Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 6
Chapter 6
Efficient Capital Markets
Questions to be answered:
• What is does it mean to say that capital markets are efficient?
• Why should capital markets be efficient?
• As a portfolio manager, why should we care if capital markets are
efficient?
• What factors contribute to an efficient market?
• Given the overall efficient market hypothesis, what are the three
sub-hypotheses and what are the implications of each of them?
• How do you test the three efficient market hypothesis (EMH) and
what are the results of the tests?
• For each set of tests, which results support the hypothesis and
which results indicate an anomaly related to the hypothesis?
What Constitutes An
Efficient Capital Market?
• Two forms of market efficiency
– Informational efficiency – the subject of this chapter
– Transactional efficiency – minimize cost
• Economies of scale
• Economies of scope
• In an efficient capital market, security prices
– Reflect all available information
– Adjust rapidly to the arrival of new information.
• Whether markets are efficient has been extensively
researched and remains controversial
Why Should Capital Markets
Be Efficient?
The premise of an efficient market:
– A large number of competing profit-maximizing participants
analyze and value securities, each independently of the others
– New information regarding securities comes to the market in
a random fashion
– Profit-maximizing investors rapidly adjust (in an unbiased
fashion) security prices to reflect the impact of new
information
Conclusion: In an efficient market, the expected returns
embedded in the current price of a security should
accurately reflect its risk
Efficient Market Hypotheses (EMH)
• Random Walk Hypothesis – first hypothesized by Louis
Bachlier, a French doctoral student in mathematics, in
1900. Said that changes in security prices occur randomly
& unpredictably.
• Eugene Fama (1970) Fair Game Model – current market
price reflect all available information about a security and
the expected return based upon this price is consistent with
its risk
• Efficient Market Hypothesis (EMH) – Fama divided EMH
into three sub-hypotheses depending on the information set
involved
– Weak-form efficient
– Semi-strong form efficient
– Strong-form efficient
Efficient Market Hypotheses (EMH)
• Weak-Form EMH - prices reflect all information contained
in the past record of prices & volumes
• Semi-strong-form EMH - prices reflect all public
information
• Strong-form EMH - prices reflect all public and private
information
Random Walk Theory: Microsoft Stock
Price Changes from March 1990 to May
2004
For Microsoft stock
over the period March
1990 to May 2004, the
correlation between a
price change on day t
and a price change on
day t+1 was +0.025.
Random Walk Theory: Weekly Returns,
May 1984 – May, 2004
FTSE 100
(correlation = -.08)
Return in week t + 1, (%)
FTSE is an
independent
company owned by
The Financial Times
and the London
Stock Exchange.
Their sole business
is the creation and
management of
indices and
associated data
services, on an
international scale.
Return in week t, (%)
Random Walk Theory: Weekly Returns,
May 1984 – May, 2004
Nikkei 500
(correlation = -.06)
Return in week t + 1, (%)
The Nikkei is the
major index for the
Tokyo Stock
Exchange.
Return in week t, (%)
Random Walk Theory: Weekly Returns,
May 1984 – May, 2004
DAX 30
(correlation = -.03)
Return in week t + 1, (%)
The DAX 30 is an
index of 30 top
German stocks. In
German, DAX is
short for
DEUTSCHER
AKTIENINDEX,
which means
“performance index”
Return in week t, (%)
Random Walk Theory: Weekly Returns,
May 1984 – May, 2004
S&P Composite
(correlation = -.07)
Return in week t + 1, (%)
The S&P 500 began
on March 1, 1957.
Today, the S&P 500
captures almost 80%
of the market value
of all US listed
stocks. For the first
50 years of its
existence, the
average annual rate
of return on the S&P
500 was 10.83%
Return in week t, (%)
Tests and Results of
Weak-Form EMH
• Statistical Tests of Independence
– Autocorrelation tests
• Test for correlation between prices today and prices tomorrow
• If EMH is true, would expect zero correlation
– Runs tests
• DeFusca et al, 2004
• Price increases assigned a positive sign; price decreases assigned a
negative sign. Test for randomness in the pattern of signs.
• Tests of Trading Rules
– Filter Rules
• A filter tells us to buy or sell depending on changes in market prices
or volumes
• The finer the filter, the higher the transactions costs
Tests and Results of
Weak-Form EMH
• Only better-known technical trading rules have been
examined
– Too much subjective interpretation of data
– Almost infinite number of trading rules
• Results generally support the weak-form EMH, but results
are not unanimous
– Tests using actual transactions data have shown positive
correlation but not shown if profitable after transactions costs
Tests of the Semistrong Form of
Market Efficiency
Two types of studies
• Return prediction studies – Can we predict either:
– Time series analysis of returns (predict future returns for one stock)
– Cross sectional distribution of returns (predict which stocks will be
in the top decile, etc.)
