Laurence Booth Sean Cleary. LEARNING OBJECTIVES Market Efficiency 10 10.1 Explain the importance of...

Laurence Booth

Sean Cleary

LEARNING OBJECTIVESLEARNING OBJECTIVES

Market Efficiency10

10.1 Explain the importance of the concept of market efficiency.10.2 Explain what is meant by “market efficiency.”10.3 Differentiate among the different levels of efficiency.10.4 Discuss the general consensus based on empirical evidence of

market efficiency, as well as the existence of some well-known anomalies.

10.5 Differentiate between behavioural finance and the traditional view of finance.

10.6 Explain the implications of market efficiency.

10.1 THE IMPORTANCE OF MARKET EFFICIENCY

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• Understanding security valuation provides guidelines to managers about how they should manage businesses on behalf of shareholders

• The discount rate that represents shareholders’ required rate of return is established as a result of benchmark rates in the capital markets such as the risk-free rate and the market risk premium

• If market prices reflect the actions of managers, then managers must learn what actions they should take in order to fulfill their legal and managerial responsibilities to shareholders

© John Wiley & Sons Canada, Ltd.Booth • Cleary – 3rd Edition


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• There are three elements of market efficiency:– Operational efficiency: transaction costs are low, thereby

enhancing trading of securities– Allocational efficiency: there are enough securities to

efficiently allocate risk– Informational efficiency: market prices fairly and quickly

reflect all available information about the firm and managers’ actions


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• The closer the link between managers’ actions and the value of the firm, the more informationally efficient the capital market

• Securities laws in Canada reflect the belief that there is, or should be, a strong connection between information and stock prices and these laws reflect a number of common principles related to parties, transactions and access to information, such as:– Continuous disclosure of all material information about the firm.– Fair and equal treatment of all market participants through

disclosure requirements that ensure all participants have simultaneous access to the same information about publicly traded firms. This avoids information asymmetries (i.e., when one party to a transaction has access to a more complete and accurate set of facts than the other party; that party has an advantage over other parties to the transaction)



• An efficient market is a market that reacts quickly and relatively accurately to new public information, which results in prices that are correct on average.

• For markets to operate efficiently, four conditions must exist:1. A large number of rational, profit-maximizing investors exist, who

actively participate in the market by analyzing, valuing and trading securities. The markets must be competitive, meaning no one investor can significantly affect the price of the security through their own buying and selling.

2. Information is costless and widely available to market participants at the same time.

3. Information arrives randomly and therefore announcements over time are not serially connected.

4. Investors react quickly and fully (and reasonably accurately) to the new information, which is reflected in stock prices.

6© John Wiley & Sons Canada, Ltd.Booth • Cleary – 3rd Edition


10.3 THE EFFICIENT MARKET HYPOTHESIS (EMH)

• The efficient market hypothesis (EMH) is the theory that markets are efficient and therefore, in its strictest sense, implies that prices accurately reflect all available information at any given time.

• There are three forms of the EMH: – Weak Form EMH– Semi-strong Form EMH– Strong Form EMH


• Weak Form EMH is the theory that security prices reflect all market data, referring to all past price and volume trading information.

• Implication: Markets that are weak-form efficient will have all historical trading data reflected or discounted in current prices and these should be of no value in predicting future prices changes.



• Semi-strong Form EMH is the theory that all publicly known and available information is reflected in security prices. It assumes the weak-form set of information is incorporated as well as all public information pertinent to the security such as: earnings, dividends, corporate investments and management changes.

• Implication: Markets that are semi-strong-form efficient will have all publicly available information reflected or discounted in current prices and so it is futile to analyze public information in an attempt to identify mispriced securities.



• Strong Form EMH is the theory that all public and private information is reflected in security prices.

• Implication: Markets that are strong-form efficient always have securities that are fairly priced. Therefore, neither publicly available information nor insider information can be used to identify mispriced securities.



• All scientific tests of the efficient market hypothesis attempt to demonstrate that using a particular source of information allows an investor to consistently earn abnormal returns.

• Abnormal returns are percentage returns that are greater than the returns from a naïve buy-and-hold strategy where an investor passively buys a market index portfolio such as the S&P/TSX 60 Composite Index.

• These studies attempt to identify active investment strategies based on trading rules and sources of information that generate greater risk-adjusted returns than a passive, naïve investment strategy. If such strategies exist, then, depending on the nature of the strategy, forms of the EMH can be declared invalid.


