FIN5558 INVESTMENTS Prof. Kofi Amoateng Chapter 7.

Stock Price Behavior and Market Efficiency

Commentary: Chapter 7 deals with (a) the foundations of market efficiency, (b) the implications of the forms of market efficiency, (c) Market efficiency and the performance of professional money managers, and (d) What stock market anomalies, bubbles, and crashes mean for market efficiency. Chapter 8 also deals with (a) Prospect theory, (b) the implications of investor overconfidence of misperceptions of randomness, (c) Sentiment-based risk and limits to arbitrage and the wide array of technical analysis methods used by investors. A. Introduction to Market Efficiency: Relation between stock prices and information available to investors indicating whether it is possible to "beat the market;" if a market is efficient, it is not possible except by luck. 1. Efficient market hypothesis (EMH): Theory asserting that, as a practical matter, the major financial markets reflect all relevant information at a given time. The primary question is: Can you, or can anyone, consistently "beat the market?" (Note that the duck on slide 7-5 is trying to beat the market with his hammer. In PowerPoint 2007, the duck is animated (This is the only animated slide in the supplements). The duck attempts to beat the market, but fails. This is intended to provide a bit of levity to the subject.) What does Beat the Market Mean? 2. Excess return: A return in excess of that earned by other investments having the same risk. To judge if an investment "beat the market," we need to know if the return was high or low relative to the risk involved. We need to determine if the investment has earned a positive excess return in order to say it "beat the market." B. Foundations of Market Efficiency: Three economic forces can lead to market efficiency. These conditions are so powerful that any one of them can result in market efficiency. These conditions are: 1. Investor Rationality. If every investor always made perfectly rational investment decisions, earning an excess return would be difficult. If everyone is fully rational, equivalent risk assets would all have the same expected returns. Put differently, no bargains would be there to be had, because relative prices would all be correct. 2. Independent Deviations from Rationality. Even if the investor rationality condition does not hold, the market could still be efficient. Suppose that many investors are irrational, and a company makes a relevant announcement about a new product. Some investors will be overly optimistic, while some will be overly pessimistic, but the net effect might be that these investors cancel each other out. In a sense, the irrationality is just noise that is diversified away. As a result, the market could still be efficient (or nearly efficient). What is important here is that irrational investors do not have similar beliefs. 3. Arbitrage. Suppose there are many irrational traders and further suppose that their collective irrationality does not balance out. In this case, observed market prices can be too high or too low
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relative to their risk. Now suppose there are some well-capitalized, intelligent, and rational investors. This group of traders would see these high or low market prices as a profit opportunity and engage in arbitragebuying relatively inexpensive stocks and selling relatively expensive stocks. If these rational arbitrage traders dominate irrational traders, the market will still be efficient. We sometimes hear the expression Market efficiency doesnt require that everybody be rational, just that somebody is. Lecture Tip. Students, like all of us, look at the world through their own experiences. They have met some irrational people in their lives. It is easy for them to think that these irrational people could be representative investors and that market efficiency simply cannot hold because of investor irrationality. C. Forms of Market Efficiency 1. Weak-form efficient market: A market in which past prices and volume figures are of no use in beating the market. Weak-form efficiency, with respect to information reflected in past price and volume figures. Past prices = future stock prices 2. Semistrong-form efficient market: A market in which publicly available information is of no use in beating the market. Semistrong-form efficiency, with respect to any publicly available information. Public information = future stock prices 3. Strong-form efficient market: A market in which information of any kind, public or private, is of no use in beating the market. Strong-form efficiency, with respect to any information, both public and private. Public & private information = future stock prices "A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return." So, a market can only be determined to be efficient with respect to specific information. To be clear, if the information allows an investor to earn excess returns on an investment, the market is not efficient with respect to that information. Therefore, if an investor uses past price information to earn an excess return, then the market is not weak-form efficient. If an investor uses a firm's financial statements to earn an excess return, the market is not semi-strong-form efficient. Finally, if an investor uses inside information to earn an excess return, the market is not strong-form efficient. **Why Would a Market Be Efficient? The driving force toward market efficiency is simply competition and the profit motive. Consider a large mutual fund such as the Fidelity Magellan Fund (one of the largest equity funds in the United States, with about $45 billion under management). Suppose Fidelity was able, through its research, to improve the performance of this fund by 20 basis points for one year only. How much would this one-time 20-basis point improvement be worth? The answer is 0.0020 times $45 billion, or $90 million. Thus, Fidelity would be willing to spend up to $90 million to boost the performance of this one fund by as little as one-fifth of 1 percent for a single year only. This example shows that even relatively small performance enhancements are worth tremendous amounts of money and thereby create the incentive to unearth relevant information and use it.

