The Market Efficiency

1. The Market Efficiency

2. Outline • Introduction • Role of the capital markets • Efficient market hypothesis • Anomalies

3. Introduction • Capital market theory springs from the notion that: • People like return • People do not like risk • Dispersion around expected return is a reasonable measure of risk

4. Role of the Capital Markets • Definition • Economic function • Continuous pricing function • Fair price function

5. Definition • Capital markets trade securities with lives of more than one year • Examples of capital markets • The Bursa Malaysia • New York Stock Exchange (NYSE) • Chicago Board Options Exchange (CBOE)

6. Economic Function • The economic function of capital markets facilitates the transfer of money from savers to borrowers • E.g., mortgages, Treasury bonds, corporate stocks and bonds

7. Continuous Pricing Function • The continuous pricing function of capital markets means prices are available moment by moment • Continuous prices are an advantage to investors • Investors are less confident in their ability to get a quick quotation for securities that do not trade often

8. Fair Price Function • The fair price function of capital markets means that an investor can trust the financial system • The function removes the fear of buying or selling at an unreasonable price • The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

9. Efficient Market Hypothesis • Definition • Types of efficiency • Weak form • Semi-strong form • Strong form • Semi-efficient market hypothesis • Security prices and random walks

10. Definition • The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair • Market efficiency research examines the relationship between stock prices and available information • The important research question: Is it possible for investors to “beat the market”

11. Definition • Prediction of the EMH theory: If a market is efficient, it is not possible to “beat the market” (except by luck) • Fama (1970): A market in which prices always ‘fully reflect’ available information is called ‘efficient’

12. What Does “Beat the market mean? • The excess return on an investment is the return in excess of that earned by other investments that have the same risk • “Beating the market” means consistently earning a positive excess return.

13. Types of Efficiency • Operational efficiency measures how well things function in terms of speed of execution and accuracy • When the cost of transferring funds is “reasonable”, market is said to be operational efficient • It is a function of the elapsed time between the receipt of an order and its execution

14. Types of Efficiency (cont’d) • Informational efficiency is a measure of how quickly and accurately the market reacts to new information • It relates directly to the EMH • The market is informationally very efficient • Security prices adjust rapidly and accurately to new information • The market is still not completely efficient

15. Types of Investment Analysis • Fundamental Analysis • Analyze earnings, dividend, sales prospects, costs, the economy, the industry, competition, capital requirements • Technical Analysis • Analyze past prices and their patterns, trading volumes technical market indicators, investor sentiment

16. Weak Form • Definition • Weak form tests • Charting (moving averages) • Runs tests • Serial correlation tests • Unit root tests (ADF, PP)

17. Definition • The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past • The current price is a fair one that considers any information contained in the past price data • If so, then technical analysis is of little use

18. Definition (cont’d) Example Which stock is a better buy? Stock A Current Stock Price Stock B

19. Definition (cont’d) Example (cont’d) Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

20. Charting • People who study charts are technical analysts or chartists • Chartists look for patterns in a sequence of stock prices • Many chartists have a behavioral element

21. Runs Test • A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance • A run is an uninterrupted sequence of the same observation • A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number

22. Conducting A Runs Test

23. Tests of Market Efficiency – Weak form tests • The question is: How well do past returns predict future returns? • The main assumption is that there should be no pattern in the time series of returns • Three theories of time series behaviour of prices can be found in the literature: • The fair-game model • The martingale or sub-martingale model • The random walk model

24. Tests of Market Efficiency – Weak form tests • The fair game model • Is based on the behaviour of average returns’ E (j,t+1) = E [rj,t+1 –E (rj,t+1 |)] = 0 • A fair game means that, on average, across a large number of samples, the expected return on a security equals its actual return

25. Tests of Market Efficiency – Weak form tests • The martingale model • It also a fair game, where tomorrow’s price is expected to be the same as today (the expected return is zero) E(Pj,t+1) = Pj,t • The sub-martingale model • Is a fair game with positive returns E(Pj,t+1) > Pj,t