10.4 EMPIRICAL EVIDENCE REGARDING MARKET EFFICIENCY


Weak Form Evidence• Anomalies are exceptions to a rule or theory. Note: an anomaly

may not violate a theory if it cannot be consistently and profitably exploited after accounting for transaction costs and taxes

• The random walk hypothesis states that security prices follow a random walk with price changes over time being independent from one period to the next. This hypothesis is logical if information arrives randomly, as it should, and if investors react quickly to it.

• Tests of weak form efficiency include:– Serial correlation tests– Runs (or signs) tests– Testing of trading rules used by technical analysts


Several anomalies contest weak form market efficiency:1. Investors overreact to

new information and this leads stock prices to over-shoot and under-shoot intrinsic value. Therefore, stock price reversals can, in some cases, favour contrarian trading strategies.


2. Momentum has been detected in stock returns (see Figure 10.1)3. Seasonal patters have been detected in stock returns, including the January

effect, day-of-the-week effect, and day-of-the-month effect

10.4 EMPIRICAL EVIDENCE REGARDING MARKET EFFICIENCYWeak Form Evidence

Weak Form Evidence• The anomalies identified by studies of financial markets

are very difficult and risky to exploit because:– Transaction costs reduce or even eliminate the

economic advantage– The anomalies occur too inconsistently to be a reliable

source of abnormal returns• Weak Form EMH Conclusion: Capital markets appear to

be weak-form efficient.



Semi-Strong Form Evidence• Tests of semi-strong form efficiency include:

– Event studies on the impact of earnings surprises and corporate announcements on stock prices

– Studies that test whether investors can use publicly available information to consistently generate abnormal returns over the long-term



Semi-Strong Form EvidenceEvent Studies• Examine stock returns to determine the impact of a particular

event on stock prices before, during and following the event• Events include:

– Company-specific announcements, such as stock splits, dividend changes, accounting policy changes and takeovers

– Economic changes, such as unexpected interest rate changes



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Semi-Strong Form EvidenceEvent StudiesFigure 10-2 illustrates the price adjustment process for:a.an efficient market b.overreaction in an inefficient

marketc.slow reaction in an efficient

market



Event Studies• Most event studies

have shown that stock prices change before an announcement, as demonstrated in Figure 10-3

• Therefore, an investor cannot usually move quickly enough when


an announcement is made to profit from the new information• This supports semi-strong form EMH, but this does not support the

strong form EMH because some investors are able to profit from private information that will cause price changes when announcements occur


Earnings Surprises• Several studies have identified a lag when earnings either exceed or fall short

of consensus earnings estimates• Positive earnings surprises cause stock prices to go up• Negative earnings surprises cause stock prices to drop• These substantial adjustments after the announcement date contract the

semi-strong form of the EMHSemi-Strong Anomaly Tests• The strongest evidence of semi-strong market efficiency is the fact that

professional fund managers with all their training, expertise, technological capability and access to date generally and on average do not consistently outperform the market on a risk-adjusted basis.

• After expenses, the average professional fund manager performs worse than their performance benchmarks over the long-term



Investment Styles• Value investment styles consistently outperform growth

investing• Value stocks have below-average price-earnings (P/E) ratios

and market-to-book (M/B) ratios, and above-average dividend yields

• Growth stocks are those that have above-average P/E and M/B ratios and below-average dividend yields, because investors are prepared to pay a premium for expected future growth in earnings and share price



Size Effect• Small capitalization stocks outperform the broad market,

although their returns were much more volatile• These findings contradict the semi-strong form of the

EMH, but transaction costs make it difficult to profit from this anomaly



The Value Line Investment Survey Effect• The Value Line Investment Survey is a widely followed stock

analysis publication that ranks stocks from best (1) to worst (5)• Substantial empirical evidence suggests that stocks ranked 1 or 2

experience superior performance over the following 12 months, while those that are assigned to lower-ranked categories perform poorly

• These findings contradict the semi-strong form of the EMH• However, transaction costs make it difficult to profit from this

anomaly



Semi-strong Form EMH Conclusion: Most studies support the semi-strong form of the EMH, although a number of anomalies have been identified.

