds do not take advantage of the
  abnormal returns in January buy stocks in
  December, thus bidding up their price and
  eliminating the abnormal returns.
• Mutual funds are also probably selling in
  December, WHY?
  

35
Evidence Against Market Efficiency

• Market Overreaction
• Recent research suggests that stock prices may
  overreact to news announcements and that the
  pricing errors are corrected only slowly
  
• Example
• Corporation announces a large decline in
  earnings,
  
• Investors overreact to the news, causing the
  stock price to overshoot is true value
  
• After the initial decline, the rises over
  subsequent days/weeks but reaches a price that is
  below its pre-announcement price.
  
• Violates the EMH because an investor could earn
  abnormally high returns, on average, by buying a
  stock immediately after a poor earnings
  announcement and then selling it after a couple
  of weeks when it has risen back to normal levels.

36
Evidence Against Market Efficiency

• New Information Is Not Always Immediately
  Incorporated into Stock Prices
  
• Although generally true, recent evidence suggests
  that,
  
• Stock prices do not instantaneously adjust to
  profit announcements.
  
• Inconsistent with the efficient market hypothesis
  
  
• Stock prices continue to rise (fall) for some
  time after the announcement of unexpectedly high
  (low) profits
  
• Post-announcement Drift

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Implications for Investing

• How valuable are published reports by investment
  advisors?
  
• Do stock prices always rise when there is good
  news?

38
Implications for Investing

• Should you be skeptical of hot tips?
• YES. If the stock market is efficient, then the
  tip is already priced in the market so that the
  stocks expected return will equal the equilibrium
  return.
• You should expect to realize only the equilibrium
  return.
  
• Thus, the hot tip is not particularly valuable
  and will not enable you to earn an abnormally
  high return.
  
• As soon as the information hits the street, the
  unexploited profit opportunity will quickly be
  eliminated
  

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Implications for Investing

• Do stock prices always rise when there is good
  news?
  
• NO. In an efficient market, stock prices will
  respond to announcements only when the
  information being announced is new and
  unexpected.
• So, if good news was expected (or as good as
  expected), there will be no stock price
  response.
  
• And, if good news was unexpected (or not as good
  as expected), there will be a stock price
  response.

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Implications for Investing

• Efficient Markets prescription for investor
• Investors should not try to outguess, time or
  beat the market by constantly buying and selling
  securities.
  
• This process does nothing but incur commissions
  costs on each trade.
  
• Most investors are guilty of buying high and
  selling low
  
• Jumping on the bandwagon too late

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Implications for Investing

• Efficient Markets prescription for investor
• The investor should pursue a buy and hold
  strategypurchase stocks and hold them for long
  periods of time.
  
• This will lead to the same (if not better)
  returns, on average
  
• The investors net profits will be higher because
  fewer brokerage commissions and transactions
  costs will have to be paid.

42
Implications for Investing

• Efficient Markets prescription for investor
• It is frequently a sensible strategy for a small
  investor to buy into a mutual fund rather than
  individual stocks.
  
• The EMH indicates that no mutual fund can
  consistently outperform the market
  
• An investor should not buy into one that has high
  management fees or that pays sales commissions to
  brokers but rather should purchase a no-load
  (commission-free) mutual fund that has low
  management fees.
• Stock index mutual fund or SYDR

43
Case Any Efficient Markets Lessons from the Tech
Crash of 2000?

• A bubble is a situation in which the price of an
  asset differs from its fundamental market value.
  
• persistent and expanding gaps between actual
  stock prices and those warranted by the
  fundamentals.
  
• These bubbles inevitably burst, creating crashes.
  
  
• Does any version of Efficient Markets Hypothesis
  (EMH) hold in light of sudden or dramatic market
  declines?
  
• Can bubbles be rational?