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Stocks, Stock Markets, and Market Efficiency

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Title: 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)

6
Investing in Stocks For the Long Run
7
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

11
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

12
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.

14
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

15
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.

16
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.

17
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

18
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
19
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
20
How efficient are financial markets?
  • Semi-Strong form efficient
  • The market adjusts almost instantaneously to new
    information

21
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.

22
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.

23
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

24
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.

25
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?

26
Performance of All Newsletters
27
Performance of Long-Lived Newsletters
28
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.

29
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

30
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.

31
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

32
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)

33
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

34
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

37
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

39
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.

40
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

41
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?
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