Chapter 10

1. Chapter 10 Market Efficiency

2. Learning Objectives • Explain the concept of efficient markets. • Describe the three forms of market efficiency – weak, semi-strong, and strong • Discuss the evidence regarding the Efficient Market Hypothesis. • State the implications of market efficiency for investors. • Outline major exceptions to the Efficient Market Hypothesis.

3. Efficient Markets • How well markets respond to new information is a very important part of obtaining the equilibrium relationship predicted by the capital market theory • Should it be possible to decide between a profitable and unprofitable investment given current information? • Efficient Markets • The prices of all securities quickly and fully reflect all available information

4. Efficient Markets Definition of “all available information” • All known information including: • Past information (e.g., last year’s earnings) • Current information as well as events that have been announced but are still forthcoming (e.g., stock splits and dividends) • Information that can be reasonably inferred • For example, if many investors believe that interest rates will decline soon, prices will reflect this belief before the actual decline occurs

5. Conditions for an Efficient Market Why the markets can be expected to be efficient? • Large number of rational, profit-maximizing investors • Actively participate in the market • Individuals cannot affect market prices (i.e., price-takers) • Information is costless and widely available to market participants at approximately the same time • Information is generated in a random fashion (e.g., announcements or currency is devalued) • Investors react quickly and fully to new information causing stock prices to adjust accordingly

6. Consequences of Efficient Market • Quick price adjustment in response to the arrival of random information makes the reward for analysis low • Prices reflect all available information • Price changes are independent of one another and move in a random fashion • New information is independent of past

7. Market Efficiency Forms • Efficient market hypothesis (EMH) • The proposition that securities markets are efficient, with prices of securities reflecting their true economic value • Three levels of Market Efficiency • Weak form – prices reflect past market data (i.e., historical price and volume information for stocks and indexes) • Semi-strong form – prices reflect all public information • Strong form – prices reflect all information, both public and private

8. Cumulative Levels of Market Efficiency and the Information Associated with Each Strong Form All Information Semi-Strong Form Public Information Weak Form Market Data

9. Weak Form • Prices reflect all past price and volume data • Technical analysis, which relies on the past history of prices, is of little or no value in assessing future changes in price • Market adjusts or incorporates this information quickly and fully

10. Semi-Strong Form • Prices reflect all publicly available information • For example: earnings, dividends, stock split announcements, new product developments, financing difficulties, and accounting changes • Investors cannot act on new public information after its announcement and expect to earn above-average, risk-adjusted returns • Encompasses weak form as a subset since market data are part of the larger set of all publicly available information

11. Strong Form • Prices reflect all information, public and private • No group of investors should be able to earn abnormal rates of return by using publicly and privately available information • Encompasses weak and semi-strong forms as subsets and represents the highest level of market efficiency

12. Evidence on Market Efficiency • Keys to testing the validity of any of the three forms of market efficiency • Consistency of returns in excess of risk • Length of time over which returns are earned • Short-lived inefficiencies appearing on a random basis do not constitute evidence of market inefficiencies, at least in an economic sense • Economically efficient markets • Assets are priced so that investors cannot exploit any discrepancies and earn unusual returns • Transaction costs matter

13. Weak-Form Evidence Ways to test for weak-form efficiency • Test for independence (randomness) of stock price changes [Random Walk Hypothesis] • If stock prices are independent, trends in price changes do not exist • Knowing and using the past sequence of price information is of no value to an investor • Test for profitability of trading rules after brokerage costs • Simple buy-and-hold better • Buying a portfolio of stocks and holding it until a common liquidation date

14. Weak-Form EMH • Stock price changes in an efficient market should be independent • Statistical tests of price changes are mostly supportive of weak-form EMH • The sign test involves classifying each price change by its sign, which means whether it was +, 0, or – • Then the “runs”in the series of signs can be counted and compared to known information about a random series • Runs tests • looking for patterns in signs of returns • i.e. + + - + - +

15. Weak-Form EMH • The signs test supports independence of stock price changes • Although some runs do occur, they fall within the limits of randomness since a truly random series will exhibit some runs • Technical trading rules • Technical analysts believe that trends not only exist but can also be used successfully • Little evidence exists that technical trading, based solely on past price and volume data, can outperform a simple buy-and-hold strategy

16. Two Apparent Contradictions to the Weak-Form EMH • Momentum or persistence in stock returns • tendency of stocks that have done well over the past 6 to 12 months to continue to do well over the next 6 to 12 months • “Contrarian” Strategies • Overreaction Hypothesis [DeBondt & Thaler (1985)] • stocks that have done well over the past 3-5 year period, will do poorly over the subsequent 3-5 year period

