14 STOCK MARKET EFFICIENCY
OHT 14.1
LEARNING OBJECTIVES
• Discuss the meaning of the random walk
hypothesis and provide a balanced judgement
of the usefulness of past price movements to
predict future share prices (weak-form
efficiency)
• Provide an overview of the evidence for the
stock market’s ability to take account of all
publicly available information including past
price movements (semi-strong efficiency)
• State whether stock markets appear to absorb
all relevant (public or private) information
(strong-form efficiency)
• Outline some of the behavioural-based
arguments leading to a belief in inefficiencies
• Comment on the implications of the evidence
for efficiency for investors and corporate
management
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.2
WHAT IS MEANT BY EFFICIENCY?
In an efficient capital market security (for
example shares) prices rationally reflect
available information.
The current level is an unbiased estimate of its
true economic value based on information
revealed
1 The direction of the price share movement
2 The size of that movement
3 The absence of abnormal profit possibilities
Most investors are too late.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
TYPES OF EFFICIENCY
1 Operational efficiency
2 Allocational efficiency
3 Pricing efficiency
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 14.3
14 STOCK MARKET EFFICIENCY
OHT 14.4
THE VALUE OF AN EFFICIENT
MARKET
1 To encourage share buying
2 To give correct signals to company managers
- feedback
- required rate of return
- disclosure
3 To help allocate resources
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
olvo share price
V
14 STOCK MARKET EFFICIENCY
OHT 14.5
New information (an electric car
announcement by BMW) and alternative stock market
reactions – efficient and inefficient
Exhibit 14.1
BMW/ share price
Line 3 Overreaction
followed by deflation
Line 2 Anticipatory
price movements
(information leak)
Efficient market
B
A
Line 4 Persistent inefficiency
Line 1 Slow reaction
–10
–5
0
Announcement
date
+5
+10 +11 Days before (–)
and days after (+)
announcement
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.6
Share index
RANDOM WALKS
180
170
Share index
160
150
140
130
120
110
100
90
80
Weeks
(a )
150
Share index
140
130
120
110
100
90
80
(b )
Weeks
Exhibit 14.2 Charts showing the movements on the FT 100 share index and a
randomly generated index of prices. Which is which?
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.7
WHY DOES THE RANDOM WALK
OCCUR?
The price at any one time reflects all
available information and it will only change
if new information arises.
Actual movement after ‘pattern’ is identified
Share price
Movement
expected by chartist
A
Time
B
6 months
Exhibit 14.3 A share price pattern disappears as investors recognise its
existence
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.8
THE THREE LEVELS OF
EFFICIENCY
1 Weak-form efficiency
Share prices fully reflect all information
contained in past price movements.
2 Semi-strong form efficiency
Share prices fully reflect all the relevant
publicly available information.
3 Strong-form efficiency
All relevant information, including that which
is privately held, is reflected in the share price.
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
WEAK-FORM TESTS
A simple price chart – chartists
Exhibit 14.4
The ‘head and shoulders’ pattern
Share price
A
B
Time
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 14.9
14 STOCK MARKET EFFICIENCY
Exhibit 14.5
OHT 14.10
A ‘line and breakout’ pattern
Share price
Break out
Resistance line
Support line
Time
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.11
The Filter approach
Focuses on the long-term trends and on filtering shortterm movements.
The Dow theory
The stock market is characterised by three trends.
• The primary trend is the long-term move in
share prices
• The intermediate trend runs for weeks or
months
• Tertiary trends last for a few days
Market index
Exhibit 14.6 The Dow theory
D
C
B
A
Time
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.12
Weak-form efficiency
Weight of evidence: the weak form of
efficiency is generally accepted.
However, there are exceptions.
• Overreaction hypothesis
– De Bondt and Thaler
– Dissanaike
– Chopra, Lakonishok and Ritter
• Simple trading rules
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.13
SEMI-STRONG FORM TESTS
Is it worthwhile expensively acquiring and
analysing publicly available information?
Semi-strong efficiency undermines fundamental
analysts.
• Information announcements
• Manipulation of earnings
• Seasonal, calendar or cyclical effects
• Small firms
• Underreaction/momemtum
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
OHT 14.14
14 STOCK MARKET EFFICIENCY
OHT 14.15
SEMI-STRONG FORM TESTS
• Value investing
– Price-earnings ratios
– Share price low relative to the balance sheet
assets (book-to-market ratio)
– High dividends relative to the share price (highyield shares)
• Bubbles
• Comment on the semi-strong efficiency
evidence
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.16
THE VIEWS OF SCEPTICAL
PRACTITIONERS
• PETER LYNCH
• BENJAMIN GRAHAM
• WARREN BUFFETT and
CHARLES MUNGER
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.17
STRONG-FORM TESTS
• It is possible to trade shares on
the basis of inside knowledge
and thereby make abnormal
profits
• Curbing insider dealing:
–
–
–
–
Criminal offence
Stock market rules
Information disclosure
No dealing at certain times
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.18
BEHAVIOURAL
FINANCE
• EMH:
– Investors are rational
– Or, even if some are irrational, the
actions of rational investors eliminate
pricing anomalies
• Behavioural finance:
– Investors frequently make systematic
errors
– These errors push share prices away
from fundamental value
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.19
BEHAVIOURAL
FINANCE
•
Three lines of defence
–
–
–
Investors are rational
Even if some are not rational, their
irrationally inspired trades of securities
are random and therefore the effects of
their irrational actions cancel each other
out without moving prices away from
their efficient level.
If the majority of investors are irrational
in similar ways and therefore have a
tendency to push security values away
from the efficient level this will be
countered by rational arbitrageurs who
eliminate the influence of the irrational
traders on prices.
•
Noise trader risk
•
Risky arbitrage
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.20
Some cognitive errors made by
investors
•
•
•
•
•
•
•
•
•
•
Overconfidence
Representativeness
Conservatism
Narrow framing
Ambiguity aversion
Positive feedback and
extrapolative expectations
Regret
Cognitive dissonance
Availability heuristic
Miscalculation of probabilities
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.21
MISCONCEPTIONS ABOUT THE
EFFICIENT MARKET HYPOTHESIS
1 Any share portfolio will perform as well as or
better than a special trading rule designed to
outperform the market
2 There should be fewer price fluctuations
3 Only a minority of investors are actively
trading, most are passive, therefore efficiency
cannot be achieved
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002
14 STOCK MARKET EFFICIENCY
OHT 14.22
IMPLICATIONS OF THE EMH FOR
INVESTORS
1 For the vast majority of people public
information cannot be used to earn abnormal
returns
2 Investors need to press for a greater volume
of timely information
3 The perception of a fair game market could be
improved by more constraints and deterrents
placed on insider dealers
IMPLICATIONS OF THE EMH FOR
COMPANIES
1 Focus on substance, not on short-term
appearance
2 The timing of security issues does not have to
be fine-tuned
3 Large quantities of new shares can be sold
without moving the price
4 Signals from price movements should be
taken seriously
Glen Arnold: Corporate Financial Management, Second edition
© Pearson Education Limited 2002