D. Some Implications of Market Efficiency 1. If markets are efficient:

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(i) Security selection is less important; investors may as well hold index funds to minimize their costs. (ii) There is little need for professional money managers. (iii) Investors should not try to time the market. (In fact, successful market timing is very difficult to achieve, even ignoring market efficiency.) 2. Lecture Tip: It may be helpful to restate the implications of market efficiency with respect to the forms of market efficiency, as follows: (i) Weak-form efficiency: If weak-form efficiency holds, then technical analysis is of no use, and the efforts of technical analysts are of no benefit to investors. (ii) Semi-strong-form efficiency: If semi-strong-form efficiency holds, then fundamental analysis using publicly available information is of no benefit, and most of the financial analysts and mutual fund managers are not providing any value. (iii)Strong-form efficiency: If strong-form efficiency holds, then inside information is of no value, suggesting that there should be no restrictions on insider trading. E. Does Old Information Help Predict Future Stock Prices? 1. In its weakest form, the efficient market hypothesis is the simple statement that stock prices fully reflect all past information. If this is true, this means that studying past price movements in the hopes of predicting future stock price movements is really a waste of time. 2. There is also a very subtle prediction at work here. That is, no matter how often a particular stock price path has related to subsequent stock price changes in the past, there is no assurance that this relationship will occur again in the future. 3. Researchers have used sophisticated statistical techniques to test whether past stock price movements are of any value in predicting future stock price movements. This turns out to be a surprisingly difficult question to answer clearly and without qualification. In short, although some researchers have been able to show that future returns are partly predictable by past returns, the predicted returns are not economically important, which means that predictability is not sufficient to earn an excess return. 4. In addition, trading costs generally swamp attempts to build a profitable trading system on the basis of past returns. Researchers have been unable to provide evidence of a superior trading strategy that uses only past returns. That is, trading costs matter, and buy-and-hold strategies involving broad market indexes are extremely difficult to outperform. F. Random Walks and Stock Prices 1. Ask your students whether stock market prices are predictable: many of them will say yes. To their surprise, it is very difficult to predict stock market prices. In fact, considerable research has shown that stock prices change through time as if they are random. That is, stock price increases and decreases are equally likely. 2. When the path that a stock price follows shows no discernible pattern, then the stocks price behavior is largely consistent with the notion of a random walk. A random walk is

related to the weak-form version of the efficient market hypothesis because past knowledge of the stock price is not useful in predicting future stock prices. 3. We illustrate daily price changes for Intel stock in the text. These daily price changes are not truly a random walk. To qualify as a true random walk, Intel stock price changes would have to be independent and identically distributed. Still, the graph of daily price changes for Intel stock is essentially what a random walk looks like. It is certainly hard to see any pattern in these daily price changes. G. How Does New Information Get into Stock Prices? 1. In its semi-strong form, the efficient market hypothesis is the simple statement that stock prices fully reflect publicly available information. Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock. The future prospects for the stock are influenced by unexpected news announcements. Prices can adjust to news announcements in three ways: i. Efficient market reaction: The price instantaneously adjusts to, and fully reflects, new information. There is no tendency for subsequent increases or decreases to occur. ii. Delayed reaction: The price partially adjusts to the new information, but days elapse before the price completely reflects new information. Overreaction and correction: The price over-adjusts to the new information; it overshoots the appropriate new price but eventually falls to the new price.

