Chapter Eight
The Capital Markets and Market Efficiency
Chapter Eight
The Capital Markets and Market Efficiency
KEY POINTS
The U. S. capital markets are the envy of much of the rest of the industrialized world.
Their three functions are a good introduction to the notion of market efficiency. When
we speak of market efficiency, we refer to informational efficiency (the rapid adjustment
of prices to new information) rather than operational efficiency (the extent to which
orders get lost or improperly filled).
There are three forms to market efficiency, with the semi-efficient market hypothesis
being a useful cousin to the traditional paradigm. There is a difference between the
random walk theory and the efficient market hypothesis.
Anomalies remain a puzzle and are a continuing area of financial research. The key
anomalies that every student should be aware of include the low PE effect, the small firm
effect, the neglected firm effect, market overreaction, the day of the week effect, and the
January effect.
TEACHING CONSIDERATIONS
Remind students of the distinction between the capital market and the money market.
The former is a physical place where long-term securities (like common stock and bonds)
trade, while the latter is an electronic linkup of the largest commercial banks where shortterm securities (like treasury bills) trade.
Students are quite interested in the business of charting and technical analysis in general.
While this text does not cover much of this subject, many instructors will want to digress
into this area a bit. A coin flipping exercise to build a chart on the chalkboard followed
by a test of the randomness of the pattern via a runs test is always useful and seemingly
interesting to the class. I assign a homework problem using the RUNS file from the
Strong Software disk.
Stress the fact that market efficiency does not mean that no one can make a profit in the
stock market. It means that because the news cannot be consistently anticipated, longterm rates of return will be consistent with their associated level of risk.
Anomalies are another topic of interest to most students. There are certain things in
finance that we do not know, and this fact should be clearly shown to the class.
Fibonacci numbers are an example of pure market folklore, but a fascinating subject
Chapter Eight
The Capital Markets and Market Efficiency
(with most university libraries subscribing to the highly mathematical Fibonacci
Quarterly).
ANSWERS TO QUESTIONS
1. It is still necessary to gather security statistics (such as betas and covariances) for
portfolio construction purposes, and it is also the activities of security analysts that, to
a large extent, help keep the market efficient.
2. This is a common, and very dangerous, question. Security markets are quite efficient,
but they are not completely efficient. The logic of the semi-efficient market
hypothesis is compelling, and there is the issue of the anomalies.
3. Only the name is similar. The semi-efficient market hypothesis deals with the
existence of different “tiers” of stocks with differing levels of investor interest, while
the semi-strong form deals with the extent of the information set.
4. Market efficiency means that security prices adjust quickly and accurately to news;
the random walk theory states that the news arrives randomly, so security price
changes cannot be predicted.
5. Do students tend to arrive in the classroom in groups of the same sex?
6. The weak form of the EMH holds that the current stock price fully reflects any
information contained in the past price series. If this is true, an analyst cannot use a
chart to predict the future.
7. Informational efficiency deals with the accuracy and speed with which security prices
react to arriving information; operational efficiency deals with the accuracy and
speed at which orders are processed.
8. Continuous pricing refers to the fact that the current value of a security can be readily
determined from the financial pages or from a computer terminal. Fair pricing refers
to the end result of market efficiency: over the long term, security prices reflect their
proper expected return given their level of risk.
9. The evidence suggests that charting does not work. The problem is that most
chartists are unable to define precisely the charting techniques they use and the
associated decision rules. Also, there is much that we do not know about finance, and
it is likely that the supply and demand dimensions of charting may contain some
information that we do not know how to unearth.
Chapter Eight
The Capital Markets and Market Efficiency
10. A positive intercept does not necessarily mean the market is inefficient. It may mean
that the model generating the intercept is misspecified, that the market index is
incorrect, or that the result is time period specific.
11. A true test of market efficiency should determine whether any apparent abnormal
profits are actually realizable. If you must pay a dollar to get a “free” fifty cents, it is
not clear that inefficiency really exists.
12. There is much folklore about the price/earnings ratio. The traditional PE is related to
past earnings, while it is future earnings that matter most. There is no consensus on
what constitutes a good PE, although the empirical evidence is slightly on the side of
low PEs.
13. Many people believe that low stock prices are positively correlated with the level of
risk: low priced stocks are risky.
14. If small firms do generate larger returns than expected by finance theory, it would
make sense for portfolios to concentrate on firms with low capitalization.
15. This would be a weak form test. The information is publicly available.
16. You can argue that if you pick them early, you will experience the period of
underperformance alluded to in the article. The stocks then have to rise enough to
recover this loss. Ideally you would want to buy value stocks just as they come back
in favor.
17. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
CFA Institute, Charlottesville, VA. All Rights Reserved).
