FIN 614 Capital Market Efficiency Professor Robert B.H. Hauswald Kogod School of Business, AU A Random Walk Down Wall Street From theory of return behavior to its practice Capital market efficiency: the hypothesis, forms information aggregated: markets conform to theory price behavior and empirical evidence common misconceptions and "arbitrage" Investment techniques: beat the markets? common practice: fundamental and technical analysis Of (Wo)Men and Mice: chartists, momentum players, contrarians and other wild beasts 1/25/2011 Market Efficiency Robert B.H. Hauswald 2
Capital Market Efficiency Efficient capital market: current market prices fully reflect available information costless trading rules do not consistently beat the market Price behavior in an efficient market stock price reaction to news in efficient and inefficient markets: nearly instantaneous vs. delayed difference? The Efficient Market Hypothesis (EMH) securities represent zero NPV investments: they are expected to return just their exact risk-adjusted rate modern (US) stock markets are, as a practical matter, efficient Causes of market efficiency: information disclosure competition among investors and traders, trading regulation 1/25/2011 Market Efficiency Robert B.H. Hauswald 3 Efficient Capital Markets An efficient capital market is one in which stock prices fully reflect available information. The EMH has implications for investors and firms. Since information is reflected in security prices quickly, knowing information when it is released does an investor no good. Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market. 1/25/2011 Market Efficiency Robert B.H. Hauswald 4
New Information in Efficient and Inefficient Markets Stock Price Overreaction to "good news" with reversion Efficient market response to "good news" Delayed response to "good news" -30-20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement 1/25/2011 Market Efficiency Robert B.H. Hauswald 5 New Information in Efficient and Inefficient Markets Stock Price Efficient market response to "bad news" Delayed response to "bad news" -30-20 -10 0 +10 +20 +30 Overreaction to "bad news" with reversion Days before (-) and after (+) announcement 1/25/2011 Market Efficiency Robert B.H. Hauswald 6
Illustration of News: Earnings Announcements 1/25/2011 Market Efficiency Robert B.H. Hauswald 7 Event Studies Suppose in the month of July (2003) 6 firms report earnings early in the day on the following dates: Firm Earnings announcement date Day +1 1 Tues 7-8-03 Wed 7-9-03 2 Thur 7-9-03 Fri 7-10-03 3 Wed 7-16-03 Thur 7-17-03 4 Fri 7-18-03 Mon 7-21-03 5 Tues 7-22-03 Wed 7-23-03 6 Wed 7-23-03 Thur 7-23-03 In event time, the earnings announcement date is day 0. 1/25/2011 Market Efficiency Robert B.H. Hauswald 8
Event Studies Cumulative Abnormal Return 10% 5% 0% -5% -10% -5-4 -3-2 -1 0 +1 +2 +3 +4 +5 Event Time (in days) Abnormal return The actual return minus the expected return Could just be the market index return for the day, or the market index return times the beta of the firm reporting the earnings announcement (CAPM) The positive jump on day 0 implies that the earnings news was, on average for these firms, better than expected: adjusting for market movements! Because the line is flat after day 0, the market seems to fully incorporated the earnings news on the event day: no additional upward or downward price trend is seen 1/25/2011 Market Efficiency Robert B.H. Hauswald 9 Response to Democratic Victory in 2006 10
Different Types of Efficiency Weak Form Security prices reflect all information found in past prices and volume. Semi-Strong Form Security prices reflect all publicly available information. Strong Form Security prices reflect all information public and private. 1/25/2011 Market Efficiency Robert B.H. Hauswald 11 Weak Form Market Efficiency Security prices reflect all information found in past prices and volume. if the weak form of market efficiency holds, then technical analysis (extrapolation) is of no value. often weak-form efficiency is represented as P t = P t-1 + Expected return + random error t Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk. 1/25/2011 Market Efficiency Robert B.H. Hauswald 12
Semi-Strong 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. 1/25/2011 Market Efficiency Robert B.H. Hauswald 13 Strong Form Market Efficiency Security Prices reflect all information public and private: even inside information! Strong form efficiency incorporates weak and semi-strong form efficiency. Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security s price. 1/25/2011 Market Efficiency Robert B.H. Hauswald 14
Three Different Information Sets All information relevant to a stock Information set of publicly available information Information set of past prices 1/25/2011 Market Efficiency Robert B.H. Hauswald 15 Three Approaches to Security Selection Technical Analysis historical price and volume movements can identify price patterns from which future prices can be forecast Fundamental Analysis Forecast future free cash flows, find PV of these to estimate security s Intrinsic Value, buy if Intrinsic value is greater than price of security ("Margin of Safety") Efficient Market Selection Assumes Fundamental Analysis works so well that current market prices will be equal to their Intrinsic Value, buy and hold, earn a return for risk bearing not security selection 1/25/2011 Market Efficiency Robert B.H. Hauswald 16