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H. Event Studies: We have included an event study for Advanced Medical Optics, Inc. (EYE) in the text. On Friday, May 25, 2007, executives of Advanced Medical Optics Inc. recalled a contact lens solution called Complete MoisturePlus Multi Purpose Solution. The company took this voluntary action after the Centers for Disease Control and Prevention (CDC) found a link between the solution and a rare cornea infection called acanthamoeba keratitis, or AK for short. Executives at Advanced Medical Optics chose to recall their product even though they did not find evidence their manufacturing process introduced the parasite that can lead to AK. Researchers use a technique known as an event study to test the effects of news announcements on stock prices. It has been our experience that students really like to get a glimpse of an actual technique used by finance researchers. You will note that we strove to focus our exposition on the reaction to the news, rather than the methods of event studies. I. Informed Traders and Insider Trading: Recall that if a market is strong-form efficient, no information of any kind, public or private, is useful in beating the market. However, inside information of many types clearly would enable you to earn essentially unlimited returns. This fact generates an interesting question: Should any of us be able to earn returns based on information that is not known to the public? In the United States (and in many other countries, though not all), making profits on nonpublic information is illegal. This ban is said to be necessary if investors are to have trust in U.S. stock markets. The United States Securities and Exchange Commission (SEC) is charged with enforcing laws
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concerning illegal trading activities. As a result, we present the distinctions among informed traders, illegal insider trading, and legal insider trading. 1. Informed Trading: When an investor makes a decision to buy or sell a stock based on publicly available information and analysis, this investor is said to be an informed trader. The information that an informed trader possesses might come from reading The Wall Street Journal, reading quarterly reports issued by a company, gathering financial information from the Internet, talking to other traders, or a host of other sources. Lecture Tip. You will notice that we do not talk about noise traders here. We left them out here because the focus of this section is on information. Talking about noise traders (and their lack of information) could deflect the discussion away from information and the types of informationbased trades. 2. Insider Trading (i) Illegal Insider Trading: For the purposes of defining illegal insider trading, an insider is someone who possesses material nonpublic information. Such information is both not known to the public and, if it were known, would impact the stock price. A person can be charged with insider trading when he or she acts on such information in an attempt to make a profit. Legal Insider Trading: A companys corporate insiders can make perfectly legal trades in the stock of their company. To do so, they must comply with the reporting rules made by the U.S. Securities and Exchange Commission. When they make a trade and report it to the SEC, these trades are reported to the public. In addition, corporate insiders must declare that trades that they made were based on public information about the company, rather than inside information. Most public companies also have guidelines that must be followed. Its Not a Good Thing: What did Martha Stewart Do? Martha Stewart was accused, but not convicted, of insider trading. She was accused, and convicted, of obstructing justice and lying to investigators. (ii) J. How Efficient are Markets? 1. Are Financial Markets Efficient? (a) There are four reasons why market efficiency is difficult to test: The risk-adjustment problem The relevant information problem The dumb luck problem The data snooping problem (b) There are three generalities based on research that are relevant to market efficiency: Short-term stock price and market movements are very difficult to predict with accuracy. The market reacts quickly and sharply to new information. There is little evidence that a market under (or over) reaction can be profitably exploited. If the stock market can be beaten, it is not obvious, so this implies that the market is not grossly inefficient. K. Some Implications of Market Efficiency

