Market Efficiency And Modern
Financial Management
Professor XXXXX
Course Name / Number
Efficient Markets
In an efficient market, prices rapidly incorporate all
relevant information.
Financial markets are much larger, more competitive, more
transparent, more homogeneous than product markets.
Much harder to create value through financial activities
The “Efficient Markets Hypothesis” (EMH) was first
formally proposed in 1970 by Eugene Fama.
2
What are the three forms of market efficiency?
Three Forms Of Market Efficiency
Weak Form
Financial asset (stock) prices incorporate all
historical information into current prices.
Past stock price changes cannot help you
predict future price changes.
Semi-strong
Form
Strong Form
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Stock prices incorporate all publicly
available information (historical and current).
Information in an SEC filing is incorporated
into a stock price as soon as it is made public.
Stock prices incorporate all information,
private as well as public.
Prices react as soon as new information is
generated.
Weak Form of Market Efficiency
Weak form: Stock price changes are not predictable
based on past changes.
Stock prices follow a random walk.
Could be a pure random walk, or a “random walk
with drift”
Technical
analysis
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• Search of profitable trading strategies
based on recurring patterns in stock prices
• Under the weak form of efficiency theory,
technical analysis is useless.
Semi-strong Form Efficiency and
Fundamental Analysis
Recall the definition of efficient markets: In an efficient
market, prices rapidly incorporate all relevant information.
Semi-strong form efficiency uses “all public information” as its
definition of “information.”
Earnings announcements
Annual reports
SEC filings
News reports
Examples
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Prices move so fast in response to public information that trading on it
profitably is nearly impossible!
Survivorship Bias And Measured
Returns On Mutual Funds
If anyone could “beat the market”, it’s the pros who
devote all of their time and energy to that effort.
A large number of publications investigate investment
performance of mutual fund managers.
Selectivity (stock-picking ability)
Timing (the ability to time market
turns)
Malkiel (1995) pointed out critical bias in studies that show superior
performance of fund manager: survivorship bias.
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• Only the returns of the companies still in existence at the end of the
analyzed period are included in analysis.
Implications Of Semi-Strong Form
Efficiency
Most studies show managers under-perform S&P
500, even before taking account of expenses.
– “Superstar” investors (Warren Buffett, Peter Lynch)
are the exception rather than the norm.
Other tests show prices react efficiently to new
information.
– Studies also find that purely accounting rule
changes that do not affect cash flow have no
impact on stock prices.
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Event Studies
Suppose in the month of July (2003) 6 firms report earnings
early in the day on the following dates:
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Firm
Earnings
announcement date
Day +1
1
Tues 7-8-03
Wed 7-9-03
2
Thur 7-9-03
Fri 7-10-03
3
Wed 7-16-03
Thur 7-17-03
4
Fri 7-18-03
Mon 7-21-03
5
Tues 7-22-03
Wed 7-23-03
6
Wed 7-23-03
Thur 7-23-03
In event time, the earnings announcement date is day 0.
Return
Abnormal Return
Cumulative Abnormal
Event Studies
Abnormal return
10%
5%
The actual return minus the
expected return
0%
-5%
-10%
-5 -4
-3
-2
-1
0
+1
+2 +3 +4
Event Time (in days)
+5
Could just be the market index
return for the day, or the
market index return times the
beta of the firm reporting the
earnings announcement
The positive bump on day 0 implies that the earnings news was, on average
for these firms, better than expected!
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Because the line is flat after day 0, this means that the market fully
incorporated the earnings news on the event day…no additional upward or
downward price trend is seen.
Evidence Against Semi-strong
Form Efficiency
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Small firm
effect
Small firms out-perform large especially in
January (January effect).
Temporal
anomalies
January effect (all firms), Monday effect
Value versus
glamour
stocks
High book-to-market (value) stocks outperform low book-to-market (glamour)
stocks.
Many people feel that “bubbles” form quite frequently in
financial asset prices: Japanese stock prices late 1980s,
NASDAQ prices through March 2000.
Behavioral Finance
Argues that market participants suffer from
systematic psychological biases that result in suboptimal decisions
Investors underreact to new information that
contradicts prior beliefs (e.g., dramatic change in
earnings).
Investors overreact to a string of similar
information (e.g., investors expect recent trends to
continue).
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Investors are overly confident in their ability to
identify misvalued stocks.
The Underreaction Phenomenon
Cumulative Abnormal Return
Stock-price momentum
The line that is going upward
is showing the returns on a
group of stocks that have (in
month 0) reported
unexpectedly high earnings.
0
-5 -4
-3
-2
-1
0
+1
+2 +3 +4
+5
The line that is trending down
is showing the returns on a
group of stocks that have (in
month 0) reported
unexpectedly low earnings.
Time (months)
Investors are under reacting to the recent good (bad) earnings news.
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Subsequent news after the announcement continues to be good (bad), so
investors didn’t fully realize how good (bad) the initial announcement was.
The Overreaction Phenomenon
Cumulative Abnormal Return
Stock-price momentum
The line that trends up and
then reverses represents
returns on stocks that have
performed very well for the
last several years, and vice
versa for the other line.
0
-5 -4
-3
-2
-1
0
+1
+2 +3 +4
+5
Time (years)
The time period we are looking at here is long--several years--and investors
are overreacting to a perceived long-term trend.
This is distinct from the previous slide where investors were--over a much
shorter time span--underreacting to brand new information.
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The Strong Form Of Market
Efficiency
Prices should reflect all information, public and
private.
– Usually tested by seeing if corporate insiders earn
superior returns on their trades in company stock
– Evidence suggests insiders can “beat the market.”
Insiders’ decision to trade at corporate level may be
informative.
– If they think stock price too high, they will sell new stock.
– If they think stock price too low, they can re-purchase shares.
– Stock prices can affect their decision to use cash or stock in
mergers.
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Corporate “Communications”
Policy
Market efficiency has clear implications for how a manager
should “communicate” with investors.
Assume your actions and words have
consequences.
– Try to predict how a particular announcement will
be interpreted by investors and be ready to
respond if they actually respond differently.
– Don’t withhold info that will likely come out
anyway.
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Do not discuss publicly information that should be
kept private.
Corporate “Communications”
Policy
Honesty is the Best Policy
– Managers who convey good and bad information
honestly and and who do not try to fool the market
will be believed, while managers with reputations for
deception will not be.
Listen to Your Stock Price
– Two types of information that markets convey to managers:
(1) reactions to specific corporate announcements
(2) movements in the firm’s stock price relative to the
overall market over extended periods of time
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– Both types of information can be very informative to the
manager.
Market Efficiency
Financial markets tend to be more efficient and
competitive than product markets.
Three forms of market efficiency: weak form, semistrong form, strong form
Empirical research found that major financial
markets are weak-form and semistrong-form.
Market efficiency research helps financial managers
in formulating their communication policy.