Investment Research 1/25/2011 Market Efficiency Robert B.H. Hauswald 17 Views Contrary to Market Efficiency Stock Market Crash of 1987 The market dropped between 20 percent and 25 percent on a Monday following a weekend during which little surprising information was released. Temporal Anomalies Turn of the year, month, week. Speculative Bubbles Sometimes a crowd of investors can behave as a single squirrel. 1/25/2011 Market Efficiency Robert B.H. Hauswald 18
The Evidence The record on the EMH is extensive, and in large measure it is reassuring to advocates of the efficiency of markets. Studies fall into three broad categories: 1. Are changes in stock prices random? Are there profitable "trading rules"? 2. Event studies: does the market quickly and accurately respond to new information? 3. The record of professionally managed investment firms. 1/25/2011 Market Efficiency Robert B.H. Hauswald 19 Are Changes in Stock Prices Random? Can we really tell? Psychologists and statisticians believe that most people want to see patterns even when faced with pure randomness. 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 weakform efficiency 1/25/2011 Market Efficiency Robert B.H. Hauswald 20
Technical Analysis The market is inefficient, long live the market!!!! Castles in the air: mania, bubbles, panics, crashes Tulip bulb craze in 1634, South sea trade in 1711 1929 stock price valuation: INVESTMENT POOLS Growth stocks in 1961, NIFTY 50 in 1972 High tech in 2000? stick to your fundamentals? Technical analysts: prices reflect "sentiment" prices reflect more than fundamental values prices are driven by prevailing market sentiments 1/25/2011 Market Efficiency Market Efficiency Robert B.H. - 8 Hauswald 21 Misinformation or Marketing? Chartists: predict future from past prices Mechanical trading rules: head & shoulders/flags, pennants, support, resistance levels, accumulation levels, corrections, waves, breakthroughs "Hold the winners, sell the losers" "Switch into 'Strong' stocks" "Don't fight the tape" Computers jazz up technical analysis belief: past prices and volume reveal information prices react slowly over long periods of time to new information or changes in investor sentiment 1/25/2011 Market Efficiency Robert B.H. Hauswald 22
Primary, Secondary and Ripple Movements Each Primary Move is made up of Three Secondary Moves 80 70 M a r k e t P r ic e 60 50 40 30 Primary Secondary 20 0 10 20 30 40 50 60 Date 1/25/2011 Market Efficiency Robert B.H. Hauswald 23 Price Head & Shoulders Move Head Right Shoulder Left Shoulder Neckline Time 1/25/2011 Market Efficiency Robert B.H. Hauswald 24
Support & Resistance Levels 50 45 Resistance Level Price 40 35 30 Support Level 25 0 20 40 60 80 100 Date 1/25/2011 Market Efficiency Robert B.H. Hauswald 25 Momentum Players Motto: "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 Suggests that the series of returns should show positive autocorrelation (correlation over time) price increases should tend to be followed by price increases, and price decreases should tend to be followed by price decreases Cyclical patterns and volatility: look at recent price plots 1/25/2011 Market Efficiency Robert B.H. Hauswald 26
Contrarians at the Gates! Assumption: investors overreact to good and bad news investors are irrational? Advice is to buy on bad news and sell on good news returns should exhibit negative serial dependence because price reversals are more likely than continuances of price changes PLOT of actual and simulated stock prices: Figure 13.5 then trade! Weekly closing of the Dow-Jones Industrials, 1955-1956 ==> Garbage in, Garbage out 1/25/2011 Market Efficiency Robert B.H. Hauswald 27 Evidence on EMH: Weak Form Technical analysis (past prices!) should not work if the market moved in a true random fashion; so test chartists vs. random walk: market is semi-strong efficient random walk: price changes should be uncorrelated and prices should look like a random walk without patterns and all-over the place statistical evidence: plots, correlations, statistical tests long term profitability of technical trading rules horse races of different trading strategies NO evidence in support of Technical Analysis net of trading costs and risk adjustment! 1/25/2011 Market Efficiency Robert B.H. Hauswald 28
Why Technical Analysis Fails Stock Price Investor behavior tends to eliminate any profit opportunity associated with stock price patterns. Sell Buy Sell Buy If it were possible to make big money simply by finding "the pattern" in the stock price movements, everyone would do it and the profits would be competed away. Time 1/25/2011 Market Efficiency Robert B.H. Hauswald 29 Tests of Semi-Strong and Strong Forms Which forms, if any, are supported by statistical examination of the data? test different versions against trading strategies theory meets practice: how could both be right? Recall two adjustments that we need to make 1. Risk adjustment: concomitant problem of incorrect risk adjustment 2. Transaction costs: need to subtract trading costs from dollar returns mechanical trading incurs high costs 1/25/2011 Market Efficiency Robert B.H. Hauswald 30