A. The notion that stock prices already reflect all available information is referred to
as the efficient market hypothesis (EMH). It is common to distinguish among
three versions of the EMH: the weak, semi-strong, and strong forms. These
versions differ by their treatment of what is meant by “all available information.”
The weak-form hypothesis asserts that stock prices already reflect all information
that can be derived from studying past market trading data. Therefore, “technical
analysis” and trend analysis, etc., are fruitless pursuits. Past stock prices are
publicly available and virtually costless to obtain. If such data ever conveyed
reliable signals about future stock performance, all investors would have learned
already to exploit such signals.
The semi-strong form hypothesis states that all publicly-available information
about the prospects of a firm must be reflected already in the stock’s price. Such
Chapter Eight
The Capital Markets and Market Efficiency
information includes, in addition to past prices, all fundamental data on the firm,
its products, its management, its finances, its earnings, etc., etc. that can be found
in public information sources.
The strong-form hypothesis states that stock prices reflect all information relevant
to the firm, even including information available only to company “insiders.”
This version is an extreme one. Obviously, some “insiders” do have access to
pertinent information long enough for them to profit from trading on that
information before the public obtains it. Indeed, such trading—not only by the
“insiders” themselves, but also by relatives and/or associates—is illegal under
rules of the SEC.
For the weak-form or the semi-strong forms of the hypothesis to be valid does not
require the strong-form version to hold. If the strong-form version was valid,
however, both the semi-strong and the weak-form versions of efficiency would
also be valid.
B. Even in an efficient market, a portfolio manager would have the important role of
constructing and implementing an integrated set of steps to create and maintain
appropriate combinations of investment assets. Listed below are the necessary
steps in the portfolio management process:
(1) Counseling the client to help the client to determine appropriate
objectives and identify and evaluate constraints. The portfolio manager
together with the client should specify and quantify risk tolerance,
required rate of return, time horizon, taxes considerations, the form of
income needs, liquidity, legal and regulatory constraints, and any unique
circumstances that will impact or modify normal management
procedures/goals.
(2) Monitoring and evaluating capital market expectations. Relevant
considerations,
such
as
economic,
social,
and
political
conditions/expectation are factored into the decision making process in
terms of the expected risk/reward relationship for the various asset
categories. Different expectations may lead the portfolio manager to
adjust a client’s systematic risk level even if markets are efficient.
(3) The above steps are decisions derived from/implemented through portfolio
policy and strategy setting. Investment policies are set and implemented
through the choice of optimal combinations of financial and real assets in
the marketplace—i.e., asset allocation. Under the assumption of a
perfectly efficient market, stocks would be priced fairly, eliminating any
added value by specific security selection. It might be argued that an
investment policy which stresses diversification is even more important in
Chapter Eight
The Capital Markets and Market Efficiency
an efficient market context because the elimination of specific risk
becomes extremely important.
(4) Market conditions, relative asset category percentages, and the investor’s
circumstances are monitored.
(5) Portfolio adjustments are made as a result of significant changes in any
or all relevant variables.
18. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA. All
Rights Reserved).
A. Efficient market hypothesis (EMH) states that a market is efficient if security
prices immediately and fully reflect all available relevant information. Efficient
means informationally efficient, not operationally efficient.
Operational
efficiency deals with the cost of transferring funds. If the market fully reflects
information, the knowledge of that information would not allow anyone to profit
from it because stock prices already incorporate the information.
1. Weak form asserts that stock prices already reflect all information that can
be derived by examining market trading data such as the history of past
prices and trading volume.
Empirical evidence supports the weak form.
A strong body of evidence supports weak-form efficiency in the major U.S.
securities markets. For example, test results suggest that technical trading
rules do not produce superior returns after adjusting for transactions costs
and taxes.
2. Semistrong form says that a firm’s stock price already reflects all publicly
available information about a firm’s prospects. Examples of publicly
available information are annual reports of companies and investment
advisory data.
Empirical evidence mostly supports the semistrong form.
Evidence strongly supports the notion of semistrong efficiency, but
occasional studies (e.g., those identifying market anomalies including the
small-firm effect and the January effect) and events (e.g., stock market
crash of October 19, 1987) are inconsistent with this form of market
efficiency. Black suggests that most so-called “anomalies” result from data
mining.
Chapter Eight
The Capital Markets and Market Efficiency
3. Strong form of the EMH holds that current market prices reflect all
information, whether publicly available or privately held, that is relevant to
the firm.
Empirical evidence does not support the strong form.
Empirical evidence suggests that strong-form efficiency does not hold. If
this form were correct, prices would fully reflect all information, although a
corporate insider might exclusively hold such information. Therefore,
insiders could not earn excess returns. Research evidence shows that
corporate officers have access to pertinent information long enough before
public release to enable them to profit from trading on this information.
