Market Efficiency And Modern Financial Management

Professor XXXXXCourse Name / Number

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Efficient Markets

In an efficient market, prices rapidly incorporate all relevant information.

The “Efficient Markets Hypothesis” (EMH) was first formally proposed in 1970 by Eugene

Fama.

What are the three forms of market efficiency?

Financial markets are much larger, more competitive, more transparent, more homogeneous

than product markets.

Much harder to create value through financial activities

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Three Forms Of Market Efficiency

Weak Form

Financial asset (stock) prices incorporate all historical information into current

prices.

Past stock price changes cannot help you predict future price changes.

Semi-strong Form

Stock prices incorporate all publicly available information (historical and

current).Information in an SEC filing is

incorporated into a stock price as soon as it is made public.

Strong Form

Stock prices incorporate all information, private as well as

public.

Prices react as soon as new information is generated.

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Weak Form of Market Efficiency

Weak form: Stock price changes are not predictable based on past changes.

Stock prices follow a random walk.

Could be a pure random walk, or a “random walk with drift”

Technical analysis

• Search of profitable trading strategies based on recurring patterns in stock prices

• Under the weak form of efficiency theory, technical analysis is useless.

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Semi-strong Form Efficiency and Fundamental Analysis

Recall the definition of efficient markets: In an efficient market, prices rapidly incorporate all relevant information.

Semi-strong form efficiency uses “all public information” as its definition of “information.”

Examples

Earnings announcements Annual reports

SEC filings News reports

Prices move so fast in response to public information that trading on it profitably is nearly impossible!

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Survivorship Bias And Measured Returns On Mutual FundsIf anyone could “beat the market”, it’s the pros who devote all of their time and energy

to that effort.

Selectivity (stock-picking ability)

Timing (the ability to time market turns)

A large number of publications investigate investment performance of mutual fund managers.

Malkiel (1995) pointed out critical bias in studies that show superior performance of fund manager: survivorship bias.

• Only the returns of the companies still in existence at the end of the analyzed period are included in analysis.

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Implications Of Semi-Strong Form EfficiencyMost studies show managers under-perform

S&P 500, even before taking account of expenses.

– “Superstar” investors (Warren Buffett, Peter Lynch) are the exception rather than the norm.

Other tests show prices react efficiently to new information.

– Studies also find that purely accounting rule changes that do not affect cash flow have no impact on stock prices.

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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.

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Event Studies

-5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Event Time (in days)

10%

-10%

0%

5%

-5%

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The actual return minus the expected return

Abnormal return

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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

The positive bump on day 0 implies that the earnings news was, on average for these firms, better than expected!

Because the line is flat after day 0, this means that the market fully incorporated the earnings news on the event day…no additional

upward or downward price trend is seen.

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Evidence Against Semi-strong Form Efficiency

Small firm effect

Small firms out-perform large especially in January (January effect).

Temporal anomalies

January effect (all firms), Monday effect

Value versus

glamour stocks

High book-to-market (value) stocks out-perform low book-to-market

(glamour) stocks.

Many people feel that “bubbles” form quite frequently in financial asset prices: Japanese stock

prices late 1980s,NASDAQ prices through March 2000.

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Behavioral Finance

Argues that market participants suffer from systematic psychological biases that result in

sub-optimal decisions

Investors underreact to new information that contradicts prior beliefs (e.g., dramatic

change in earnings).

Investors overreact to a string of similar information (e.g., investors expect recent

trends to continue).

Investors are overly confident in their ability to identify misvalued stocks.

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The Underreaction Phenomenon

-5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (months)

0

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The line that is going upward is showing the returns on a group of

stocks that have (in month 0) reported unexpectedly

high earnings.

The line that is trending down is showing the returns on a group of

stocks that have (in month 0) reported unexpectedly

low earnings.

Stock-price momentum

Investors are under reacting to the recent good (bad) earnings news.

Subsequent news after the announcement continues to be good (bad), so investors didn’t fully realize how good (bad) the initial announcement was.

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The Overreaction Phenomenon

The line that trends up and then reverses represents

returns on stocks that have performed very well for the last several years, and vice

versa for the other line.

-5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (years)

0

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Stock-price momentum

The time period we are looking at here is long--several years--and investors are overreacting to a perceived long-term trend.

This is distinct from the previous slide where investors were--over a much shorter time span--underreacting to brand new information.

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The Strong Form Of Market Efficiency

Prices should reflect all information, public and private.

– Usually tested by seeing if corporate insiders earn superior returns on their trades in company stock

– Evidence suggests insiders can “beat the market.”

Insiders’ decision to trade at corporate level may be informative.

– If they think stock price too high, they will sell new stock.– If they think stock price too low, they can re-purchase

shares.– Stock prices can affect their decision to use cash or stock

in mergers.

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Corporate “Communications” Policy

Market efficiency has clear implications for how a manager should “communicate” with investors.

Assume your actions and words have consequences.

– Try to predict how a particular announcement will be interpreted by investors and be ready to respond if they actually respond differently.

– Don’t withhold info that will likely come out anyway.

Do not discuss publicly information that should be kept private.

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Corporate “Communications” Policy

Honesty is the Best Policy– Managers who convey good and bad information

honestly and and who do not try to fool the market will be believed, while managers with reputations for deception will not be.

Listen to Your Stock Price

– Two types of information that markets convey to managers:

(1) reactions to specific corporate announcements

(2) movements in the firm’s stock price relative to the overall market over extended periods of time

– Both types of information can be very informative to the manager.

Financial markets tend to be more efficient and competitive than product markets.

Three forms of market efficiency: weak form, semi-strong form, strong form

Empirical research found that major financial markets are weak-form and semistrong-

form.

Market efficiency research helps financial managers in formulating their

communication policy.

Market Efficiency