by Charles M. C. Lee Peking University Stanford University Presented at

1. The Magic of Markets: market efficiency and capital market research in accounting by Charles M. C. Lee Peking University Stanford University Presented at 2008 American Accounting Association (AAA) Conference Anaheim, California

2. Should capital market researchers assume price = value? “Price is what you pay, value is what you get.” - Warren Buffett

3. Seminar Outline • Informational role of markets • The social value of markets in society • Limits of a naïve view of market efficiency • An alternative framework • Integrating behavioral finance and fundamental analysis • Applications to accounting research

4. The Role of Markets What is the social value of markets?

5. Frederick von Hayek (1899-1992) American Economic Review (1945): The Use of Knowledge in Society The role of markets in society What is the social value of markets? • The central economic problem of society is planning (resource allocation) under uncertainty • Planning involves two types of knowledge: • - Scientific Knowledge (theoretical or technical) • - Knowledge of particular circumstances of time and place • Even the best central planner doesn’t have knowledge of the 2nd type • - Hence de-centralized planning dominates central planning

6. Frederick von Hayek (1899-1992) American Economic Review (1945): The Use of Knowledge in Society The role of markets in society What is the social value of markets? • Hayek’s view on planning: • - Planning calls for “the utilization of knowledge not given to anyone in its totality.” It follows that the “man on the spot” is the best person to make resource allocation decisions. • Hayek’s view on the role of markets: • - As a minimum the “man on the spot” needs to know the relative scarcity of various resources. This information is quickly and succinctly provided by market prices. • Markets facilitates de-centralized planning • - The price system is a vital knowledge aggregation mechanism.

7. Frederick von Hayek (1899-1992) American Economic Review (1945): The Use of Knowledge in Society The role of markets in society What is the social value of markets? • Implications: • - Price is a public good • - Market economies are better than centrally planned ones • - Price should be, in general, a good indicator of “value” (i.e., the relative scarcity of an asset) • What Hayek did not say: • - How markets become efficient • - What affects this process (besides regulatory intervention)

8. Quickly and Without bias • In past prices (Weak) • In public domain (S.S.) • Both public & private (S.) • If we define the intrinsic value of a firm as the present value of its future payoffs • Then, operationally, the EMH is often interpreted to mean price reflects a stock's intrinsic value The Efficient Market Hypothesis • Fama (1965, 1991): The market price "incorporates" all "currently available information"

9. A. B. Shiller (1984) “Returns on speculative assets are nearly unforecastable; this fact is the basis of the most important argument in the oral tradition against a role for mass psychology in speculative markets. One form of this argument claims that because real returns are nearly unforecastable, the real price of stocks is close to the intrinsic value, that is, the present value with constant discount rate of optimally forecasted future real dividends. This argument for the efficient markets hypothesis represents one of the most remarkable errors in the history of economic thought. It is remarkable in the immediacy of its logical error and in the sweep and implications of its conclusion.” - From page 8 (emphasis added) What does he mean? There are two definitions of market efficiency: A: “No free lunch” (Zero arbitrage profits)B. “The Price is Right” (Pt = Vt) (Consider P = V + e; and e is r.w.) B. => A. but definitely A. ≠> B.

10. Why do we believe markets are efficient? • Shleifer (2001): The theoretical case for the EMH • All investors are rational • Some investors irrational, but their trades cancel out • Some systematic irrationality, but it is eliminated by rational arbitrageurs • => A visceral faith in the process of arbitrage ! • Lee (2001): Is this faith well grounded? • Arbitrage is merely a mechanism • Ocean vs. millpond • 2. It is almost always costly and risky • Information, trading, & holding costs • It requires sufficient mispricing to function properly • Arbitrage and mispricing must co-exist

11. The Central Paradox “If information is costly, prices cannot perfectly reflect the information which is available; because if it did, those who spend resources to obtain it would receive no compensation.” - Grossman and Stiglitz (1980) Grossman and Stiglitz (1980): - If information is costly, mispricing and arbitrage must co- exist in equilibrium - The cost of information determines the equilibrium ratio of information quality between informed and uninformed traders.