Summary of Semi-Strong Form Anomalies:• Value investing has consistently outperformed growth investing• The size effect shows that small market capitalization (small cap)

stocks tend to outperform large capitalization stocks on a risk-adjusted returns basis

• The Value Line Investment Survey effect



Strong Form EvidenceEvidence on Strong Form Efficiency• If a market is strong-form efficient, then not even insiders could profit from

using information about the company that is unknown to the investing public, since prices reflect all public and private information

• Tests of strong form efficiency focus on determining whether any group of investors has information that allows them to earn abnormal profits consistently– Several studies have found consistent abnormal profits, while others found

only slightly better than average returnsStrong Form EMH Conclusion: On balance, evidence does not support the strong

form of the EMH. Insider trading laws restrict the ability of investors to act on their inside information. These laws may explain the lack of strong evidence for this form of the EMH.



1. Weak form efficiency is very well supported, although a few anomalies do exist

2. Semi-strong form efficient is well supported, but more contradictory evidence exists for this version of the EMH than for the weak form

3. Strong form efficiency is not very well supported by the evidence, and it is reasonable to conclude that markets are not strong form efficient in the strictest sense



10.5 BEHAVIOURAL FINANCE• Behavioural finance is a field of financial thought that suggests investor

behaviour is not always rational but is influence by psychological biases that cause investors to make systematic errors in judgement

• The “traditional view of finance” suggests that investors:– Consider all available information– Act rationally and do not make systematic errors, either in

processing information or in implementing decisions– Adhere to the basic tenets of modern portfolio theory, which implies

they are risk averse, they diversify, and they consider risk in the context of a well-diversified portfolio

• But, to quote a legendary investor, Peter Bernstein, evidence “reveals repeated patterns of irrationality, inconsistency and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.”


• Loss aversion causes an investor to place a heavier emphasis on losses than on comparable gains.

• Unlike risk aversion, where investors dislike risk but are willing to assume it if they are adequately compensated, loss aversion results in investors seeking to avoid loss even if it results in suboptimal investment decisions such as: investing too conservatively, holding on to poor investments too long, or selling good investments too quickly

• Anchoring is the tendency to become emotionally tied to some initial price or perception, so investors may be unwilling to sell an investment that has lost value until they recover their investment even though the investment is unlikely to regain its value

• Mental accounting is the process of accounting for individual investments separately which can result in poor diversification and inconsistent attitudes towards risk depending on the source of funds


10.5 BEHAVIOURAL FINANCE

• Bubbles are significant and generally unwarranted increases in asset prices that lead to unsustainably high price levels

• Notable bubbles through history:– Dutch Tulip Bulb Bubble (1636)– South Sea Bubble and Mississippi Bubble (1720)– U.S. Stock Price Bubble (1927 to 1929)– Japanese Real Estate and Stock Price Bubble (1985 to 1989)– Internet Stock Bubble (1995 to 2000)– U.S. Real Estate Bubble and Sub-Prime Crisis (2000s)

• In bubbles investors exhibit herd-like behaviour, overconfidence and fear of regret if they fail to participate in the bubble

• Investors also place heavier than normal emphasis on the importance of recent (positive) events during bubbles, and discount past, less spectacular returns as being unimportant or irrelevant to the future


10.5 BEHAVIOURAL FINANCE

10.6 IMPLICATIONS OF MARKET EFFICIENCY• Empirical evidence suggests: markets react quickly and relatively

accurately to new public information• Markets may not be perfectly efficient, but they are relatively

efficientImplications for Investors1. Technical analysis is not likely to be rewarded2. Fundamental analysis is also unlikely to be successful at generating

abnormal profits after transaction costs and taxes3. Active trading strategies are unlikely to outperform passive, buy-and-

hold strategies, favouring index mutual funds or exchange-traded funds (ETFs)

4. Investors should focus on the basics of good investing by defining investment goals in terms of expected returns and acceptable risk levels


Implications for Corporate Officers1. The timing of security issues or share repurchases is

unimportant because prices are correct, over average2. Management should monitor the price of a firm’s

securities to see whether price changes reflect new information or short-run momentum and/or overreaction


10.6 IMPLICATIONS OF MARKET EFFICIENCY

© John Wiley & Sons Canada, Ltd. 31

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COPYRIGHTCopyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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Laurence Booth Sean Cleary. LEARNING OBJECTIVES Market Efficiency 10 10.1 Explain the importance of...

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