Market Efficiency

News and Returns All news, and announcements contain anticipated and

unexpected components The market prices assets based on what is

expected to happen (Anticipated news)Changes in expectations will cause the price to move

Unexpected news is a surprise and will cause prices to moveSurprises cause unexpected returns

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Breaking Returns Down

A security’s return is comprised of:1. The expected return, based on expectations2. The un-expected return, based on surprises

Therefore, a stock’s return is:

return theofpart unexpected theis

return theofpart expected theis

where

U

R

URR

Where does U come from? Systematic Surprises:

Difference between what we expect our factor to do and what actually happens

Ex: Market goes up 10% when expected 7% Unique Surprises:

Unanticipated eventsEx: CEO dies

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Breaking Returns Down (2)

We defined returns as: We can break U down further: is the return earned because of unexpected

movements in systematic risk is the return from unique surprises

URR

mRR

m

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Example Lets use the Fama French factors:

SML, HML, and Mkt Our model is:

εFβFβFβRR M ktM ktH M LH M LSM LSM L

Surprises Expected SML to be 3%, but it was 8%; surprise is?

0.08 – 0.03 = 5% Expected HML to be 4%, but it was 1%; surprise is?

0.01 – 0.04 = -3% Expected Mkt to be 10%, but it was stable; surprise is?

0.00 - 0.10 = -10% Finally, the firm attracted a “superstar” CEO, and this

unanticipated development contributes 1% to the return.

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Example Betas The stock’s betas are:

1. SML = -2.30

2. HML = 1.50

3. Mkt = 0.50

The stock’s expected return is 8%

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Example’s Actual Return

%1%)10(50.0%)3(50.1%530.2%8 R

εFβFβFβRR M ktM ktH M LH M LSM LSM L

%12R

Underlying Assumption

The assumption we made, and that drove the last example, is that the stock is priced in an efficient market

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What is an efficient market? A market is efficient when it uses all available

information to price assets.Information is quickly incorporated into prices

Efficiency is the degree to which prices reflect available information.

Stock prices only respond to surprises, which arrives randomly, so prices follow a random walk

Price tomorrow = today’s price + random (+/-)

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Price: Today and Tomorrow

Do you see a pattern that you want to put money on?

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Reactions to Beating Expectations

Efficient Response

Over Reaction

Under Reaction

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Reaction to Not Meeting Expectations

Over Reaction

Efficient Reaction

Under Reaction

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Potential Causes of Efficient Markets

Investor RationalityEveryone is rational → Everyone makes the right

decision Independent Deviation from Rationality

No one is rational → Everyone makes the wrong decision but each makes a different wrong decision

Average out the wrongness

ArbitrageOnly some people are rational → Smart money takes

from less smart money

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Types of Efficient Markets

Weak

Semi-Strong

Strong

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Weak Form Efficiency

Prices reflect all information contained in past prices and volumesNo investor is able to form a trading strategy based

on historic prices and volumes and earn an excess return

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Disbelievers

Chartists, or Technical AnalystsAnalyze “charts” of a stock‘s Price and/or Volume

Chartist believe in identifiable and predictable patterns in these characteristicsMake investment decisions based on these patterns

Brokerage firms tend to love chartists

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Head and Shoulders

Why Technical Analysis Fails

-If there is a profitable pattern, everyone would do it

-If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern

Sto

ck P

rice

Time

Sell

Sell

Buy

Buy

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Semi-Strong Form Efficiency

Security prices reflect all publicly available information.Encompasses weak form efficiency

Publicly available information includes: Historical price and volume information

Published accounting statements

Information found in the WSJ

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Disbelievers

Fundamental AnalystsUse revenues, earnings, future growth forecasts,

return on equity, profit margins, and other data to determine a company's underlying value and potential for future growth (Financial Statements)

These guys make more sense than technical analysts. Why?

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Strong Form Efficiency Strong form efficiency says that anything

pertinent to the stock price and known to at least one investor is already incorporated in the security’s price.Public & PrivateImplies: Insider trading will not earn excess return

Strong form efficiency incorporates weak and semi-strong form efficiency.

Disbelievers

Pretty much everyone Insiders trading is generally profitable

Galleon Raj Rajaratnam

Martha Stewart

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What EMH Does and Does NOT Say

Investors can throw darts to select stocks. Kind of: We still need to consider risk

Prices are random or uncaused. Prices reflect information. Price CHANGES are driven by new information,

which by definition is random

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Implications of Efficient Markets Purchase or sale of any security can never be a

positive NPV transaction. Trust market prices Stocks with similar risk are substitutes Mutual fund managers cannot systematically

outperform the market

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The Evidence The record on the EMH is extensive,

and generally supportive of the market being semi-strong form efficient

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Event Studies

Event Studies examine returns around information release datesEX: Earnings, Dividend announcementsA test of semi-strong form efficiency

Look at how quickly prices adjust to the informationLooking for under-reaction, over-reaction, early

reaction, or delayed reaction around the event.

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Event Study Results The studies generally support the view that the

market is semi-strong form efficient. Studies suggest that markets may even have

some foresight into the future, i.e., news tends to leak out in advance of public announcements.

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Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing

Dividend Omissions

0.146 0.108

-0.72

0.032-0.244-0.483

-3.619

-5.015-5.411-5.183

-4.898-4.563-4.747-4.685-4.49

-6

-5

-4

-3

-2

-1

0

1

-8 -6 -4 -2 0 2 4 6 8

Days relative to announcement of dividend omission

Cum

ulat

ive

abno

rmal

ret

urns

(%

)

Efficient market response to “bad news”

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The Record of Mutual Funds If the market is semi-strong form efficient,

then mutual fund managers, should not be able to consistently beat the average market return

When we compare the record of mutual fund performance to a market index, we see that mutual funds are not able to CONSISTENTLY beat the market.Consistent with the market being semi-strong form

efficient

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Mutual Fund Performance

Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).

-2.13%

-8.45%

-5.41%

-2.17% -2.29%

-1.06%-0.51%-0.39%

All funds Small-companygrowth

Other-aggressive

growth

Growth Income Growth andincome

Maximumcapital gains

Sector

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Insider trading

Strong form market efficiency implies that even insiders trading on private information cannot earn excess return

A number of studies find that insiders are able to earn abnormal profitsViolation of Strong form efficiency

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Verdict on Market Efficiency

Market is pretty efficient Opportunities for easy profits are rare. Financial managers should assume, at least as

a starting point, that security prices are fair and that it is difficult to outguess the market.

New information is rapidly incorporated into the prices.

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EMH Exercises Indicate whether or not the EMH is contradicted, if

so which form of EMH is contradicted An investor consistently earn an abnormal return over

that expected by the market by examining charts of historical prices

The acquisition of the latest annual report of a company enables an investor to earn an abnormal return.

A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows.

By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments.

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EMH Exercises An investor consistently earn an abnormal return over that expected by

the market by examining charts of historical prices Yes, Weak

The acquisition of the latest annual report of a company enables an investor to earn an abnormal return. Yes, Semi-Strong

A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows. No

By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments. Yes, Semi-Strong

Why We Care

Offering several points of view on how the market works, and the evidence for and againstUsing this you can form your own opinion about

how the market works and invest accordingly

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