B. Technical analysis in the form of charting involves the search for recurrent and
predictable patterns in stock prices to enhance returns. The EMH implies that
this type of technical analysis is without value. If past prices contain no useful
information for predicting future prices, there is no point in following any
technical trading rule for timing the purchases and sales of securities. According
to weak-form efficiency, no investor can earn excess returns by developing
trading rules based on historical price and return information. A simple policy of
buying and holding will be at least as good as any technical procedure. Tests
generally show that technical trading rules do not produce superior returns after
making adjustments for transactions costs and taxes.
Fundamental analysis uses earnings and dividend prospects of the firm,
expectations of future interest rates, and risk evaluation of the firm to determine
proper stock prices. The EMH predicts that most fundamental analysis is
doomed to failure. According to semistrong-form efficiency, no investor can
earn excess returns from trading rules based on any publicly available
information. Only analysts with unique insight receive superior returns.
Fundamental analysis is no better than technical analysis in enabling investors to
capture above-average returns. However, the presence of many analysts
contributes to market efficiency.
In summary, the EMH holds that the market appears to adjust so quickly to
information about individual stocks and the economy as a whole that no
technique of selecting a portfolio—using either technical or fundamental
analysis—can consistently outperform a strategy of simply buying and holding a
diversified group of securities, such as those making up the popular market
averages.
C. Portfolio managers have several roles or responsibilities even in perfectly
efficient markets. The most important responsibility is to:
Chapter Eight
The Capital Markets and Market Efficiency
1. Identify the risk/return objectives for the portfolio given the investor’s
constraints. In an efficient market, portfolio managers are responsible for
tailoring the portfolio to meet the investor’s needs rather than to beat the
market, which requires identifying the client’s return requirements and risk
tolerance. Rational portfolio management also requires examining the
investor’s constraints, such as liquidity, time horizon, laws and regulations,
taxes, and such unique preferences and circumstances as age and
employment.
Other roles and responsibilities include:
2. Developing a well-diversified portfolio with the selected risk level.
Although an efficient market prices securities fairly, each security still has
firm-specific risk that portfolio managers can eliminate through
diversification. Therefore, rational security selection requires selecting a
well-diversified portfolio that provides the level of systematic risk that
matches the investor’s risk tolerance.
3. Reducing transaction costs with a buy-and-hold strategy. Proponents
of the EMH advocate a passive investment strategy that does not try to find
under- or overvalued stocks. A buy-and-hold strategy is consistent with
passive management. Because the efficient market theory suggests that
securities are fairly priced, frequently buying and selling securities, which
generate large brokerage fees without increasing expected performance,
makes little sense. One common strategy for passive management is to
create an index fund that is designed to replicate the performance of a
broad-based index of stocks
4. Developing capital market expectations. As part of the asset-allocation
decision, portfolio managers need to consider their expectations for the
relative returns of the various capital markets to choose an appropriate
asset allocation.
5. Implementing the chosen investment strategy and review it regularly
for any needed adjustments. Under the EMH, portfolio managers have
the responsibility of implementing and updating the previously determined
investment strategy for each client.
D. Whether active asset allocation among countries could consistently outperform a
world market index depends on the degree of international market efficiency and
the skill of the portfolio manager. Investment professionals often view the basic
issue of international market efficiency in terms of cross-border financial market
integration or segmentation. An integrated world financial market would
Chapter Eight
The Capital Markets and Market Efficiency
achieve international efficiency in the sense that arbitrage across markets would
take advantage of any new information throughout the world. In an efficient
integrated international market, prices of all assets would be in line with their
relative investment values.
Some claim that international markets are not integrated, but segmented. Each
national market might be efficient, but factors might prevent international capital
flows from taking advantage of relative mispricing among countries. These
factors include psychological barriers, legal restrictions, transaction costs,
discriminatory taxation, political risks, and exchange risks.
Markets do not appear fully integrated or fully segmented. Markets may or may
not become more correlated as they become more integrated since other factors
help to determine correlation. Therefore, the degree of international market
efficiency is an empirical question that has not yet been answered.
ANSWERS TO PROBLEMS
1.
RUNS TEST
Input R, N1, and N2 below:
# of runs (R):
N1:
N2:
mean:
8
10
5
7.67
sigma:
1.64
Z score:
PROBABILITY OF
GETTING
OCCURING BY
CHANCE:
2 – 5. Student responses.
A run is an uninterrupted
series of the same sign.
For instance, the series
below has 6 runs:
H H H T T
^
^
|
|
|
1
2
0.20
H T H T T T
^ ^ ^
^
| | |
3 4 5
6
R=6, N1=5, N2=6
(or R=6, N1=6, N2=5)
RUNS OUT
8OF
41.96%
15OBSERVATIONS