17. Two Apparent Contradictions to the Weak-Form EMH • Contrarian strategies are trading strategies designed to exploit the overreaction hypothesis • Since the underlying rationale is to purchase or sell stock in anticipation of achieving future results that are contrary to their past performance record • DeBondt and Thaler are testing whether the overreaction hypothesis is predictive • In other words, knowing past stock returns appears to help significantly in predicting future stock returns

18. Semi-Strong-Form Evidence • Event studies • Empirical analysis of stock price behaviour surrounding a particular event • Usually use an index model of stock returns such as single-index model • Examine company unique returns • The residual error between the security’s actual return (Rit ) and that given by the index model E(Rit) • Abnormal return (Arit) = Rit - E(Rit) n • Cumulative abnormal return (CAR) = ΣArit t=1 CAR is the sum of the individual abnormal returns over the period of time under examination

19. Stock splits (Fig 10.4 pg 281) Implications of split reflected in price immediately following the announcement and not the event itself Accounting changes Quick reaction to real change in economic value (e.g., depreciation, inventory reporting [LIFO vs. FIFO]) Initial public offerings Only issues purchased at offer price yield abnormal returns This is attributed to underpricing by the underwriters Announcements and news Little impact on price after release Involving economic news (e.g., inflation or Bank of Canada rate) Semi-Strong-Form Evidence

20. Professional Portfolio Manager Performance • There is substantial evidence that portfolio managers do not outperform the market (or earn abnormal risk-adjusted returns) over the long run • The average active portfolio manager may underperform the market index by 50 to 200 basis points • Based on fund averages (US-based equity mutual funds & pension funds)

21. Strong-Form Evidence • Test performance of groups which have access to nonpublic (private) information • Corporate insiders have valuable private information • A corporate insider is an officer, director, or major stockholder of a corporation who might be expected to have valuable inside information • Evidence that many have consistently earned abnormal returns on their stock transactions (strong-form efficiency is not supported) • Insider transactions must be publicly reported (OSC requires reporting y the tenth day of the next month)

22. Implications of Efficient Market Hypothesis • What should investors do if markets are efficient? • 1- Technical analysis • Not valuable if weak-form holds • The evidence accumulated to date overwhelmingly favors the weak-form EMH and casts doubt on technical analysis

23. Implications of Efficient Market Hypothesis • 2- Fundamental analysis • Seeks to estimate the intrinsic value of a security • Not valuable if semi-strong-form holds (since stock prices reflect all relevant publicly available information, gaining access to information others already have is of no value) • EMH suggests that investors who use the same data and make the same interpretations as other investors will experience average results

24. Implications of Efficient Market Hypothesis • 3- Money Management • For professional money managers (assuming that the market is efficient) • Less time spent on assessing individual securities • Passive investing favored (one passive investment strategy that is becoming increasingly popular is indexing, which involves the construction of portfolios designed to mimic the performance of a chosen market benchmark portfolio, such as S&P/TSX Composite Index) • Otherwise, must believe in superior insight

25. Implications of Efficient Market Hypothesis • 3- Money Management • Tasks that portfolio managers have to perform if markets are informationally efficient • Maintain correct amount of diversification • Achieve and maintain a desired level of portfolio risk • Manage tax burden • Control transaction costs (can be done through index funds)

26. Market Anomalies • Exceptions (techniques or strategies) that appear to be contrary to market efficiency • Regardless of how persuasive the case for market efficiency is, debate of this issue id likely to persist

27. Market Anomalies • Size effect • Tendency for small firms to have higher risk-adjusted returns than large firms • Market betas could not account for the abnormal returns • Bid-ask spreads, which are higher for smaller stocks, could not account for the abnormal returns As a result, when trading on the TSX, the small-firm strategy may be a viable strategy for increasing portfolio returns without an offsetting increase in risk

28. Market Anomalies Seasonality in stock returns • January effect • Tendency for small firm stock returns to be higher in January • Of the 30.5% small-size premium, half of the effect occurs in January • Referred to as “the small firm in January effect” because it is most prevalent for the returns of small-cap stocks • More than half of the excess January returns occurred during the first five trading days of that month

29. Market Anomalies Seasonality in stock returns • Day-of-the-week effect • The average Monday return is negative and significantly different from the average return of the other four days • Day-of-the-month effect • Returns tend to be higher on the last trading day of each month

30. Conclusions about Market Efficiency • Support for market efficiency is persuasive • Much research using different methods • Also many anomalies that cannot be explained satisfactorily • Markets are quite efficient, but not totally • To outperform the market, superior fundamental analysis (beyond the norm) must be done • The fundamental analysis that is done everyday is already reflected in stock prices

31. Conclusions about Market Efficiency • If markets are operationally efficient, some investors with the skill to detect a divergence between price and semi-strong value (price based on all available public information) earn profits • Excludes the majority of investors • Anomalies offer opportunities • Controversy about the degree of market efficiency still remains • The evidence to date suggests that investors face an operationally efficient market