C HAPTER 7, L ecture N otes

1. CHAPTER7, Lecture Notes Stock Price Behavior and Market Efficiency Chapter Sections: Introduction to Market Efficiency What Does “Best the Market” Mean? Foundations of Market Efficiency Forms of Market Efficiency Why Would a Market Be Efficient? Some Implications of Market Efficiency Informed Traders and Insider Trading How Efficient are Markets? Market Efficiency and the Performance of Money Managers Anomalies Bubbles and Crashes All Stars of Investing A better name for this chapter might be, “Can You ‘Beat the Market?’” “I can calculate the movement of the stars, but not the madness of men.” – Sir Isaac Newton

2. Random Walks & Efficient Markets • Random Walk Hypothesis • The theory that stock price movements are unpredictable • In the short term, yes, they appear random • In the long term, no (We hope – Failure is not an option!) • Efficient Market Hypothesis • A market in which securities reflect all possible information quickly and accurately • If there are large numbers of knowledgeable investors who react quickly to new information, security prices will adjust quickly and accurately • The New York Stock Exchange is an efficient market A Random Walk Down Wall Street

3. Levels of Market Efficiency • Weak Efficiency Hypothesis • Past data on stock prices are of no use in predicting future prices • However, stock prices do tend to demonstrate momentum • Stock prices tend to rise more often than they fall • And they tend to move far higher than is usually justified (mania, bubble) or far lower than is usually warranted (crash) • “The market can stay irrational longer than you can stay solvent.” − John Maynard Keynes If this theory is true, then technical analysis (which we will cover in Chapter 8) is useless.

4. Levels of Market Efficiency (continued) • Semi-strong Efficiency Hypothesis • Abnormally large profits cannot be consistently earned using publicly available information • In other words, no amount of analysis that you do to determine the future price of a stock will help you “beat the market” • But there are many, many investors who have • We will look at some of them later • What does the theory say about those investors? • They are just lucky! • “The more I practice, the luckier I get.” If this theory is true, then fundamental analysis (which we covered in Chapters 6 & 17) is useless.

5. Levels of Market Efficiency (continued) • Strong Efficiency Hypothesis • No information, public or private, allow investors to earn abnormally large profits consistently • But one insider information trade can make you rich instantly • If you do not get caught, that is… This is obviously false. If you had material nonpublic information (the legal term for insider information) about a company, you could make a fortune overnight! But you could also go to jail.

6. Market Efficiency Rational • The Random Walk and Efficient Market theorists are often also major proponents of index funds • They point to the fact that many professional money managers simply do not “Beat the Market” • Especially during bull markets • From 1963 to 1998, the S&P 500 index outperformed general equity mutual funds 22 out of 36 times They reason that you are better off accepting (close to) the market’s return with low-cost index funds since their theory tells them that no one can consistently “beat the market.”

7. Market Efficiency Rational (continued) • Why can’t many pros beat the averages? • Many mutual funds have high annual operating expenses and high turnover rates, and… • Many mutual fund managements have a very short time horizon • Consequently, many mutual fund managers have a very short lifespan • But the premises and casual observations of the Efficient Market theories show them to be patently absurd • Many money managers have “Beaten the Market” • Over long periods of time (“the more I practice…”) Plus if markets are efficient and rational, how do you explain …?

8. Manias • Occasionally, investors get caught up in what are called “manias” (a.k.a. “bubbles”) • The Internet bubble of the 1990’s was the latest stock mania • Before that, there was the “Nifty-Fifty” of the early 1970’s • The mania of the 1920’s resulted in the Crash of 1929 • In the 1840’s, there were 400 railroad firms • The “Granddaddy of all Manias” was the Dutch tulip bulb craze of the early 1600’s • Extraordinary Popular Delusions & the Madness of Crowds • The Botany of Desire • Each time, the phrase was… • “It’s a New Era” or • “It’s Different This Time” or • “The old ways of valuing stock are gone” • Each time, they were wrong! So much for “Rational Efficient Markets!”