Fees and Transaction Costs 1/25/2011 Market Efficiency Robert B.H. Hauswald 31 Testing the Semi-Strong EMH Using public information, can one generate riskadjusted trading profits? Investigate accounting changes based strategies should we buy stock in companies that announces change of accounting policy buy stock based on firms choice of LIFO vs FIFO if prices (inflation) are rising, LIFO accounting leads to higher cash flows because of lower taxes but it produces lower net income. "Fooling" investors by changes in accounting? Not this one 1/25/2011 Market Efficiency Robert B.H. Hauswald 32
Event Studies Tests Event Studies are tests of the semi-strong form of market efficiency, i.e., whether prices reflect all publicly available information. Event studies examine prices and returns over time particularly around the arrival of new information test for evidence of underreaction, overreaction, early reaction, delayed reaction around the event adjusting for market-wide effects: idiosyncratic returns in response to "relevant" new information 1/25/2011 Market Efficiency Robert B.H. Hauswald 33 Event Study Results Event study methodology has been applied to a large number of events including: Dividend increases and decreases; earnings announcements Mergers; capital-structure changes; new issues of stock Capital spending; R&D The studies generally support the view that the market is semistrong-from efficient. markets may even have some foresight into the future news tends to leak out in advance of public announcements. 1/25/2011 Market Efficiency Robert B.H. Hauswald 34
The Record on Mutual Funds If the market is semistrong-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. 1/25/2011 Market Efficiency Robert B.H. Hauswald 35 The Record of Mutual Funds All funds -2.13% Smallcompany growth Otheraggressive growth Growth Income Growth and income -0.39% -0.51% Maximum capital gains -2.17% -2.29% Sector -1.06% -5.41% -8.45% Taken from Lubos Pastor and Robert F. Stambaugh, "Mutual Fund Performance and Seemingly Unrelated Assets," Journal of Financial Exonomics, 63 (2002). 1/25/2011 Market Efficiency Robert B.H. Hauswald 36
Evidence on Strong EMH Form Stock prices reflect all publicly AND privately available information: implies what? Mutual funds excess returns are fund managers are either better at picking stocks than most people? access to private information? after adjusting for risk and transaction costs: managers apparently NOT better at picking stocks on average Insider trading: do insiders earn excess returns? Yes, if returns calculated from time of purchase or sale rather than from time of announcement of purchase or sale 1/25/2011 Market Efficiency Robert B.H. Hauswald 37 Past Performance and Beating the Market 1/25/2011 Market Efficiency Robert B.H. Hauswald 38
The Forms of Market Efficiency Weak efficiency: you cannot beat the market by knowing past prices and trading on this knowledge supported by evidence after risk and trading cost adjustments Semi-strong efficiency: you cannot consistently beat the market using publicly available information most controversial form of the theory: largely supported Strong efficiency: no (public or private) information of any kind can be used to beat the market evidence shows this form does not hold so become an insider? 1/25/2011 Market Efficiency Robert B.H. Hauswald 39 EMH Misconceptions Capital market history shows: 1. prices respond very rapidly to new information 2. future prices changes are difficult to predict 3. mispriced stocks (accurately predictable future price level): difficult to identify and exploit Market efficiency does not mean irrelevance of investment decisions: the risk/return trade-off still applies rather: you cannot expect to consistently "beat the market" on a risk-adjusted basis using costless trading strategies The EMH does not say prices are random; but rather price changes in an efficient market are random and independent: they cannot be predicted before they happen 1/25/2011 Market Efficiency Robert B.H. Hauswald 40
Conclusions Markets are reasonably efficient evidence supports weak and semi-strong forms of market efficiency but not strong form Implication for trading: to make excess profits need information no one else has, or ability to process available information much better There are market anomalies, BUT little evidence that they produce large dollar profits consistently after adjusting for risk and transaction costs many an "arbitrage strategy" is NOT riskless! Implications: beating the market is hard, so do your homework: get information first and diversify avoid transaction costs, minimize taxes, corporate governance 1/25/2011 Market Efficiency Robert B.H. Hauswald 41 The Take-Away 1/25/2011 Market Efficiency Robert B.H. Hauswald 42