MARKET EFFICIENCY Market efficiency describes the extent to which available information is quickly reflected in the market price. An efficient capital market that reflects all available news and information. MARKET VALUE VS. INTRINSIC VALUE In an efficient market, o New information is quickly absorbed, information and stock prices adjust in response. o Superior, risk-adjusted returns are not achievable. o A large number of investors analyze and value securities for profit. o New information comes to the market independent from other news and in a random fashion. In a highly efficient market, passive management (buying and holding a broad market portfolio) that does not seek superior risk-adjusted returns) is preferred to active management, particularly due to lower costs. Market value is the price at which an asset can currently be bought or sold. Intrinsic value (fundamental value) is the value that would be placed on it by investors if they had a complete understanding of the asset’s investment characteristics. If investors believe a market is highly efficient, they will usually accept market prices equal intrinsic values. FACTORS CONTRIBUTING TO AND IMPEDING MARKET EFFICIENCY 1. Market participant: A large number of investors follow the major financial markets closely on a daily basis, and if mispricing exist in these markets, investors will act so that these mispricing disappear quickly. 2. Information Availability and Financial Disclosure: The more information market participants have, the more accurate the market’s estimates of intrinsic value thus creating greater market efficiency. 3. Limits to Trading: Restrictions on short selling limit arbitrage trading, which impedes market efficiency. 4. Transactions and InformationAcquisition Costs: Traders incur these costs as when trying to detect and exploit market inefficiencies. WEAK FORM on surprise announcements since the market would quickly react to the new information. o Encompasses the weak form. STRONG FORM Security prices fully reflects all past market data, which refers to all historical price and trading volume information. Tests of whether securities markets are weak-form efficient require looking at patterns of prices. o See whether there is any serial correlation in security returns, which would imply a predictable pattern. o If any such trading rule consistently generates abnormal risk-adjusted returns. o Technical analysts – those trading on analysis of historical trading information – should earn no abnormal returns. SEMI-STRONG FORM Prices reflect all publicly known and available information, including all historical price information. o Under this assumption, analyzing any public financial disclosures made by a company to determine a stock’s intrinsic value would be futile since every detail would be taken into account in the stock’s market price. Similarly, an investor could not earn consistent abnormal returns by acting Prices reflect all public and private information. o Encompasses weak form and semistrong form efficient market. Insiders would not be able to earn abnormal returns from trading on the basis of private information. Prices reflect all private information, i.e. everything that the management of a company knows about the financial condition of the company that has not been publicly released. Most research indicates that markets are not strong form efficient. o Therefore, the need for insider trading laws. COULD ABNORMAL RETURNS BE EARNED THROUGH VARIOUS STRATEGIES AND ACTIVE MANAGEMENT, ASSUMING DIFFERENT TYPES OF MARKET EFFICIENCY? WHAT ARE MARKET ANOMALIES? Market anomalies occur when a change in the price of an asset or security cannot directly be linked to current relevant information known in the market, or the release of new information. Anomalies may be a result of data mining (data snooping). As such, market anomalies are only valid if they are consistent over long periods of time and not the result of data mining or examining data with the intent of developing a hypothesis. CATEGORIES OF MARKET ANOMALIES 1. Time-Series Anomalies Calendar anomalies: Significant differences in returns on different days, months, or years. o The most commonly known calendar anomaly is the January effect, in which stocks tend to outperform in the month of January – part of which may be explainable by individual investors or fund managers selling off during the previous December. Overreaction and momentum anomalies o Overreaction: Stock prices become inflated (depressed) for those companies releasing good (bad) news. o Momentum: Securities that have experienced high returns in the short term tend to continue to generate high returns in subsequent periods. 2. Cross-sectional Anomalies Size effect: Small companies tend to outperform larger companies. o Equities of small-cap companies tend to outperform equities of large-cap companies on a riskadjusted basis. Value effect: Value stocks, which generally are stocks with below-average price-to-earnings and market-to-book ratios, and above average dividend yields, have consistently outperformed growth stocks over long periods of time o The anomaly contradicts semistrong market efficiency because all the information used to categorize stocks in this manner is publicly available. 3. Other Anomalies Closed-end fund discounts: Closed-end funds sometimes sell at a discount to their net asset value, or the price that the fund’s holdings could theoretically be sold for if fully liquidated. o Anomaly may be explained by tax inefficiency and expectations of manager underperformance. Earnings surprise: Stock prices have a tendency to underreact to new information, allowing for a momentum strategy (buying stocks with recent positive developments and selling stocks with recent negative developments) to be potentially profitable. Initial public offerings (IPOs): Investors able to purchase a stock at its initial offering price earn excess returns. o This is somewhat understandable as investment banks arranging the IPOs are often incentivized to set a low price. Prior information: Some researchers have found that equity returns relate to prior information like interest rates, inflation rates, stock volatility, and dividend yields. o However, this is not evidence of a market anomaly as abnormal returns cannot be earned using such information. BEHAVIORAL FINANCE Assumes that: o Investors suffer from cognitive biases that may lead to irrational decision making. o Investors may overreact or underreact to new information. Runs contrary to traditional finance, which assumes that: o Investors behave rationally. o Investors process new information quickly and correctly. BEHAVIORAL FINANCE 1. Loss Aversion Bias People have a tendency to dislike losses more than they like comparable gains. This may help to explain under-reaction and overreaction market anomalies. 2. Overconfidence Bias Investors tend to overestimate their ability to accurately determine intrinsic values, and may not process information appropriately as a result, which ultimately leads to mispriced securities. This mispricing has been shown to mainly take place in higher-growth companies, whose prices react slowly to new information. 3. Information Cascades Information cascades refer to the transmission of information from those participants who act first and whose decisions influence the decisions of others. As investors base the decisions on the actions of other investors acting before them, stock returns may be serially correlated and lead to overreaction anomalies. Research has shown information cascades to be greater for companies with poor quality information. 4. Herding Bias Market participants tend to trade along with other investors, while potentially ignoring their own private information or analysis. This bias may also serve as a possible explanation for the under-reaction and overreaction market anomalies.