9. Manias (continued) • Why do manias occur over and over again? Why haven’t investors learned their lesson? • Any ideas? “[market manias] will happen over and over again because the public is infinitely stupid.” – Leonard Kaplan, president of commodities brokerage firm Prospector Asset Management in Evanston, Illinois.

10. Manias (continued) • Benjamin Graham sez… “The speculative public is incorrigible. It will buy anything, at any price, if there seems to be some ‘action’ in progress. It will fall for any company identified with ‘franchising,’ computers, electronics, science, technology, or what have you, when the particular fashion is raging. … the abuses are so largely the result of the public’s own heedlessness and greed.” – The Intelligent Investor, 1972 edition Replace “franchising,” computers, etc. with Internet, biotechnology, etc. and Good Ol’ Ben could have been writing in 2000 instead of 1972. Today, the buzz words are social networking and China.

11. Crashes • How do most manias end? • Yep – You guessed it! They invariably end with a crash. • “The bigger the party, the bigger the hangover” • They are not fun but the odds are you will live through at least one during your investing career “With this many strong years, I have the concern that there are a vast majority of companies that are significantly overvalued on a long-term basis.” -- Jon Lovelace, August 1999, mutual fund manager with almost 50 years experience at the time Oh, by the way, the 2008/2009 market crash was not caused by a stock market bubble. It was a real estate bubble (and the mortgage-backed bonds that were tied to the real estate mortgages).

12. Eleven Worst Days of the Dow Jones Industrial Average Crashes (continued)

13. Index Funds, Market Indices, Manias, and Crashes • Recall: Index funds and ETFs rely on indices • “Instead of trying to beat the market, just buy the market and be happy with the market return” • But sometimes an index can become skewed • Especially when a sector or region becomes “hot” MSCI EAFE 12/31/89 S&P 500 3/31/00 Info Tech, 33.3% P/E: 59.2 Japan, 59.8% P/E: 51.9 All else, 66.7% P/E: 19.3 All else, 40.2% P/E: 13.0

14. Anomalies, Silly Theories, Oddities • Timing Theories • The Monday Effect – Best day to buy (or is it sell?) • The January Effect – As goes January, so goes the year • The “Santa Claus” Rally – “Turn-of-the-year” effect • “Sell in May and Go Away!” • September and October – Worst months of the year • November to March – Best months of the year • Super Bowl Theory • National League Wins – bullish • American League Wins – bearish • Hemlines of skirts • Mini skirts – bullish (1920’s, 1960’s) • Long skirts – bearish (1930’s, 1970’s) • Politics and the Stock Markets There are many other silly theories such as the Lipstick Indicator, the Boston Snow Indicator (a.k.a. the BS Indicator), the Hot Waitress Indicator, and the Aspirin Count Theory.

15. All Stars of Investing • Peter Lynch • Fund Manager of Fidelity’s Magellan mutual fund • “Buy what you know” • Warren Buffet • “Don’t buy a stock; buy a company” • Puts emphasis on the value of the entire company • Benjamin Graham • He was Warren Buffet’s teacher • “Father of Value Investing” • Wrote “The Intelligent Investor” and “Security Analysis” • John Templeton • One of the first mutual fund managers to invest globally

16. All Stars of Investing (continued) • Bill Miller • Fund Manager of Legg Mason Value Trust • For 15 years calendar years in a row, he beat the S&P 500, an unprecedented record! • He became (unfortunately for him, as far as I was concerned) the financial media’s mega-star • But then he did not beat the S&P 500 in 2006 and lagged badly in 2007 and 2008 during the turmoil • He seemed to redeem himself in 2009 when he was up over 40% beating the 26% return of the S&P 500 • But then again trailed the S&P 500 badly in 2010 and 2011 • He will be retiring this year • I was surprised Legg Mason let him stay as long as they did

