Market Efficiency – Part I

Market Efficiency & Modern Financial Management

Efficiency in financial versus product markets Why financial markets tend to be more competitive & efficient

Introduction to market efficiency Key feature of modern economic thought & market workings

What is an efficient market? The three forms of market efficiency

The three “forms” of market efficiency Weak form, semi-strong form, and strong-form efficiency

What does market efficiency imply for corporate financial management? How do markets process firm-specific information releases? How should managers communicate with investors & analysts?

Financial Versus Product Markets

Many examples of corporations creating value through real asset investments R&D, product innovations, marketing programs create value Few product markets approach perfect competition standard Manufactured goods face barriers to entry (branding, capital

requirements, physical distribution costs)

Far fewer opportunities to create value through purely financial activities Financial markets much larger, more competitive, more

transparent, more homogeneous than product markets Innovations cannot be patented; easily imitated Arbitrage is easy & safe; keeps relative prices in line

Much harder to create value thru purely financial activities

Economic Definitions Of Efficiency

Form Definition Example

Allocative A financial system exhibits allocative efficiency if it allocates capital to its highest and best (most productive) use.

Stock market investors shun security offers from firms in declining industries, but welcome offerings from firms in more promising industries.

Operational A financial system exhibits operational efficiency if it produces a given output at lowest possible input cost--or, alternatively, it maximizes output for any given level of inputs.

Average daily trading volume on the New York Stock Exchange now over 10 times its level of 20 years ago--in the same Wall Street location. The NASDAQ market’s trading volume has increased even more.

Informational In a market exhibiting informational efficiency, asset prices incorporate all relevant information fully and instantaneously.

When company A receives a takeover bid from company B that seems certain to succeed, the stock price of A increases immediately to reflect the per share bid premium.

• Do security prices reflect information ?– An efficient capital market is one in which

security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all relevant information.

• Why look at market efficiency?– Implications for business and corporate

finance– Implications for investment

Efficient Market Hypothesis (EMH)

Early Study on Market Behavior

– In the 1950s, researchers couldn’t find any predictable pattern in stock prices.

– Immediate conclusion was that these results appeared to support the irrationality of the market.

Does randomness = irrationality?

– Suppose researchers found that security prices are predictable and then developed a model to predict the prices.

– Following this model, investors would reap unending profits simply by purchasing stocks that would appreciate in price and selling stocks that would decrease in price!

Ramifications of Predictability

– Suppose a model predicts that XYZ stock price (currently $100) would rise dramatically in three days to $110.

– Obviously, everybody will want to BUY it; no one would want to SELL it.

– The prediction of under-pricing of a security would lead to an immediate price increase!

Ramifications of Predictability

– As soon as there is any information predicting that stock XYZ is under-priced, investors will flock to buy the stock and immediately bid up its price to a fair level.

– However, if prices are bid immediately to fair levels, given all available information, it must be that these prices increase or decrease only in response to new information.

– New information (by definition) must be unpredictable, which means that stock prices should follow a “random walk.”

Grossman-Stiglitz Theorem

ASSUMPTIONS:Two types of investors:

- Uninformed: Liquidity or noise traders

- Informed: Spend serious amounts of money to dig up

information no one else has

Grossman/Stiglitz Theorem

• Informed: Do research until marginal benefit = marginal cost.

• Uninformed: Do NO research.

• Some of the informed have marginal benefits > marginal costs, some have marginal benefits < marginal costs. On average, marginal benefit = marginal cost.

Grossman/Stiglitz Theorem

Example:

A manager of a $50 billion fund wants to increase returns 1/2% above what the market averages. How much is she willing to spend to do this??

Willing to spend:

$50 billion x .005 = $ 0.25 billionor$250 million on research to find incorrectly priced stocks.

Grossman/Stiglitz Theorem

• So, the informed make the market efficient for the uninformed! Justification for professionals!!

• If active managers fail to use information properly or have excessive transaction costs, they will do worse than a passive portfolio.

• In equilibrium, investors should earn the same return investing in a passive index fund as in an actively managed fund after research & transaction costs.

