FINANCE IN A FINANCE IN A CANADIAN SETTINGCANADIAN SETTING

Sixth Canadian EditionSixth Canadian Edition

Lusztig, Cleary, Lusztig, Cleary, SchwabSchwab

CHAPTER NINECHAPTER NINE

Market EfficiencyMarket Efficiency

Learning ObjectivesLearning Objectives

1.1. Compare and contrast the three forms of Compare and contrast the three forms of market efficiency.market efficiency.

2.2. Define and compare fundamental analysis Define and compare fundamental analysis and technical analysis.and technical analysis.

3.3. Discuss the random walk hypothesis and its Discuss the random walk hypothesis and its implications for investors.implications for investors.

4.4. Explain the role of information in market Explain the role of information in market efficiency and what this means to investors.efficiency and what this means to investors.

5.5. Discuss the empirical evidence about market Discuss the empirical evidence about market efficiency and draw some conclusions.efficiency and draw some conclusions.

Market PricesMarket Prices

Whether a stock price is “right” Whether a stock price is “right” depends on whether the market has depends on whether the market has chosen the proper discount rate and chosen the proper discount rate and whether future cash flow expectations whether future cash flow expectations are correct are correct

Efficient marketEfficient market – a market that gets – a market that gets future expectations and prices “right”future expectations and prices “right”

Information efficiencyInformation efficiency – implies proper – implies proper forecasting and pricingforecasting and pricing

Market EfficiencyMarket Efficiency

Efficient markets hypothesis (EMH)Efficient markets hypothesis (EMH) – – states that markets are efficient, with states that markets are efficient, with market prices reflecting all available market prices reflecting all available information at any given time information at any given time

Three common forms of market Three common forms of market efficiency include:efficiency include:

1.1. Weak formWeak form – states that stock prices – states that stock prices fully reflect all information contained fully reflect all information contained in past prices and volumes of tradingin past prices and volumes of trading

Market EfficiencyMarket Efficiency

2.2. Semi-strong formSemi-strong form – suggests security – suggests security prices adjust rapidly reflecting all prices adjust rapidly reflecting all available public informationavailable public information

3.3. Strong formStrong form – implies share prices – implies share prices reflect all public information and reflect all public information and relevant information such as insider relevant information such as insider tradingtrading

Trading StrategiesTrading Strategies

Fundamental analysisFundamental analysis – uses – uses economic, industry, and company economic, industry, and company data to estimate a fundamental value data to estimate a fundamental value for a stockfor a stock

Technical analysisTechnical analysis – uses recent – uses recent patterns in stock price movements to patterns in stock price movements to determine what to buy and what to determine what to buy and what to sellsell

Random Walk Random Walk HypothesisHypothesis

RWH argues that technical and RWH argues that technical and fundamental analysis are not fundamental analysis are not accurate analysing toolsaccurate analysing tools

RWH suggests that stock price RWH suggests that stock price movements are unpredictablemovements are unpredictable

Implications of the EMHImplications of the EMH

For the investor, the EMH implies:For the investor, the EMH implies:

1.1. Since all publicly available information is Since all publicly available information is reflected in current prices, there is no reflected in current prices, there is no point in researching individual point in researching individual investmentsinvestments

2.2. Investment advisors advice is of no valueInvestment advisors advice is of no value

3.3. Timing regarding when to buy or sell is Timing regarding when to buy or sell is irrelevantirrelevant

Implications of the EMHImplications of the EMH

For corporate financial officers, the EMH For corporate financial officers, the EMH implies:implies:

1.1. Timing of a security issue is unimportantTiming of a security issue is unimportant

2.2. It does not make sense to “play” interest It does not make sense to “play” interest ratesrates

3.3. Since investors always get the price of Since investors always get the price of stocks “right,” managers should pay stocks “right,” managers should pay attention to changes in the firm’s attention to changes in the firm’s securitiessecurities

Conceptual Arguments Conceptual Arguments Regarding Market Regarding Market

EfficiencyEfficiency Three major conceptual reasons Three major conceptual reasons

why financial markets are why financial markets are efficient are:efficient are:

1.1. Investor rationalityInvestor rationality

2.2. ArbitrageArbitrage

3.3. Competition or new entryCompetition or new entry

Empirical EvidenceEmpirical Evidence

1.1. Weak form evidence Weak form evidence • January effectJanuary effect• Weekend effectWeekend effect

2.2. Semi-strong form evidenceSemi-strong form evidence• The average professional fund manager does The average professional fund manager does

not outperform the market bench market on a not outperform the market bench market on a risk adjusted basisrisk adjusted basis

3.3. Strong form evidenceStrong form evidence• Corporate insiders earned abnormal returns on Corporate insiders earned abnormal returns on

their stock transactionstheir stock transactions

Financial Panics and Stock Financial Panics and Stock Market CrashesMarket Crashes

The most damaging evidence The most damaging evidence against market efficiency is the against market efficiency is the repeated manias, panics, and repeated manias, panics, and crashes throughout the history of crashes throughout the history of financial markets such as:financial markets such as:

- The Great Crash of 1929- The Great Crash of 1929

- Black Monday of 1987- Black Monday of 1987

SummarySummary

1.1. Various degrees of market efficiency, such Various degrees of market efficiency, such as weak, strong, and semi-strong forms as weak, strong, and semi-strong forms can be distinguished.can be distinguished.

• Weak formWeak form efficiency implies that market prices efficiency implies that market prices incorporate all the information that can be incorporate all the information that can be inferred from previous price movements.inferred from previous price movements.

• Semi-strongSemi-strong formform efficiency implies that market efficiency implies that market prices incorporate all publicly available prices incorporate all publicly available information.information.

• Strong formStrong form efficiency implies that all existing efficiency implies that all existing information is incorporated in current prices.information is incorporated in current prices.

SummarySummary

2.2. As in any other areas of business, consistently As in any other areas of business, consistently superior returns can only be achieved through superior returns can only be achieved through sustainable competitive advantage.sustainable competitive advantage.

3.3. The random walk theory postulates that stock The random walk theory postulates that stock price movements are inherently unpredictable.price movements are inherently unpredictable.

4.4. For investors, the existence of efficient markets For investors, the existence of efficient markets implies that no benefits are to be derived from implies that no benefits are to be derived from researching individual securities since all researching individual securities since all available information is already reflected in the available information is already reflected in the price.price.

SummarySummary

5. Both investors and corporate managers 5. Both investors and corporate managers must pay careful attention to the must pay careful attention to the concepts of market efficiency. “Playing concepts of market efficiency. “Playing the market” and reliance on expert the market” and reliance on expert advice may often not provide the advice may often not provide the consistent returns claimed or desired.consistent returns claimed or desired.