• Event studies
– Examine how fast stock prices adjust to specific economic events
Tests and Results of
Semistrong-Form EMH
• Time series tests for abnormal rates of return
– short-horizon return studies have had little success
– long-horizon return studies have been quite successful
based on
• Dividend yield (Dividend/Price)
• Default spread – difference in yield between B bonds & AAA
bonds (acts as proxy for the market risk premium)
• Term structure spread – difference in yield between short & long
Government bonds & T bills
– When dividend yield and the default spread are high, it
implies that investors expect a high return on stocks &
bonds. Tends to occur during poor economic
environments (low growth rates and higher perceived risk
by investors). Invest now for high future returns!!
Tests and Results of
Semistrong-Form EMH
• More time series tests:
– Quarterly earnings reports may yield abnormal returns;
• Due to unanticipated earnings change
• Results suggest abnormal returns are earned in the 13 – 26
weeks after the announcement of large unanticipated earnings
changes (referred to as an earnings surprise)
• Studies by Rendleman et al found
– 31% of the change in stock price occurred before the
announcement
– 18% on the day of the announcement
– 51% following the announcement date
– These results do not support the EMH.
Tests and Results of
Semistrong-Form EMH
• The January Anomaly
– Stocks with negative returns during the year had higher
returns immediately after the first of the new year
• December trading volume abnormally high for these stocks
• Most of the January effect occurs on the first trading day in the
new year
– Tax selling toward the end of the year has been
mentioned as the reason for this phenomenon (although
a similar pattern has been found in countries with
different tax laws)
– Such a seasonal pattern is inconsistent with the EMH
Tests and Results of
Semistrong-Form EMH
• Other calendar effects
– All the market’s cumulative advance occurs during the
first half of trading months
– Monday/weekend returns are significantly negative
– For large firms, the negative Monday effect occurred
before the market opened (it was a weekend effect)
– For smaller firms, most of the negative Monday effect
occurred during the day on Monday (it was a Monday
trading effect)
Tests and Results of
Semistrong-Form EMH
• Predicting cross-sectional returns
– Basic premise:
• All securities should earn a return based on their risk
• Securities with equal risk should earn an equal return
• Studies examine alternative measures of size or
quality as a tool to rank stocks in terms of riskadjusted returns
– These tests involve a joint hypothesis and are
dependent both on market efficiency and the asset
pricing model used
Tests and Results of
Semistrong-Form EMH
• Price-earnings ratios and returns
– Low P/E stocks experienced superior risk-adjusted
results relative to the market,
– High P/E stocks had significantly inferior risk-adjusted
results
– Publicly available P/E ratios appear to possess valuable
information regarding future returns
• This is inconsistent with semistrong form
efficiency
Tests and Results of
Semistrong-Form EMH
• Price-Earnings/Growth Rate (PEG) ratios
– Studies have hypothesized an inverse relationship
between the PEG ratio and subsequent rates of return.
– This is inconsistent with the EMH
• However, the results related to using the PEG ratio to select
stocks are mixed
Tests and Results of
Semistrong-Form EMH
• The size effect (total market value of the firm’s
equity)
– Several studies have examined the impact of size on
risk-adjusted rates of return
– The studies show that small firms consistently
experience significantly larger risk-adjusted returns
than large firms
• But some of the size effect seems to have disappeared
– Firm size is a major efficient market anomaly
Tests and Results of
Semistrong-Form EMH
• Ratio of Book Value of a firm’s Equity to Market
Value of its equity
– Significant positive relationship found between current
values for this ratio and future stock returns
– Results inconsistent with the EMH
• Size and BV/MV appear to dominate other ratios such as
P/E ratio or leverage
• This combination only works during periods of loose
monetary policy
Tests and Results of
Semistrong-Form EMH
• Event studies
– Stock split studies show that splits do not result in
abnormal gains after the split announcement, but before
– Initial public offerings seems to be underpriced by
almost 18%, but that varies over time, and the price is
adjusted within one day after the offering
• Suppose you had bought stock immediately following each
IPO & then held that stock for five years.