The Hard Truth

• NO EASY MONEY!

Random Walk Hypothesis

If stock prices follow a random walk (with or without a trend), then future stock prices cannot be predicted based on past stock prices.

New information is a “surprise”.

When new information arrives, stock prices will adjust immediately.

Example: Positive Surprise

Price

Time

New Information Arrives

Stock Price of XYZ

Efficient Market Hypothesis (EMH)

• In 1970 Eugene Fama defined the efficient market hypothesis and divided it into 3 levels.– Weak Form Efficient– Semi-Strong Form Efficient– Strong Form Efficient

• Each differs with respect to the information that is reflected in the stock prices.

Relation of 3 Forms of EMH

All Public Info

All Public & Private Info

Weak

Semi-Strong

Strong

Past Market Info

Three Forms Of Market EfficiencyForm Definition Example

Weak Form

Financial asset (stock) prices incorporate all historical information into current prices; future stock prices cannot be predicted based on an analysis of past stock prices.

Nothing of value is to be gained by analyzing past stock price changes, since this doesn’t help you predict future price changes. Renders “technical analysis” useless.

Semi-strong Form

Stock prices incorporate all publicly available information (historical and current); there will not be a delayed response to information disclosures.

The relevant information in an SEC filing will be incorporated into a stock price as soon as the filing is made public.

Strong Form

Stock prices incorporate all information--private as well as public; prices will react as soon as new information is generated, rather than as soon as it is publicly disclosed.

Stock prices will react to a dividend increase as soon as the firm’s board of directors votes--and before the board announces its decision publicly.

EMH: Weak Form

• Stock Prices reflect all past market price and volume information– It is impossible to make abnormal risk

adjusted returns by using past prices or volume data to predict future stock prices.

Technical Analysts

• Do not think the stock market is weak form efficient.

• Believe that investors are emotionally driven and predictable. Therefore, you can exploit this predictability, as it shows up in past prices and volume.

• “Quants” – use computers to find patterns.

Technical AnalystsPrice

Time

Stock First Starts Rising

Buy Here Stock Price of XYZ

EMH: Semi-Strong Form

Stock Prices reflect all publicly available information about a firm.

It is impossible to make abnormal risk- adjusted returns by analyzing any public information to predict future stock prices.

Fundamental Analysts

• Do not think the stock market is semi-strong form efficient.

• They use publicly available information to identify firms that are worth more (or worth less) than everyone else’s estimate of their values.

EMH: Strong Form

Stock Prices reflect all information (public and private) about a firm.

It is impossible to make abnormal risk- adjusted returns by analyzing publicly

available information or trading based on private or “inside” information.

Trading On Inside Information

• Not legal to trade on inside information

• offenders prosecuted

• Rules protect the small investor

Question…

• What is the meaning of the Efficient Markets Hypothesis to the Investment Industry?– debate between active and passive portfolio

management.– Billions of dollars are at stake!

• Active Management– Security analysis– Timing

• Passive Management– Buy and Hold– Index Funds

Active or Passive Management

• Even if the market is efficient a role exists for portfolio management:– Appropriate risk level– Tax considerations– Other considerations

Market Efficiency & Portfolio Management

Ironic Situation

• If the stock market is efficient, you may be better off buying index funds.

• However, if everyone buys index funds, market would not be as efficient, because no one is willing to search for information.

Difficult to Determine If Market is Efficient

If we can find people who beat the market based on skill, this would imply abnormal returns are possible and the market is not efficient.

Difficult to distinguish luck from skill!

Applied to Professional Investors• Record whether or not an investor beats the

market each year for 10 years.

• By pure chance there is a 50% probability an investor will beat the market in any given year (ignoring fees and expenses).

• If there are 10,000 professional money managers, how many will have a perfect record of beating the market every year due to chance?

SOLUTIONPossible Permutations (outcomes) over 10 years

= 210 = 1024

Probability of being correct each year for 10 years

= 1 / 1024 = 0.00097

Expected number of “gurus”

= 10,000 x 0.00097 = 9.7