Lecture Notes – October 5th
Things to have – websites/slides
http://www.federalreserveeducation.org/about-the-fed/history/
http://www.kansascityfed.org/publicat/balanceofpower/balanceofpower.pdf
http://www.federalreserveeducation.org/resources/search/?rGrade=9-12
http://www.tradingeconomics.com/brazil/currency
Readings – Chapter 6 in the book will be today’s topic. We will then turn to chapters 9
& 10 on Central Banks and Monetary Policy
Comment:
Someone from Teach for America is going to be here at 9:50 next Monday to give a 5
minute presentation between classes.
Efficient Markets Hypothesis
Today we are going to talk about the efficient markets hypothesis. Do not worry –
this is not going to be on this mid-term.
In an efficient market the prices of securities fully reflect all available public
information.
Let’s start with an economist joke. This is only slightly better than most
mathematician jokes I know…
Two economists are walking down the street when one spots a $100 dollar bill lying
on the ground. As he stoops down to pick it up the other says –don’t bother – if it
were real then someone would have already picked it up.
One thing that this joke says though is that information needs to disseminate in
order for markets to be efficient. Certainly there has to be a first person to spot the
$100 bill and thus it is possible that the economists were first. If the street were
quiet then it would make it even more plausible that the economists were first.
The point that the joke is trying to make is that markets are so efficient that there is
a tiny probability that you are the first person with new information.
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Therefore you cannot beat the market. If you think you know something that the
market does not know, the market will win. Namely you cannot access publicly
available information and expect to be able to beat the market with it.
Let’s look at some examples and decide whether they reflect efficient markets or
not. Currencies. Here is a chart of the Brazilian Real from 1994-2001. This was not
an efficient market. Here is a chart of the HK Dollar from 96 to 2004. Again not an
efficient market. Government control meant that these markets did not fluctuate
according to market forces…
The DJIA is considered to be an efficient market. The US Dollar is considered to be
an efficient market.
We are going to talk about several things in this class
1. arbitrage
2. information flow
3. evidence for and against efficient markets
4. behavioral economics.
Arbitrage
Arbitrage is a mechanism by which market participants eliminate unexploited profit
opportunities.
For example you knew that the pound is going to strengthen against the dollar in
one week – what do you do to take advantage of this?
What’s the trade?
then you could borrow 1m USD for 1 week, buy pounds, hold them in a bank account
for a week, covert them back into USD and repay the borrowing. If you knew this
was going to be true then this would be called pure arbitrage. DRAW A PICTURE
There are two types of arbitrage – this example would be called pure arbitrage. You
know what is going to happen and your job is to figure out a strategy to exploit the
arbitrage. The other type is statistical arbitrage. This comes in many different
guises but basically it is a strategy in which you have a better than even chance of
beating the market. The classic would be to look at pairs trading. This is a trading
strategy in which you find two highly correlated stocks in which one has
outperformed the other recently. You then position yourself to take advantage of
reversion to the mean.
What’s the trade?
You buy the underperformer and sell the outperformer.
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When I was at Credit Suisse we had access to information regarding BRL. We had
bought Garantia bank in 1998. In January 1999 when the central bank ceded
control of the Real we were positioned correctly to take advantage of the
devaluation that occurred. The theory goes that we had connections inside the
central bank and knew in advance that there was going to be a devaluation.
Information dissemination
In an efficient market these sorts of opportunities would not exist for long. Once
information became available that the pound was going to strengthen then people
would trade against this, they would buy pounds with dollars which would increase
the value of the pound and relatively quickly – possibly in a matter of minutes - the
price of the pound would reflect all available information.
Note this does not mean that there are not opportunities when new information is
made available – only that the market will disseminate this information quickly and
remove the arbitrage.
In 1980 Stiglitz and Grossman pointed out a paradox with the EMH
If prices reflect all information, then there is no gain from going to the trouble of
gathering it, so no on will. A little inefficiency is necessary to give informed
investors an incentive to drive prices towards efficiency.