17. All Stars of Investing (continued) • What do all these people have in common? • Courage to not follow the crowd • The “conventional wisdom” is usually not very wise! • A eye for unrecognized value • Almost a “sixth sense” • Gary Kasparov was once asked why he and Anatoly Karpov were the two best chess players in the world • His answer was astonishingly simple and direct • “We attack better than anybody else and we defend better than anybody else” • These people bought the best companies and they avoided the worst companies

18. All Stars of Investing (continued) • Speaking of avoidance… • As a mutual fund investor, I am not looking to find the next Peter Lynch or Bill Miller or Warren Buffet • I am looking to avoid the next Charles Steadman • Charles Steadman ran his own mutual fund, the Steadman American Industry Fund, from December 1959 until his death in late 1997 • His cumulative total return was -42.9% • He would have done much better simply placing his investors’ funds into a savings account at a bank • He would have done better putting it in a mattress! • Maybe he came from the life insurance industry…

19. Warren Buffet sez… “Be fearful when others are greedy. Be greedy when others are fearful.” His mentor, Benjamin Graham said it this way, “Buy when most people including experts are overly pessimistic, and sell when they are actively optimistic.”

20. John Templeton sez… “Bear markets are born of pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy.” On a similar note, he also said, “To buy when others are despondently selling and sell when others are avidly buying requires the greatest fortitude and pays the greatest reward.”

21. Famous Myths & Stupid Sayings • “It can’t go any lower” • Oh, yes it can! It can go to zero! • “It can’t go any higher” • Oh, yes it can! If the earnings are continuing to grow, there is no limit to how high the price can go • “It is only $3 a share – What can I lose?” • It does not matter how low the price is, the price can go to zero and you can lose all your money • Remember: Price is irrelevant; valuation is the key • “It has to come back” • Have any of you ever heard of Penn Central?

22. Famous Myths & Stupid Sayings (continued) • “It is always darkest before the dawn” • Sometimes it’s always darkest before it’s pitch black • “When it rebounds to $10, I will sell” • A stock has no idea you bought it at $10 • If you would not buy it now at this price, sell it now! • “If it goes down 10%, sell” • Stock prices fluctuate greatly, even blue chips • If you sold each stock that lost 10%, you would almost always sell your winners along with your losers • “It is taking too long” • Patience is an investor’s most important trait • Besides, it gives you a chance to buy more!

23. Famous Myths & Stupid Sayings (continued) • “Look at all the money I’ve lost – I didn’t buy it” • Coulda’, Woulda’, Shoulda’ • You did not lose a cent by not buying a stock that did well – Do not fret over it! • “I missed that one, I will catch the next one” • The “next” one rarely makes it • Why wait for the next Microsoft? Buy Microsoft! • “The stock has gone up, I must be a genius” • “Never mistake a bull market for brains” • Old Wall Street saying • “The stock has gone down, I must be an idiot” • Ditto (but in reverse)

24. Famous Myths & Stupid Sayings (continued) • “It’s Different This Time” • Well, technically, yes. It is different every time. • But that does not mean you should pay an astronomical price for a company that probably will never make a dollar of profit (Hint: Internet stocks) • “It’s a New Era” • Ditto (When you hear this one, it is time to sell) • “It’s a Permanent Trend” • Ain’t No Such Thing! Markets move in cycles. • “Stocks are too risky” • Even with all the shenanigans and stupidity, they are still the best long-term financial investment

25. CHAPTER7 – REVIEW Stock Price Behavior and Market Efficiency Chapter Sections: Introduction to Market Efficiency What Does “Best the Market” Mean? Foundations of Market Efficiency Forms of Market Efficiency Why Would a Market Be Efficient? Some Implications of Market Efficiency Informed Traders and Insider Trading How Efficient are Markets? Market Efficiency and the Performance of Money Managers Anomalies Bubbles and Crashes All Stars of Investing Next week: Chapter 8, Behavioral Finance and the Psychology of Investing