12. EMH and Newtonian Physics • It’s been said that for all practical purposes, the EMH is like Newtonian physics (we can generally assume “the price is right”) • Price is certainly a meaningful indicator of “value” • - In most settings, consumers and producers should appeal to market prices in resource allocation decision • - This is, after all, the central role of markets in society • However, does that apply also to those charged with the study of markets? • - In some settings, perhaps… (e.g., some regulatory applications) • I believe, in many settings, a naïve view of market efficiency (P=V) does a great disservice to our profession, because it provide an inadequate framework for understanding some issues of first-order importance to the effective operation of markets.

13. Practical Problems and Limitations • 1. Excessive trading volume • - in the traditional model, there should be little or no trading • 2. Excess volatility in returns • - returns are too volatile to be explained by a DDM • 3. Returns predictability • - Higher returns for lower risk stocks (Sloan, LSV, Piotroski) • 4. Realized returns are a poor proxy for expected returns • - The noisy nature of realized returns (Elton) • - Ex ante versus ex post cost-of-capital (GLS; CGV) • 5. No role for information & market pricing dynamics • - Absence of a conceptual framework for thinking about information • flows and the dynamics of market price adjustment & discovery • For those who make a living studying markets, to ignore these problems would be an abdication of responsibility.

14. Cornell Cayuga MBA Fund “Quant meltdown”

15. Recent Performance

16. II. An Integrative Framework Modeling mispricing as an equilibrium phenomenon

17. Shiller (1984): A Noise Trader Alternative • Consider a world with two types of traders: • Information traders (smart money) •  = rho; expected real return such that there is no demand for shares by smart money •  = phi; risk premium that would induce smart money to hold all the shares • Noise traders (ordinary investors) • Time varying demands, not based on optimal forecast of expected returns. • yt = noise trader demand; total value of stocks demanded per share by these investors.

18. Noise trader demand Fundamental value Arbitrage costs Shiller (1984): In equilibrium, price is: As  (phi) zero, we have the EMH as a special case As  (phi) infinity, noise traders determine the price

19. Investor Sentiment Fundamental value Implications of the Model Arbitrage costs • Price is a weighted average of a stock’s fundamental value and noise trader demand (as long as arbitrage involves some cost, price  value) • Fundamental analysis (i.e., valuation and cash flow projection) is only one component of investing in stocks • Rational investors (smart traders) need to consider "fads" and "fashions", as well as "fundamentals”. • Returns are not necessarily easy to forecast. The time-series behavior of Yt matters. Is it mean-reverting? If so, how quickly?

20. Investor Sentiment Fundamental value How might we measure sentiment? A. Focus on fundamental value • Estimate the present value of future cash flows for a firm (V), and compare it to price. The difference is a measure of investor sentiment. B. Focus on noise trader demand • Look for sentiment indicators that help to predict the direction of noise trader demand (Yt )

21. What gives rise to sentiment? • Sentiment involves systematic deviations of price from intrinsic value • The mistakes must be correlated across noise traders • More like mass psychology than animal spirits • What gives rise to a common sentiment? (what affects Yt ?) • sub-optimal use of actual signals • misreaction to value-relevant information (earnings surprises, quality-of-earnings indicators) • Black: “pseudo-signals” • signals that contain no real information, yet are persuasive

22. Example: Conolog Corp (CNLG), Thurs 2/17/2005 Up 30%+ on new information

23. The news event… “Institutional ownership by a prestigious global fund manager such as Barclays is a vote of confidence in our Company.”

