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Finance 334 Chapter 7

Efficient Market Hypothesis Theory that asserts: major financial markets reflect ALL relevant information at a given time Hypothesis stating that, as a practical matter, investors cannot consistently “beat the market”
Market Efficiency Research Examines the relationship between stock prices and available information -Is it possible for investors to “great the market?”If a market is efficient, it is not possible to beat the market
Excess Return Return in excess of that earned by other investments that have the same risk
Beating the Market Consistently earning a positive excess return
Three Economic Forces than can lead to Market Efficiency -Investors use their information in a rational matter -There are independent deviations from rationality -Arbitrageurs exist
Investors use their information in a rational manner -Rational investors do not systematically overvalue or undervalue financial assets -If every investor always made perfectly rational investment decisions, it would be difficult, if not impossible to earn an excess return
There are independent deviations from rationality -Suppose that many investors are irrational, and a company makes an announcement i. Some investors will be overly optimistic ii. Some will be overly pessimistic -The net effect might be that these investors cancel each other out-so the irrationality is just noise that is diversified away and the market could still be efficient (or nearly efficient) -What is important here is that irrational investors have different beliefs
Arbitrageurs exist -Suppose there are many irrational traders and their collective irrationality does not balance out -Further suppose there are well capitalized, intelligent and rational investors i. This group of traders, called arbitrageurs, look for profit opportunities ii. Arbitrage: buying relatively inexpensive stocks and selling relatively expensive stocks -If these rational arbitrage traders dominate irrational traders, the market will still be efficient
Forms of Market Efficiency-What information is used Weak form Efficient Market Semistrong form Efficient Market Strong form Efficient Market
Weak Form Efficient Market Past prices and volume figures are of no use in beating the market TECHNICAL ANALYSIS IS OF LITTLE USE
Semistrong Form Efficient Market Publicly available information is of no use in beating the market FUNDAMENTAL ANALYSIS IS OF LITTLE USE
Strong Form Efficient Market Information of any kind, public or private, is of no use in beating the market INSIDE INFORMATION IS OF LITTLE USE
Why would a market be efficient -The driving force toward market efficiency is simply competition and the profit motive -Small performance enhancement can be worth a tremendous amount of money (when multiplied by the $ amount involved) -Creates incentives to unearth relevant information and use it
Does Old Information Help Predict Future Prices? -Some researchers have been able to show that future returns are partly predictable by past returns. BUT: there is not enough predictability to earn an excess return -Trading costs swamp attempts to build a profitable trading system built on past returns -Result: buy and hold strategies involving broad market indexes are extremely difficult to outperform
Technical Analysis Implication No matter how often a particular stock price path has related to subsequent stock price changes in the past, there is no assurance that this relationship will occur again in the future
Some Implications of Market Efficiency: Random Walks and Stock Prices If you were to ask people you know whether stock market prices are predictable, many of them would say yes. To their surprise, and perhaps yours, it is very difficult to predict stock market prices. In fact, considerable research has shown that stock prices change through time as if they are random. That is, stock price increases are about as likely as stock price decreases.
Random Walk No discernable pattern to the path that a stock price follows, then the stock’s price behavior is largely consistent with a random walk
How New Information Gets into Stock Prices In its semi-strong form, the EMH states simply that stock prices fully reflect publicly available information. Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock.But, the future prospects for the stock are influenced by unexpected news announcements.
Prices could adjust to unexpected news in three ways: Efficient Market Reaction Delayed Reaction Overreaction and Correction
Efficient Market Reaction The price instantaneously adjusts to the new information
Delayed Reaction The price partially adjusts to the new information
Overreaction and Correction The price over adjusts to the new information, but eventually falls to the appropriate price
Event Studies To test for the effects of new information on stock prices, researchers use this approach
Researchers are interested in -The adjustment process itself -The size of the stock price reaction to a news announcement
On Friday, May 25, 2007, executives of Advanced Medical Optics, Inc. (EYE), recalled a contact lens solution called Complete MoisturePlus Multi Purpose Solution. Advanced Medical Optics took this voluntary action after the Centers for Disease Control and Prevention (CDC) found a link between the solution and a rare cornea infection. The medical name for this cornea infection is acanthamoeba keratitis.The event study name for this cornea infection is AK.EYE Executives chose to recall their product even though no evidence was found that their manufacturing process introduced the parasite that can lead to AK. Further, company officials believed that the occurrences of AK were most likely the result of end users who failed to follow safe procedures when installing contact lenses.On Tuesday, May 29, 2007, EYE shares opened at $34.37, down $5.83 from the Friday closing price.