Evidence on Efficient Market Hypothesis
The theory of efficient markets really started in the 1960’s with the creation of a
“database” of historical market prices from 1926 to the present. Now this doesn’t
sound like much but it actually was. First you didn’t have a hard drive to load the
data onto. Second you didn’t have good data incorporating splits and dividends etc.
It is quite hard to come up with a clean dataset. Bloomberg is your friend they do
this for you.
During the 1960’s and 1970’s numerous studies were written supporting the
efficient markets hypothesis. The high point for belief in the hypothesis was in the
1970’s – basically the theory said, “believe the stock market. “
Evidence In Favor
Performance of investment analysts and mutual funds
One implication of the efficient market hypothesis is that when purchasing a
security one should not expect an abnormally high return.
1. No strong evidence of long-term outperformance of investment analysts and
mutual funds
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This example is in your book but I did a bit more digging around and although it is
held up as an example of why the efficient market hypothesis is true, I’m not
convinced.
Economist Burton Malkiel wrote in his personal finance book from the 1980’s that
“a blindfolded monkey throwing darts at a newspaper’s financial pages could select
a portfolio that would do just as well as one carefully selected by experts.”
From 1988 to 2002 the Wall Street Journal ran a column called the “Investment
Dartboard.” In the contest Wall Street Journal Staffers playing the part of monkeys
threw the darts and they had investment professionals pick their own stocks.
On October 7,1998 the Journal presented the results of the 100th dartboard contest.
The pros won 61% of the time. Additionally the pros edged the DJIA 51% of the
time.
Some issues raised:
1. The announcement effect – by announcement effect. People invested in the
picked stocks which artificially raised prices in the first couple of days after
the column was published.
2. Pros picked riskier stocks than appear in the DJIA
3. After a contest ended, the dartboard stocks tended to perform well.
There are, however, numerous studies that do show that mutual funds do not
outperform over the long term. In particular the funds that might show up in the
top quartile of returns over a given 5 year period
So one question that arises in the efficient market theory is how long does it take for
new information to disseminate.
Stock prices do appear to reflect publically available information.
Namely if information is already publically available, a positive announcement
about a company will not, on average, raise its stock price.
So – if something is already public then validation about it from the company does
not change the company’s stock price
Random Walk
This basically states that if the EMH is true then the only things that will move a
stock price from its equilibrium is the incorporation of new information. Given that
one cannot predict the news this means that a stock is as likely to go up as it is to go
down.
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This is a very important concept in finance especially the derivatives market. Pretty
much the entire derivatives market as we know it today is predicated on this idea.
Let’s do an example: Pretend we have a drunkard leaning against a lamp post. If he
starts to wander around he will follow a random path. If one thinks about where he
might be after a period of time if the path is truly random then the mean of his
distribution will be the lamp post. The standard deviation expands as sqrt of time.
We can think about stock prices in exactly the same way. We do not know exactly
where the stock will be tomorrow or in the next 5 minutes or in the next year but
our best guess is that it will be where it is today (adjusted for dividends of course)
and it will have a distribution that is related to the square root of the elapsed time.
One challenge in markets and other things if one analyses history then a random
path doesn’t necessarily look random. We then come up with all sorts of theories
that explain the randomness.
A good book to read is Naseem Taleb – Fooled by Randomness.
Evidence against Market Efficiency
Small-firm effect – there are studies that show small firms earn abnormally high
returns over long periods of time – even when the greater risk for these firms has
been taken into account. EMH has suggested that this might be due to the fact that
gathering information on small firms could be too expensive so the EMH might not
apply.
January Effect – Over long periods of time stock prices tend to experience an
abnormal price rise from December to January that is predictable. Could be
explained by harvest capital losses in December and re-invest in January. Thus the
market falls in December and rises again in January. If this were a predictable effect
then people who do not experience capital gains taxes (institutional private
pensions for example) do not sell in November and buy in late December and
capture this effect.
