The Magic of Markets:
market efficiency and capital market
research in accounting
by
Charles M. C. Lee
Peking University
Stanford University
Presented at
2008 American Accounting Association (AAA) Conference
Anaheim, California
Should capital market
researchers assume
price = value?
“Price is what you pay,
value is what you get.”
- Warren Buffett
Seminar Outline
• Informational role of markets
– The social value of markets in society
– Limits of a naïve view of market efficiency
• An alternative framework
– Integrating behavioral finance and
fundamental analysis
– Applications to accounting research
The Role of Markets
What is the social value of markets?
The role of markets in society
What is the social value of markets?
Frederick von Hayek (1899-1992)
American Economic Review (1945):
The Use of Knowledge in Society
• The central economic problem of society is planning (resource
allocation) under uncertainty
• Planning involves two types of knowledge:
- Scientific Knowledge (theoretical or technical)
- Knowledge of particular circumstances of time and place
• Even the best central planner doesn’t have knowledge of the 2nd type
- Hence de-centralized planning dominates central planning
The role of markets in society
What is the social value of markets?
Frederick von Hayek (1899-1992)
American Economic Review (1945):
The Use of Knowledge in Society
• Hayek’s view on planning:
- Planning calls for “the utilization of knowledge not given to anyone in its
totality.” It follows that the “man on the spot” is the best person to make
resource allocation decisions.
• Hayek’s view on the role of markets:
- As a minimum the “man on the spot” needs to know the relative scarcity
of various resources. This information is quickly and succinctly provided
by market prices.
• Markets facilitates de-centralized planning
- The price system is a vital knowledge aggregation mechanism.
The role of markets in society
What is the social value of markets?
Frederick von Hayek (1899-1992)
American Economic Review (1945):
The Use of Knowledge in Society
Implications:
- Price is a public good
- Market economies are better than centrally planned ones
- Price should be, in general, a good indicator of “value” (i.e., the
relative scarcity of an asset)
What Hayek did not say:
- How markets become efficient
- What affects this process (besides regulatory intervention)
The Efficient Market Hypothesis
•
Fama (1965, 1991): The market price "incorporates"
Quickly and
all "currently available information"
Without bias
•In past prices (Weak)
•In public domain (S.S.)
•Both public & private (S.)
•
If we define the intrinsic value of a firm as the present
value of its future payoffs

V
•
t

i 1
E (D |  )
(1 r )
t i
t
i
Then, operationally, the EMH is often interpreted to
mean price reflects a stock's intrinsic value
(P  V ,  t )
t
t
Shiller (1984)
“Returns on speculative assets are nearly unforecastable; this fact is the
basis of the most important argument in the oral tradition against a role for
mass psychology in speculative markets. One form of this argument
A. claims that because real returns are nearly unforecastable, the real price of B.
stocks is close to the intrinsic value, that is, the present value with constant
discount rate of optimally forecasted future real dividends. This argument
for the efficient markets hypothesis represents one of the most remarkable
errors in the history of economic thought. It is remarkable in the
immediacy of its logical error and in the sweep and implications of its
conclusion.”
- From page 8 (emphasis added)
What does he mean?
There are two definitions of market efficiency:
A: “No free lunch” (Zero arbitrage profits)
B. => A.
but definitely
A. ≠> B.
B. “The Price is Right” (Pt = Vt)
(Consider P = V + e; and e is r.w.)
Why do we believe markets are efficient?
Shleifer (2001): The theoretical case for the EMH
1.
2.
3.
All investors are rational
Some investors irrational, but their trades cancel out
Some systematic irrationality, but it is eliminated by rational
arbitrageurs
=> A visceral faith in the process of arbitrage !
Lee (2001): Is this faith well grounded?
1.
2.
3.
Arbitrage is merely a mechanism
Ocean vs. millpond
It is almost always costly and risky
Information, trading, & holding costs
It requires sufficient mispricing to function properly
Arbitrage and mispricing must co-exist
The Central Paradox
“If information is costly, prices cannot perfectly reflect the
information which is available; because if it did, those who
spend resources to obtain it would receive no compensation.”
- Grossman and Stiglitz (1980)
Grossman and Stiglitz (1980):
- If information is costly, mispricing and arbitrage must coexist in equilibrium
- The cost of information determines the equilibrium ratio of
information quality between informed and uninformed
traders.
EMH and Newtonian Physics
It’s been said that for all practical purposes, the EMH is like
Newtonian physics (we can generally assume “the price is right”)
• Price is certainly a meaningful indicator of “value”
- In most settings, consumers and producers should appeal to
market prices in resource allocation decision
- This is, after all, the central role of markets in society
• However, does that apply also to those charged with the study of
markets?
- In some settings, perhaps… (e.g., some regulatory applications)
I believe, in many settings, a naïve view of market efficiency (P=V)
does a great disservice to our profession, because it provide an
inadequate framework for understanding some issues of first-order
importance to the effective operation of markets.
Practical Problems and Limitations
1. Excessive trading volume
- in the traditional model, there should be little or no trading
2. Excess volatility in returns
- returns are too volatile to be explained by a DDM
3. Returns predictability
- Higher returns for lower risk stocks (Sloan, LSV, Piotroski)
4. Realized returns are a poor proxy for expected returns
- The noisy nature of realized returns (Elton)
- Ex ante versus ex post cost-of-capital (GLS; CGV)
5. No role for information & market pricing dynamics
- Absence of a conceptual framework for thinking about information
flows and the dynamics of market price adjustment & discovery
 For those who make a living studying markets, to
ignore these problems would be an abdication of
responsibility.
Cornell Cayuga MBA Fund
“Quant
meltdown”
Recent
Performance
II. An Integrative Framework
Modeling mispricing as an equilibrium
phenomenon
Shiller (1984): A Noise Trader
Alternative
Consider a world with two types of traders:

 
E
R
Q
t
t

t
• Information traders (smart money)
 = rho; expected real return such that there is no demand for shares by
smart money
 = phi; risk premium that would induce smart money to hold all the shares
• Noise traders (ordinary investors)
Time varying demands, not based on optimal forecast of expected returns.
yt = noise trader demand; total value of stocks demanded per share by these
investors.
Shiller (1984):
In equilibrium, price is:
Noise trader demand
Fundamental value
( D )   E (Y
E
P 
(1   )

t
t
k 0
t k
t
k 1
t k
)
Arbitrage costs
As  (phi) zero, we have the EMH as a special case
As  (phi) infinity, noise traders determine the price
Implications of the Model
Investor Sentiment
Fundamental value
( D )   E (Y
E
P 
(1   )

t
t
k 0
t k
t
k 1
t k
)
Arbitrage costs
• Price is a weighted average of a stock’s fundamental value and noise trader
demand (as long as arbitrage involves some cost, price  value)
• Fundamental analysis (i.e., valuation and cash flow projection) is only one
component of investing in stocks
• Rational investors (smart traders) need to consider "fads" and "fashions", as
well as "fundamentals”.
• Returns are not necessarily easy to forecast. The time-series behavior of Yt
matters. Is it mean-reverting? If so, how quickly?
How might we measure sentiment?
Investor Sentiment
Fundamental value
( D )   E (Y
E
P 
(1   )