Even if all markets are efficient, asset allocation is still important because the risk-return tradeoff still holds. 1. Market Efficiency and the Performance of Professional Money Managers There have been a number of studies that compare the performance of mutual fund managers with market indices. The results of almost every study indicate that the market indices outperform the mutual fund managers. This is further evidence in favor of market efficiency. Mutual fund managers should be experts in technical and fundamental analysis, and they should be able to use these tools to earn excess returns, if anybody can. Lecture Tip: An interesting study by Fortin and Michelson [Journal of Financial Planning, February 1999] compares the performance of a large sample of mutual funds categorized by investment objective, to their respective market indexes. For example, growth funds were compared to the S&P 500, corporate bond funds were compared to the Lehman Brothers Corporate Bond index, international funds were compared to the Morgan Stanley EAFE index, and small company equity funds were compared to the Wilshire 2000. This study found that, on average, the benchmark indices significantly outperformed the mutual funds for all fund categories but one. The one category that the funds outperformed the index was small company equity funds. Apparently the fund managers are able to exploit enough market inefficiencies in the small firm equity market to allow excess returns to accrue. L. Anomalies In this section, several well-known market anomalies are discussed: the Day-of-the-week effect; the amazing January effect (and two of its extensions), and; Bubbles and Crashes (including the Market Crashes of 1929, 1987, the Asian Crash, and the Dot-Com Bubble and Crash). 1. Day-of-the-week effect: This is the term for the tendency for Monday to have a negative average return. Table 7.2 shows the day-of-the-week effect, which indicates that Monday is the only day with a negative average return (Monday Blues). Notice that Friday has a high positive return. This effect is statistically significant, but it is difficult to exploit it to earn a positive excess. About all we can do is use this in our trading decisions; purchase a stock late on Monday and sell our stocks late on Friday. 2. January effect: This is the term for the tendency for small stocks to have large returns in January. Figures 7.9a and 7.9b show the results of the January effect. Small stocks tend to have much higher returns in January, whereas larger stocks (S&P 500) do not show this result. The bulk of the return occurs in the first few days of January. The effect is more pronounced for stocks that have significant declines. This effect exists in most major markets around the world. Two factors are important in explaining the January effect: tax-loss selling and institutional investors rebalancing their portfolios. 3. Turn-of-the-Year Effect: Researchers have delved deeply into the January effect to see whether the effect is due to returns during the whole month of January or to returns bracketing the end of the year. Table 7.4 shows our calculations concerning this effect. The returns in the Turn-of-the-Year Days category are higher than returns in the Rest-of-the-Days category. Further, the difference is apparent in the 1984-2009 period. However, the difference was more than twice as large in the 1962-1983 period.