Technical analysis
In some markets it appears there are resistance levels – psychologically important
levels through which the market struggles to break.
Market Overreaction - stocks may overreact to news announcements and pricing
errors are only corrected slowly. An investor could buy stocks immediately after
poor earnings announcement and sell it after a couple of weeks when it has risen
back to normal levels.
External Agents
Recall from last week’s lecture on the Market Segmentation Theory we had a
treasury supply curve that was indifferent to the price of bonds. This would be a
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huge problem in market efficiency. How can you deal with external agents that are
well funded, can move the market and do not act rationally.
Excessive Volatility –the volatility of the index is higher than would be predicted by
looking at the volatility of the dividends. (look at the index as a discounted sum of
future dividends.
Mean Reversion – stocks with low returns today tend to have higher returns in the
future.
New information is not immediately incorporated into stock prices.
Behavioral Economics
Consider two types of investors. We have smart investors who are out there
properly incorporating the latest information into the market price and trying to
arbitrage the market to get it back to the correct equilibrium. Then we have “noise
traders” who buy and sell trends, invest without the latest knowledge. One can
think of the noise traders as the herd.
The EMH assumes that smart investors should be able to trade against less informed
“noise traders” and overwhelm them by driving prices to reflect true value. It
became clear that there are limits to their ability to arbitrage folly away. A Harvard
economist, Shleifer, pointed out that it could be too costly for informed investors to
borrow enough to bet against the noise traders. Once it is admitted that prices can
move away from fundamentals for a long time then informed investors might do
better by riding the trend rather than fighting it The trick then would be to get out
just before momentum changes. Thus rational investors might contribute to
bubbles.
This leads to behavioral economics. This tries to apply the insights of psychology to
finance. The argument here is that people tend to be too confident of their own
abilities and tend to extrapolate recent trends into the future. This behavior can
contribute to bubbles forming.
In addition losses can make investors extremely and irrationally risk-averse – thus
exaggerating price falls when a bubble bursts.
Adaptive Markets Hypothesis
Andrew Lo of MIT has introduced a new theory. The adaptive markets hypothesis
which suggest that humans are neither fully rational nor irrational. Instead they
make best guesses as to what might work and then use trial and error. If one
investment strategy fails then they try another. He does not see markets as efficient
but instead as fiercely competitive – old strategies become obsolete and new ones
are created.
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Conclusion
One might look at the EMH as having too parts:
1 – there is no-free-lunch
2 – the price-is-right part
The first part has been strengthened over the past few years as some investment
strategies that looked great had more risk than was originally thought. This is your
classic cautionary tale. If something appears to be a sure thing then be careful.
The second part seems a bit suspect. The difficulty is that the mapping of
information to fair market value is not clear cut.
Let me leave you with a couple of thoughts. First a cautionary tale about
information – there is no free lunch.
Here’s a great strategy. Let’s assume that equity returns are normally distributed
(not particularly realistic but you can draw a different distribution assumption and
change the strategy slightly so it doesn’t matter). What do I mean by this. I mean
that starting today if we look out a year then the distribution of possible returns in
normally distributed. Now if we do some historical analysis what we will find is
that generally the stock market goes up and down less than 10% per year. So the
strategy is to double down the losses if the market goes down more than 10% per
year and sell the profits if the market goes up more than 10%. Now my investment
strategy will look great during most years. In fact it should outperform the market
during most years. I’ve sold options so I bring in premium and I stay invested in the
market as usual.
If I run this strategy during a number of benign years then I can build up a track
record of out performance. In fact I am taking outsized risk to the downside of the
distribution and giving up my outsized gains on the upside. In the long run I should
underperform my peers but it might take time for this to show up.
Inefficient Markets
I should say that people do outperform the markets on a regular basis but not
necessarily easily. As mentioned at the beginning not all markets are efficient. In
particular there are inefficient markets where prices do not reflect all publically
available information. For example, private equity, property, etc. These are
interesting investment opportunities precisely because in theory one can be smarter
than the next guy and make money in these.
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