t
t
k 0
t k
t
k 1
t k
)
A. Focus on fundamental value
– Estimate the present value of future cash flows for a firm (V),
and compare it to price. The difference is a measure of
investor sentiment.
B. Focus on noise trader demand
– Look for sentiment indicators that help to predict the direction
of noise trader demand (Yt )
What gives rise to sentiment?
• Sentiment involves systematic deviations of
price from intrinsic value
– The mistakes must be correlated across noise traders
– More like mass psychology than animal spirits
• What gives rise to a common sentiment? (what
affects Yt ?)
• sub-optimal use of actual signals
– misreaction to value-relevant information
(earnings surprises, quality-of-earnings indicators)
• Black: “pseudo-signals”
– signals that contain no real information, yet are persuasive
Example: Conolog Corp (CNLG),
Thurs 2/17/2005
Up 30%+ on new
information
The news event…
“Institutional ownership by a
prestigious global fund manager
such as Barclays is a vote of
confidence in our Company.”
Commentary…
Understanding the information
All of the 461k shares of stock held by BGI are in passive,
not active, funds:
Date
Acc't
Short nm
Name
2/16/2005 CONOLOG CORP Passive Fund
Stock
Fund
500069
EQINDX
Extended Equity Market Fd
Price
3.169
Shares
229,520
Value
727,349
2/16/2005 CONOLOG CORP Passive Fund
609666
6058
NRRIT Extended Market Fund
3.169
35,246
111,695
2/16/2005 CONOLOG CORP Passive Fund
502925
ALLOC
US EQUITY MARKET FUND A
3.169
181,336
574,654
2/16/2005 CONOLOG CORP Passive Fund
511419
ALLOC
US EQUITY MARKET FUND B
3.169
15,760
49,943
461,862
1,463,641
Equilibrium is reached by the
end of the third day…
An Example: KKD (7/7/01)
"I go to the convenience store by my house to buy the donuts
which are delivered at 4 am. The place is Jam packed, and it's
surreal how many people are walking around with Krispy bags.
People literally run from their cars and practically tackle each
other at the Krispy Kreme Doughnut cabinet."
4CommonSense
"I can't understand how ANYTHING can taste that good. If this
isn't the stuff classic American brand names are made of,
nothing is. These things are addictive and they bring pleasure to
the senses."
"A well-managed company with nothing but upside for the next
12-18 years…They have NO market penetration to speak of in
the United States as a whole…People are just beginning to hear
of them and everybody wants one." - EMCauley
On the other hand…
So what is next for KKD?
Best value estimate
KKD: Revisited (next 12 months)
Best value estimate
KKD: Revisited (a longer view)
How bad is the problem?
Prices in equity markets are much noisier than
many people expect
Black (1986):
"All estimates of value are noisy, so we can never know
how far away price is from value. However, we might
define an efficient market as one in which price is within
a factor of 2 of value, i.e., the price is more than half of
value and less than twice value… By this definition, I
think almost all markets are efficient almost all the time.
"Almost all" means at least 90%."
How bad is the problem?
Evidence from Closed-end Funds:
• A closed-end fund is a publicly traded stock whose only asset consists of
a portfolio of other publicly traded securities. The closed-end fund puzzle
is the empirical phenomenon that the stock price (SP) of these funds is
rarely equal to the net asset value (NAV) of these securities.
• Typically, these funds trade at a discount to their NAV (DISC = (SPNAV)/NAV*100). Occasionally, they also trade at a premium. For U. S.
funds DISC routinely fluctuate between an upper bound of around +5 to
10%, and a lower bound of –30% to 40%. (LST (1991))
 What accounts for the upper and lower bounds on DISC?
 If arbitrage bounds can be this wide when valuation is transparent, how
wide would they be for other stocks?
Relevance to Accounting Research
B. Investor Sentiment
A. Fundamental value

P
1.
2.
•
•
3.
•
•
t
  Et
k 0
( Dt  k )   E t (Y t  k )
(1   )
k 1
C. Arbitrage
Costs
Provides a conceptual framework for Security Analysis
Helps us understand the relationship between information risk and
the cost-of-capital
Whether higher information risk increases firms’ cost-of-capital
Why realized returns are such noisy proxies for ex ante risk
Offers conceptual guidance in future market-based research
The traditional model (P=V) is too naïve & has no role for
information flows & market pricing dynamics
Focuses attention on the 3 irreducible elements of market
adjustment to information
But I don’t like behavioral assumptions…
B. Investor Sentiment
A. Fundamental value

P
•
•
•
t
  Et
k 0
( Dt  k )   E t (Y t  k )
(1   )
k 1
C. Arbitrage
Costs
This is a useful framework in which to think about mispricing in
equilibrium, even if you do not wish to make behavioral
assumptions
Two out of the three key elements do not require behavioral
assumptions
However, if you wish to understand forces that drive price away
from “value” (the time-series behavior of Yt), you need a theory
of mistakes
Objections to Behavioral Models
Shleifer: The “metaphysical”
defense of the EMH
They violate the “Prime Directive” of financial economics:
"Explain asset prices by rational models. Only if all attempts fail, resort to
irrational investor behavior… (T)he burgeoning behavioralist literature…has
lost all the constraints of this directive – that whatever anomalies are
discovered, illusory or not, behavioralists will come up with an explanation
grounded in systematic irrational investor behavior" (Rubinstein (2000))
In fact, most recent models in behavioral finance are based on economic
principles of rational arbitrage.
Who are noise traders anyway? If they are so dumb, how do they
survive?
With a continuous information flow, even rational traders cannot calibrate the
quality of their own signal. Hence, everyone noise trades.
In fact, noise trading is a necessary part of the price discovery process described
by Hayek & envisioned by Black.
We discover the quality of our own information through trial and error –
LEARNING is how markets become efficient (Berk and Green 2005)
Summary
• The market is a wonderful aggregator of information.
Its ability to quickly reflect the consensus view is almost magical. It solves
the central planner's problem.
• But, the magic continues only b/c the process is flawed.
The market is in a constant state of adjustment, and mispricing is an
equilibrium condition. This must be the case for arbitrage to do its magic.
• Do not automatically assume P=V
Unshackle V from P, or you will miss a lot of what is going on in markets
• Focus on information flow and market adjustment
dynamics Information flow is the market’s life blood
• When it comes to market efficiency, don’t ask “yes or
no”? Instead, ask: "how", "when", and "why"? That is
what makes capital market research fun!