26. Tests of Market Efficiency – Weak form tests • The random walk model • The simplest form version is the independently and identically distributed increments case, in which the dynamics of prices are given by the equation: Pt =  + Pt-1 + t t~ IID(0, 2)

27. Tests of Market Efficiency – Weak form tests • Hypotheses Ho: Prices follow random walk HA: Market is weak form efficient If the random walk hypothesis holds, the weak form of the EMH must hold, but not vice versa. Thus, evidence supporting the random walk model is the evidence of market efficiency. But violation of the random walk model need not be evidence of market inefficiency in the weak form

28. Semi-Strong Form • The semi-strong form of the EMH states that security prices fully reflect all publicly available information • E.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc. • If so, then fundamental analysis is of little use.

29. Semi-Strong Form (cont’d) • Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as: • Stock splits • Cash dividends • Stock dividends • This means investor are seldom going to beat the market by analyzing public news

30. Semi Strong Form Tests • Event studies (dividend announcements, stock splits, earning surprises): market usually reacts as expected • Anomalies small cap stocks, low P/E stocks, low share price stocks : not as expected • Above normal return theoretically possible, but minimized by search costs, transaction costs

31. Strong Form • The strong form of the EMH states that security prices fully reflect all public and private information • This means even corporate insiders cannot make abnormal profits by using inside information • Inside information is information not available to the general public

32. Strong Form Tests • Institutional investors (experts): No above normal returns after costs of search, transaction, and management • Corporate insiders can earn excess returns temporarily • Talented analysts can take advantage of lags in the adjustment process

33. Semi-Efficient Market Hypothesis • The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others • Less well-known companies are less efficiently priced • The market may be tiered • A security pecking order may exist

34. Security Prices and Random Walks • The unexpected portion of news follows a random walk • News arrives randomly and security prices adjust to the arrival of the news • We cannot forecast specifics of the news very accurately

35. Why would a Market be Efficient? • The driving force toward market efficiency is simply competition and the profit motive • Even a relatively small performance enhancement can be worth a tremendous amount of money (when multiplied by the dollar amount involved) • This creates incentives to unearth relevant information and use it

36. Are Financial Markets Efficient? • Market efficiency is difficult to test • There are four basic reasons for this: • The risk-adjustment problem • The relevant information problem • The dumb luck problem • The data snooping problem

37. Are Financial Markets Efficient? • Nevertheless, 3 generalities about market efficiency can be made: • 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

38. 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 • It makes little sense to time the market

39. Anomalies • Definition • Low PE effect • Low-priced stocks • Small firm effect • Neglected firm effect • Market overreaction • January effect

40. Anomalies (cont’d) • Day-of-the-week effect • Turn-of-the calendar effect • Persistence of technical analysis • Chaos theory

41. Definition • A financial anomaly refers to unexplained results that deviate from those expected under finance theory • Especially those related to the efficient market hypothesis

42. Low PE Effect • Stocks with low PE ratios provide higher returns than stocks with higher PEs • Supported by several academic studies • Conflicts directly with the CAPM, since study returns were risk-adjusted

43. Low-Priced Stocks • Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price • There is an optimum trading range • Every stock with a “high” stock price should split

44. Small Firm Effect • Investing in firms with low market capitalization will provide superior risk-adjusted returns • Supported by academic studies • Implies that portfolio managers should give small firms particular attention

45. Neglected Firm Effect • Security analysts do not pay as much attention to firms that are unlikely portfolio candidates • Implies that neglected firms may offer superior risk-adjusted returns

46. Market Overreaction • The tendency for the market to overreact to extreme news • Investors may be able to predict systematic price reversals • Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

47. January Effect • Stock returns are inexplicably high in January • Small firms do better than large firms early in the year • Especially pronounced for the first five trading days in January

48. January Effect (cont’d) • Possible explanations: • Tax-loss trading late in December (Branch) • The risk of small stocks is higher early in the year (Rogalski and Tinic)

49. Types of Firms in January

50. Day-of-the-Week Effect • Mondays are historically bad days for the stock market • Wednesday and Fridays are consistently good • Tuesdays and Thursdays are a mixed bag