How Efficient Is the Market?

1. How Efficient Is the Market? Efficient Market Hypothesis (EMH) Random Walk Hypothesis Forms of EMH Implications of EMH Predictability Anomalies Professional Management

2. Efficient Market Hypothesis • Definition • Prices of securities fully reflect all available information about these securities • Question • Is a $20 bill you find while walking down a busy street worth $20?

3. Random Walk Hypothesis • Tracing the evolution of several economic variables  predictstock prices? • Kendall (1953)  no predictable patterns • Random Walk • Stock prices are random • More precisely • Expected return is positive over time • Positive trend and random around the trend

4. Random Walk Hypothesis • Positive Trend with random fluctuation Security Prices Time

5. Efficient Markets and Random Walk • Stock prices fully and immediatelyreflect all available information • Once information becomes available, market participants analyze it • Competition assures that prices reflect all available information

6. Forms of EMH • Meaning of all available information • Weak Form • Information contained in market trading data • Past prices, volumes, interest rate, CPI, etc. • Technical analysis (e.g. trend-chasing or “charting”) is irrelevant • Semi-strong Form • All publicly available information • All earnings forecasts, accounting information • Fundamental analysis is irrelevant • Strong Form • All information relevant to the firm including insider information • Insider Trading

7. More on Fundamental Analysis • Stock price should be equal to discounted value of expected future cash flow! • Information used • Earnings and dividend forecasts • Future interest rate forecasts • Firm risk evaluation • Process • Step 1: examine past earnings and company balance sheets • Step 2: evaluation of quality of the firm’s management, firm’s standing in its industry, and prospects of the industry • Step 3: determine the present discounted value of all the payments to a shareholder

8. Forms of EMH Strong Form Set Semi-strong Form Set Weak Form Set

9. Fundamental vs. Technical Analysis • Is it like astronomy vs. astrology? • Depends if you believe in EMH...

10. Implications of EMH • Active Management (against EMH?) • Stock picking (security analysis) • Market Timing • Economically feasible only for managers of large portfolios • Do even large mutual funds have the ability to uncover mispriced securities? • Passive Management (for EMH?) • A well-diversified portfolio • Buy and hold strategy • Index Funds

11. Implications of EMH • Role of Portfolio Management • Diversification • Idiosyncratic risk should be diversified away at a minimal cost • Appropriate risk level • Provide the systematic risk level that investors can tolerate • Tax considerations • Growth vs Income stocks, munis vs Treasuries • Other considerations

12. Are Markets Efficient? • EMH implies • A great deal of portfolio managers’ activities (the search for mispriced securities) is wasted effort • Active management may hurt clients because of costs and imperfectly diversified portfolios • Not hailed by professional portfolio managers • Empirical tests of the hypothesis • Tests of predictability in stock returns (weak EMH) • Testing some trading rules (weak EMH) • Event studies (semi-strong EMH) • Studying insider trades (strong EMH) • Assessing performance of professional managers

13. Predictability – Short-Term • Auto (serial) correlation • Return correlation of two consecutive periods • Returns over short horizons (monthly or less) • Lo, Mamaysky and Wang (2000, JF) • Technical trading offers excess return • Lehman (1990, QJE), Conrad and Kaul (1988, JB), Lo and MacKinlay (1988, RFS) • Positive short-term correlation

14. Predictability – Intermediate-Term • Returns over intermediate horizons (3-12 mon) • Jagadeesh and Titman (1993, JF) • Stocks exhibit a momentum property in which good or bad recent performance continues • Performance of individual stocks • Highly unpredictable • Portfolios of the past winners appear to outperform portfolios of the past losers. • Momentum strategy: • Long on winners and short on losers (still works)

15. Predictability – Long-Term • Returns over long horizons (multi-years) • DeBondt and Thaler (1985, JF) • Negative long-term serial correlation over long horizons (5-year prediction, 3-year estimation) • Stocks exhibit a price-reversal property in which good or bad recent performance reverses • Fama and French (1988, JF) • Contrarian profits reflect time-varying risk premium • Contrarian strategy: • Long on losers and short on winners

16. Anomalies • Small-firm-in-January effect • Stocks of small firms have earned abnormal returns, primarily in the month of January • Neglected-firm effect and liquidity effects • The tendency of investments in stock of less well-known firms to generate abnormal returns • Book-to-market ratios • The higher the book-to-market ratio, the higher returns • P/E effect • Portfolios of low P/E stocks exhibit higher average risk-adjusted returns than high P/E stocks • Closed-end fund puzzle: Price < NAV

17. Royal Dutch vs. Shell – Where Is Arbitrage?

18. Why Do Anomalies Happen? • Limits to arbitrage • Fundamental risk in exploiting arbitrage opportunities • Implementation costs • Models risk (i.e. a model not properly accounting for risk) • Liquidity issues and non-traded assets • Behavioral effects • Overconfidence • Mental accounting • Prospect theory • etc…

19. Event Studies • Cumulative Abnormal Return (CAR) • Market Model approach • Non-event time: run rit = ai + bi rmt + eit • Event time: • Excess Return = (Actual - Expected) • eit = Actual - (ai + bi rmt) • CARt = e-T+ e-T+1 +…+et CAR t 0 +T -T

20. Event Studies – CAR for Target Companies before Takeover Attempts

21. Anomalies after Earnings Announcements • Earnings Announcements • Foster, Olsen, and Shevlin (1984, Accounting Review)

22. Professional Management • Some evidence of persistent positive and negative performances • Potential measurement error for benchmark returns • Style changes • Risk premiums • Superstar phenomenon • or statistical outliers?..

23. Persistence of Mutual Fund Performance Carhart (1997, JF) - not much of a long term persistence!

24. Wrap-up • What is an efficient market? • What is the weak form of EMH? • What is the semi-strong form of EMH? • What is the strong form of EMH? • What is the evidence of predictability? • What is the relationship between an anomaly and EMH?