-Researchers must make sure that overall market news is accounted for in their analysis -To separate the overall market from the isolated news concerning Advanced Medical Optics, Inc researchers would calculate abnormal returns:Abnormal return=observed return-expected return-Expected return calculated using a market index (S&P 500) or by using a long term average return on the stock -Researchers then align the abnormal return on a stock to the days relative to the news announcement
Researchers then align the abnormal return on a stock to the days relative to the news announcement -Researchers usually assign the value of zero to the news announcement day -One day after the news announcement= +1-Two days after the news announcement= +2 -One day before the news announcement= -1
*According to the EMH, the abnormal return today should only relate to information released on that day *To evaluate abnormal returns, researchers usually accumulate them over a 60 or 80 day period
-The first cumulative abnormal return, or CAR, is just equal to the abnormal return on day -40. -The CAR on day -39 is the sum of the first two abnormal returns. -The CAR on day -38 is the sum of the first three, and so on. -By examining CARs, researchers can see if there was over- or under-reaction to an announcement.
-As you can see, Advanced Medical Optics, Inc.’s cumulative abnormal return hovered around zero before the announcement. -After the news was released, there was a large, sharp downward movement in the CAR. -The overall pattern of cumulative abnormal returns is essentially what the EMH would predict. That is:-There is a band of cumulative abnormal returns,-A sharp break in cumulative abnormal returns, and -Another band of cumulative abnormal returns.
It is illegal to make profits on non-public information -It is argued that this ban is necessary if investors are to have trust in US stock markets -The US Securities and Exchange Commission (SEC) enforces laws concerning illegal trading activities
Informed Trading When an investor makes a decision to buy or sell a stock based on publicly available information and analysis-Reading Wall Street Journal -Reading quarterly reports issued by a company -Gathering financial information from the Internet -Talk to other investors
Legal Insider Trading Informed traders: Legal Insider Trading -Company insiders can make perfectly legal trades in the stock of their company -They must comply with the reporting rules made by the SEC -When company insiders make a trade and report it to the SEC, these trades are reported to the the public by the SEC -Corporate insiders must declare that trades that they made were based on public information about the company, rather than “inside information” Most public companies also have guidelines that must be followed. For example, it is common for companies to allow insiders to trade only during certain windows during the year, often sometime after earnings have been announced.
Who is an Insider Someone who has material non public information -Not known to the public and if it were known, would impact stock price -A person can be charged with insider trading when he or she acts on such information in an attempt to make a profit
Illegal Insider Trading: Tipper Person who has purposely divulged material non-public information
Tippee Person who has knowingly used such information in an attempt to profit
*It is difficult for the SEC to prove that a trader is truly a tippee
It is difficult to keep track of insider information flows and subsequent trades -Suppose a person makes a trade based on the advice of a stockbroker -Even if the broker based this advice on material non-public information, the trader might not have been aware of the broker’s knowledge. -The SEC must prove that the trader was, in fact, aware that the broker’s information was based on material non-public information. -Sometimes, people accused of insider trading claim that they just “overheard” someone talking.
For example, a tipper could be a CEO who spills some inside information to a friend who does not work for the company. If the friend then knowingly uses this inside information to make a trade, this tippee is guilty of insider trading. Example of “overhearing”: Suppose you are at a restaurant and overhear a conversation between Bill Gates and his CFO concerning some potentially explosive news regarding Microsoft, Inc. If you then go out and make a trade in an attempt to profit from what you overheard, you would be violating the law (even though the information was “innocently obtained.”) When you take possession of material non-public information, you become an insider, and are bound to obey insider trading laws. Note that in this case, Bill Gates and his CFO, although careless, are not necessarily in violation of insider trading laws.