4. Turn-of-the-Month Effect: Financial market researchers have also investigated whether a turn-of-the-month effect exists. Table 7.5 shows the results of our calculations. It appears that this effect was stronger in the 1984-2009 period than in the 1962-1983 period. 5. The Holiday-effect in Middle Eastern Equity markets: A day after the Holy Friday Prayer of the Islamic countries is marked by relatively high stock prices. The same is true with the Tel Avi market in Israel where a day after the Sabbath day is marked by relatively high stock prices. M. The Earnings Announcement Puzzle Researchers have found that it takes days (or even longer) for a market price to adjust fully to information about earnings surprises. In addition, some researchers have found that buying stocks after positive earnings surprises is a profitable investment strategy. The Price-Earnings (P/E) Puzzle: The P/E ratio is widely followed by investors and is used in stock valuation. Researchers have found that, on average, stocks with relatively low P/E ratios outperform stocks with relatively high P/E ratios, even after adjusting for other factors, like risk. Because a P/E ratio is publicly available information, it should already be reflected by stock prices. However, purchasing stocks with relatively low P/E ratios appears to be a potentially profitable investment strategy. N. Bubbles and Crashes 1. A bubble occurs when market prices soar far in excess of what normal and rational analysis would suggest. Investment bubbles eventually pop because they are not based on fundamental values. When a bubble does pop, investors find themselves holding assets with plummeting values. 2. A crash is a significant and sudden drop in market wide values. Crashes are generally associated with a bubble. Typically, a bubble lasts much longer than a crash. A bubble can form over weeks, months, or even years. Crashes, on the other hand, are sudden, generally lasting less than a week. However, the disastrous financial aftermath of a crash can last for years. The Crash of 1929: Although the Crash of 1929 was a large decline, it pales with respect to the ensuing bear market. As shown in Figure 7.11, the DJIA rebounded about 20 percent following the October 1929 crash. However, the DJIA then began a protracted fall, reaching the bottom at 40.56 on July 8, 1932. This level represents about a 90 percent decline from the record high level of 386.10 on September 3, 1929. By the way, the DJIA did not surpass its previous high level until November 24, 1954, more than 25 years later. 4. The Crash of October 1987 (Black Monday): NYSE circuit breakers: This is the name for rules that kick in to slow trading when the DJIA declines by more than a preset amount in a trading session. In fact, if the DJIA declines far enough, trading will halt. On October 19, 1987 (Black Monday) the Dow plummeted 500 points to 1,700 with about $500 billion in losses that day. There are several explanations for what happened: 3.
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Irrational investors bid up stock prices and the bubble popped. Markets were volatile, the economy was shaky, and Congress was in session considering anti-takeover legislation. Program trading quickly created very large sell orders. Interestingly, the market recovered very quickly. The market was up in 1987 and the bull market continued for many years after the crash. As a result of the crash, NYSE circuit breakers were introduced. These circuit breakers required trading halts based upon 10, 20, and 30 percent declines in the DJIA. The trading halts vary from 30 minutes, to two hours, to the rest of the trading day. 5. The Asian Crash: The crash of the Nikkei Index, which began in 1990, lengthened into a particularly long bear market. It is quite like the Crash of 1929 in that respect. In three years from December 1986 to the peak in December 1989, the Nikkei 225 Index rose 115 percent. Over the next three years, the index lost 57 percent of its value. In April 2003, the Nikkei Index stood at a level that was 80 percent off its peak in December 1989. The Dot-Com Bubble and Crash: By the mid-1990s, the rise in Internet use and its international growth potential fueled widespread excitement over the new economy. Investors did not seem to care about solid business plansonly big ideas. Investor euphoria led to a surge in Internet IPOs, which were commonly referred to as dot-coms because so many of their names ended in .com. Of course, the lack of solid business models doomed many of the newly formed companies. Many of them suffered huge losses and some folded relatively shortly after their IPOs. The Amex Internet Index soared from a level of 114.60 on October 1, 1998, to its peak of 688.52 in late March 2000, an increase of about 500 percent. The Amex Internet Index then fell to a level of 58.59 in early October 2002, a drop of about 91 percent. By contrast, the S&P 500 Index rallied about 31 percent in the same 19982000 time period and fell 40 percent during the 20002002 time period.

7. The Crash of October 2008: Although still under debate, many agree that one of the underlying causes of the crash of 2008 was excess liquidity, which allowed unworthy borrowers to obtain financing, primarily for mortgages. Moreover, much of this was done at low teaser rates. When these rates reset, require payments increased, resulting in bankruptcies for these so-called subprime loans. If house prices had continued to climb, borrowers could have refinanced, avoiding trouble. However, this did not happen.

O. Selected Problems. 1. The following are the daily returns for both the overall market and for Dexter Inc. What is the cumulative abnormal return on Dexter, Inc., stock for these 5 days?

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2. Swenson Co. announced its merger plans on August 25 and had a daily return of 0.7 percent. Tyler Co. announced its merger plans on August 26 and had a daily return of 0.5 percent. The Underwood Co. announced its merger plans on August 27 and had a daily return of -0.1 percent. The daily market returns for August 25 through August 27 were 0.2, 0.3, and -0.4, respectively. What is the combined cumulative abnormal return for the announcement date? Solution: Combined cumulative daily abnormal return = [0.7% - 0.2%] + [0.5% 0.3%)] + [-0.1% - (-0.4%] = 1.0 % 3. What are some of the key lessons to be learned from historical stock market crashes? Solution: Feedback: Student answers will vary but should display a basic understanding of market crashes. Students can address causes of crashes, the suddenness of crashes, and the variances in post-crash market behavior. 4. . What should the primary role of portfolio managers be given the research to date on their market performance and based on the assumption that markets are efficient? Solution: Feedback: The role of portfolio managers is the construction and maintenance of a diversified portfolio designed to meet the needs and risk tolerances of their investors.