24. Commentary…

25. All of the 461k shares of stock held by BGI are in passive, not active, funds: Understanding the information

26. Equilibrium is reached by the end of the third day…

27. An Example: KKD (7/7/01) "I go to the convenience store by my house to buy the donuts which are delivered at 4 am. The place is Jam packed, and it's surreal how many people are walking around with Krispy bags. People literally run from their cars and practically tackle each other at the Krispy Kreme Doughnut cabinet." - 4CommonSense "I can't understand how ANYTHING can taste that good. If this isn't the stuff classic American brand names are made of, nothing is. These things are addictive and they bring pleasure to the senses." "A well-managed company with nothing but upside for the next 12-18 years…They have NO market penetration to speak of in the United States as a whole…People are just beginning to hear of them and everybody wants one." - EMCauley

28. On the other hand…

29. So what is next for KKD? Best value estimate

30. Best value estimate KKD: Revisited (next 12 months)

31. KKD: Revisited (a longer view)

32. How bad is the problem? Prices in equity markets are much noisier than many people expect Black (1986): "All estimates of value are noisy, so we can never know how far away price is from value. However, we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value… By this definition, I think almost all markets are efficient almost all the time. "Almost all" means at least 90%."

33. How bad is the problem? Evidence from Closed-end Funds: • A closed-end fund is a publicly traded stock whose only asset consists of a portfolio of other publicly traded securities. The closed-end fund puzzle is the empirical phenomenon that the stock price (SP) of these funds is rarely equal to the net asset value (NAV) of these securities. • Typically, these funds trade at a discount to their NAV (DISC = (SP-NAV)/NAV*100). Occasionally, they also trade at a premium. For U. S. funds DISC routinely fluctuate between an upper bound of around +5 to 10%, and a lower bound of –30% to 40%. (LST (1991)) • What accounts for the upper and lower bounds on DISC? • If arbitrage bounds can be this wide when valuation is transparent, how wide would they be for other stocks?

34. Relevance to Accounting Research B. Investor Sentiment A. Fundamental value C. Arbitrage Costs • Provides a conceptual framework for Security Analysis • Helps us understand the relationship between information risk and the cost-of-capital • Whether higher information risk increases firms’ cost-of-capital • Why realized returns are such noisy proxies for ex ante risk • Offers conceptual guidance in future market-based research • The traditional model (P=V) is too naïve & has no role for information flows & market pricing dynamics • Focuses attention on the 3 irreducible elements of market adjustment to information

35. But I don’t like behavioral assumptions… B. Investor Sentiment A. Fundamental value • This is a useful framework in which to think about mispricing in equilibrium, even if you do not wish to make behavioral assumptions • Two out of the three key elements do not require behavioral assumptions • However, if you wish to understand forces that drive price away from “value” (the time-series behavior of Yt), you need a theory of mistakes C. Arbitrage Costs

36. Shleifer: The “metaphysical” defense of the EMH Objections to Behavioral Models They violate the “Prime Directive” of financial economics: "Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior… (T)he burgeoning behavioralist literature…has lost all the constraints of this directive – that whatever anomalies are discovered, illusory or not, behavioralists will come up with an explanation grounded in systematic irrational investor behavior" (Rubinstein (2000)) In fact, most recent models in behavioral finance are based on economic principles of rational arbitrage. Who are noise traders anyway? If they are so dumb, how do they survive? With a continuous information flow, even rational traders cannot calibrate the quality of their own signal. Hence, everyone noise trades. In fact, noise trading is a necessary part of the price discovery process described by Hayek & envisioned by Black. We discover the quality of our own information through trial and error – LEARNING is how markets become efficient (Berk and Green 2005)

37. Summary • The market is a wonderful aggregator of information. • Its ability to quickly reflect the consensus view is almost magical. It solves the central planner's problem. • But, the magic continues only b/c the process is flawed. • The market is in a constant state of adjustment, and mispricing is an equilibrium condition. This must be the case for arbitrage to do its magic. • Do not automatically assume P=V • Unshackle V from P, or you will miss a lot of what is going on in markets • Focus on information flow and market adjustment dynamics Information flow is the market’s life blood • When it comes to market efficiency, don’t ask “yes or no”? Instead, ask: "how", "when", and "why"? That is what makes capital market research fun!