BE AWARE WHEN YOU TAKE POSSESSION OF MATERIAL NON PUBLIC INFORMATION, YOU BECOME AN INSIDER AND ARE BOUND TO OBEY INSIDER TRADING LAWS
-Martha Stewart was accused but not convicted of insider trading -Martha Stewart was accused and convicted of obstructing justice
Are Financial Markets Efficient Most extensively documented of all human endeavors Difficult to test-Risk adjustment problem -Relevant Information problem -Dumb luck problem -Data snooping problem
Three generalities about market efficiency: -Short term stock price and market movements appear to be difficult to predict with any accuracy -The market reacts quickly and sharply to new information, and various studies find little or no evidence that such reactions can be profitably exploited -If the stock market can be beaten, the way to do so is not obvious
Some Implications if Markets are Efficient -Security selection becomes less important, because securities will be fairly priced-There will be a small role for professional money managers -Little sense to time the market
You have a terrific advantage if you follow this investment strategy: -Hold a broad-based market index. One such index that you can easily buy is a mutual fund called the Vanguard 500 Index Fund (there are other market index mutual funds)-The fund tracks the performance of the S&P 500 Index by investing its assets in the stocks that make up the S&P 500 Index. -The low level and variation of the dashed red line means that the percentage of professional money managers who can beat the Vanguard 500 index fund over a 10 year investment period is low and stable
*The performance of professional money managers is especially troublesome when we consider the enormous resources at their disposal and the substantial survivorship bias that exists-Mangers and funds that do especially poorly disappear -If it were possible to beat the market, then the process of elimination should lead to a situation in which the survivors can beat the market -The fact that professional money managers seem to lack the ability to outperform a broad market index is consistent with the notion that the equity market is efficient
What is the Role for Portfolio Managers in an Efficient Market? -Build a portfolio to the specific needs of individual investors -Well diversified portfolio
Influences of Portfolio Age Tax bracket Risk aversion Employer
Market Anomalies -Anomalies generally do not involve many dollars relative to the overall size of the stock market -Anomalies are fleeting and tend to disappear when discovered -Anomalies are not easily used as the basis for a trading strategy because transaction costs render many of them unprofitable -The Day of the Week Effect-The Amazing January Effect -Turn of the Year Effect -Turn of the Month Effect
Day of the Week Effect Tendency for Monday to have a negative average return-economically significant Exists in other markets (bonds) and exists in markets outside USDefied explanation since it was discovered in early 1980s-Much stronger in 1950-1979 time period
January Effect Tendency for small cap stocks to have large returns in January -The effect is due to returns during the whole month of January -Due to returns bracketing the end of the year
Turn of the Year Effect -The effect is due to returns during the whole month of January -Due to returns bracketing the end of the year
Turn of the Year Days The last week of daily returns in a calendar year and the first two weeks of daily returns in the next calendar year BIGGER THAN REST OF DAYS RETURNS Strong 62-85
Rest of the Days Any daily return that does not fall into this three week period
Turn of the Month Effect Daily returns from the last day of any month or the following three days of the following month Exceed Rest of days returns Strong 86-09Not 62-85
Rest of Days Any other daily returns
Bubble Occurs when market prices soar far in excess of what normal and rational analysis would suggest -Investment bubbles eventually pop -When a bubble does pop, investors find themselves holding assets with plummeting values -Can form over weeks, months or years
Crash Significant and sudden drop in market values -Crashes are generally associated with a bubble -Sudden, generally lasting less than a week-Aftermath can last for years
The Crash of 1929 As you can see in this slide, on Friday, October 25th, the Dow Jones Industrial Average closed up about a point, at 301.22. On Monday, October 28th, it closed at 260.64, down 13.5%. On Tuesday, October 29th the Dow closed at 230.07, with an inter-day low of 212.33, which is about 30% lower than the closing level on the previous Friday. On this day, known as “Black Tuesday,” NYSE volume of 16.4 million shares was more than four times normal levels.
The Crash of 1987 From the then market high on August 25, 1987 of 2,746.65 to the intraday low on October 20, 1987, the market had fallen over 40%.
Circuit Breakers Triggered if DJIA drops by 10, 20 or 30 percent -10% drop will halt trading for at most one hour-20% drop will halt trading for at most two hours -30% drop will halt trading for the remainder of the day
The Asian Crash The crash of the Nikkei Index, which began in 1990, lengthened into a particularly long bear market. It is quite like the Crash of 1929 in that respect. The Asian Crash started with a booming bull market in the 1980s. Japan and emerging Asian economies seemed to be forming a powerful economic force. The “Asian economy” became an investor outlet for those wary of the U.S. market after the Crash of 1987.To give you some idea of the bubble that was forming in Japan between 1955 and 1989, real estate prices in Japan increased by 70 times, and stock prices increased 100 times over. In 1989, price-earnings ratios of Japanese stocks climbed to unheard of levels as the Nikkei index soared past 39,000. In retrospect, there were numerous warning signals about the Japanese market. At the time, however, there was continued optimism about the continued growth in the Japanese market. Crashes never seem to occur when the outlook is poor, so, as with other crashes, many people did not see the impending Nikkei Crash. As you can see in the slide, in three years from December 1986 to the peak in December 1989, the Nikkei Index rose 115%. Over the next three years, the index lost 57% of its value. In April 2003, the Nikkei Index stood at a level that was 80% off its peak in December 1989, and it has not recovered much through June 2005.
Amex Internet Index The Amex Internet Index soared from a level of 114.60 on October 1, 1998 to its peak of 688.52 in late March 2000, an increase of 500%. The Amex Internet Index then fell to a level of 58.59 in early October 2002, a drop of 91%.
S&P 500 Index S&P 500 Index rallied about 31% in the same 1998-2000 time period, and fell 40% during the 2000-2002 time period.
The Crash of October 2008 From the then market high on August 25, 1987 of 2,746.65 to the intraday low on October 20, 1987, the market had fallen over 40%.
Bull Market Trend is up
Bear Market Down market, trend is down

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