• Over the period 1970 – 2002, your average annual return
would have been 4.2% less than the return on a portfolio of
similar-sized stock
– Listing of a stock on an national exchange such as the
NYSE may offer some short term profit opportunities
for investors
Tests and Results of
Semistrong-Form EMH
• Event studies (continued)
– Stock prices quickly adjust to unexpected world events
and economic news and hence do not provide
opportunities for abnormal profits
• Patell & Wolfson found that when new information is released,
the major part of the adjustment in price occurs within 10
minutes of the announcement
– Announcements of accounting changes are quickly
adjusted for and do not seem to provide opportunities
– Stock prices rapidly adjust to corporate events such as
mergers and offerings
– The above studies provide support for the semistrongform EMH
Summary on the
Semistrong-Form EMH
• Evidence is mixed
– Strong support from numerous event studies
with the exception of exchange listing studies
– Studies on predicting rates of return for a crosssection of stocks indicates markets are not
semistrong efficient
• Dividend yields, calendar patterns, and earnings
surprises all appear to yield valuable information
• Predictors such as size, the BV/MV ratio & P/E
ratios appear to yield valuable information
Tests and Results of
Strong-Form EMH
• Strong-form EMH contends that stock prices fully reflect
all information, both public and private
• This implies that no group of investors has access to
private information that will allow them to consistently
earn above-average profits
Testing Groups of Investors
•
•
•
•
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
Corporate Insider Trading
• Insiders include corporate officers, directors, and owners
of 10% or more of any equity class of securities
• Insiders must report their trades to their Provincial
Securities Commission within 10 calendar days of a trade
occurring
• These insider trading reports are made public within
minutes of filing (note that the textbook refers to 6 weeks –
in Canada, it is within minutes of filing)
• Corporate insiders generally experience above-average
profits
Corporate Insider Trading
• This implies that many insiders had private information
from which they derived above-average returns on their
company stock
• Studies showed that public investors who traded with the
insiders based on announced transactions would have
enjoyed excess risk-adjusted returns (after commissions),
but the markets now seems to have eliminated this
inefficiency (soon after it was discovered)
• Other studies indicate that you can increase returns from
using insider trading information by combining it with key
financial ratios and considering what group of insiders is
doing the buying and selling
Stock Exchange Specialists
• Specialists have monopolistic access to information about
unfilled limit orders
• You would expect specialists to derive above-average
returns from this information
• The data generally supports this expectation
Security Analysts
• Tests have considered whether it is possible to identify a
set of analysts who have the ability to select undervalued
stocks
• The analysis involves determining whether, after a stock
selection by an analyst is made known, a significant
abnormal return is available to those who follow their
recommendations
• There is evidence in favor of the existence of superior
analysts
– Warren Buffet, Peter Lynch (Fidelity Magellan Fund)
Warren Buffet
• Buffet Partnership Ltd (1957 – 1969) beat the
Dow Jones Industrial Average every year of its
existence, with a cumulative return of 2,749%
versus the Dow’s cumulative return of 152.6%
• Buffet acquired Berkshire Hathaway in 1965.
• Since then he beat the return on the Dow in 36 out
of 41 years
• After-tax cumulative return of 305,134% versus
5,583% (pre-tax) for the Dow.
Ivan Boesky
• By 1986 Ivan Boesky had become an arbitrageur who had
amassed a fortune of about US$200 million by betting on
corporate takeovers.
• He was investigated by the US SEC for making
investments based on tips received from corporate insiders.
• These stock acquisitions were sometimes brazen, with
massive purchases occurring only a few days before a
corporation announced a takeover.
• Although insider trading of this kind was illegal, laws
prohibiting it were rarely enforced until Boesky was
prosecuted.
• Boesky cooperated with the SEC and informed on several
of his insiders, including junk bond trader Michael Milken.
• As a result of a plea bargain, Boesky received a prison
sentence of 3.5 years and was fined US$100 million.
• Although he was released after two years, he was barred
from working in the securities business for the remainder
of his life.
Professional Money Managers
• Trained professionals, working full time at investment
management
• If any investor can achieve above-average returns, it
should be this group
– Mark Carhart analyzed 1,493 mutual funds to see if professional
money managers could out-perform the market
– He found that, on average, mutual funds earn a lower return than
the benchmark after expenses and roughly match the benchmark
return before expenses
Conclusions Regarding the
Strong-Form EMH
• Mixed results, but much support
• Tests for corporate insiders and stock
exchange specialists do not support the
hypothesis
– Both groups seem to have monopolistic access
to important information and use it to derive
above-average returns
The Rationale and
Use of Index Funds and ExchangeTraded Funds
• Efficient capital markets and a lack of superior analysts
imply that many portfolios should be managed passively
(so their performance matches the aggregate market &
minimizes the costs of research and trading)
• ETFs duplicate the composition and performance of many
indices