Stock Market Efficiency
Corporate Finance 26
Stock market efficiency: Introduction
• What is efficiency?
• The value of an efficient market
• Random walks
• Weak-form efficiency
• Semi-strong form efficiency
What is meant by efficiency?
• In an efficient capital market, security (for example
shares) prices rationally reflect available information
• If new information is revealed about a firm, it will be
incorporated into the share price rapidly and rationally, with
respect to the direction of the share price movement and
the size of that movement
• No trader will be presented with an opportunity for making a
return on a share greater than a fair return for the riskiness
associated with that share, except by chance
• Stock market efficiency does not mean that investors have
perfect powers of prediction
• The current share price level is an unbiased estimate of its
true economic value based on the information revealed
Efficiency?
• Market efficiency does not mean that share prices are equal to true value at
every point in time
• Errors that are made in pricing shares are unbiased; price deviations from
true value are random
• There is an equal chance of our being too pessimistic at £7 as being too
optimistic
• Prices are set by the forces of supply and demand
• Hundreds of analysts and thousands of traders
• Example: BMW announces a prototype electric car
What efficiency does not mean
• Prices do not depart from true economic value
• You will not come across an investor beating the
market in any single time period
• No investor following a particular investment
strategy will beat the market in the long term
Types of efficiency
• 1 Operational efficiency
• 2 Allocational efficiency
• 3 Pricing efficiency
New information (an electric car announcement by BMW) and alternative stock
market reactions – efficient and inefficient
The value of an efficient market
• 1 To encourage share buying
• 2 To give correct signals to company managers
–
Managers need to be assured that the implication of a
decision is accurately signalled to shareholders and to
management through the share price
–
The rate of return investors demand on securities
–
Information communicated to the market
• 3 To help allocate resources
Random walks
A share price pattern disappears as investors recognise its existence
The three levels of efficiency
1 Weak-form efficiency. Share prices fully reflect all
information contained in past price movements
2 Semi-strong form efficiency. Share prices fully reflect
relevant publicly available information
3 Strong-form efficiency. All relevant information,
including that which is privately held, is reflected in the
all the
share price
Weak-form tests
• There will be no mechanical trading rules based on
movements which will generate profits in excess of
market return (except by chance)
• A simple price chart
Head & Shoulder’s pattern
past
the average
A ‘line and breakout’ pattern
Weak-form tests
• The filter approach
–
Focus on the long-term trends and to filter out short-term
movements
• The Dow theory
Weak form efficiency - general conclusion
• The evidence and the weight of academic opinion is that the
weak form of the EMH is generally to be accepted
• Benjamin Graham: “One principle that applies to nearly all
these so-called ‘technical approaches’ is that one should buy
because a stock or the market has gone up and should sell
because it has declined… the exact opposite of sound
business sense everywhere else… we have not known a
single person who has consistently or lastingly made money
by thus ‘following the market”’
Return reversal
• De Bondt and Thaler (1985)
–
Shares that had given the worst returns over a three-year
period outperformed the market by an average of 19.6 percent
in the next 36 months
• Chopra et al. (1992)
–
Extreme prior losers outperform extreme prior winners by
5–10 per cent per year during the subsequent five years
• Arnold and Baker (2005)
–
Loser shares outperformed winner shares by 14 percent per
year
Cumulative market-adjusted returns for UK share portfolios constructed on the
basis of prior five-year returns
Source: Arnold and Baker (2007).
Market-adjusted buy-and-hold five-year test-period returns for loser minus winner
strategies for each of the 39 portfolio formations
Source: Arnold and Baker (2007).
Price (return) momentum
• Jegadeesh and Titman (1993): a strategy that selects shares on their
past six-month returns and holds them for six months, realises a
compounded return above the market of 12.01 per cent per year on
average
• Possible explanations:
–
–
Investors underreacting to new information
Investors overreacting during the test period
• Rouwenhorst (1998) showed price momentum in 12 developed
country stock markets
• Liu et al. (1999)
• Hon and Tonks (2003)
• Arnold and Shi (2005)
–
Tested the strategy over the period 1956 to 2001
• While on average, winners outperform losers by up to 9.92 percent per
year the strategy is fairly unreliable
Price momentum
Portfolios are constructed on six-month prior-period returns and held for six months. Buy-and-hold
monthly returns over the six months for the winner portfolio minus the loser portfolio. Each portfolio
formation is shown separately
Source: Arnold and Shi (2005).
Moving averages
• Brock et al. (1992)
• If investors (over the period 1897 to 1986) bought the 30
shares in the Dow Jones Industrial Average when the shortterm moving average of the index (the average over, say, 50
days) rises above the long-term moving average (the average
over, say, 200 days) they would have outperformed the
investor who simply bought and held the market portfolio
• ‘However, transaction costs should be carefully considered
before such strategies can be implemented’ (Brock et al. 1992)
• The trading rules did not work in the 10 years following the
study period (Sullivan et al. 1999)
Semi-strong form tests
• Is worthwhile expensively acquiring and analysing
available information?
publicly
• Fundamental analysts try to estimate a share’s true value
future business returns
based on
• Majority of the early evidence (1960s and 1970s)
the hypothesis
• Some academic studies which appear to suggest that the
less than perfectly efficient
supported
market is
Semi-strong form tests
• Information announcements
– Ball and Brown (1968)
• Seasonal, calendar or cyclical effects
– The weekend effect
– The January effect
– Hour of the day effect
– Cease to exist
– High transaction costs
– Accusation of ‘data-snooping’
Small firms
• Studies in the 1980s found that smaller firms’ shares
outperformed in the USA, Canada, Australia, Belgium,
Finland, the Netherlands, France, Germany, Japan and Britain
• Perhaps the researchers had not adequately allowed for the
extra risk of small shares, beta
• Some researchers have argued that small firms suffer more in
recessions
• Proportionately more expensive to trade in small companies’
shares
• ‘Institutional neglect’
The small-cap reversal in the United States and the United Kingdom
Source: Dimson, E., Marsh, P. and Staunton, M. (2002) Triumph of the Optimists: 101 Years of Global Investment Returns.
Princeton, NJ, and Oxford: Princeton University Press.
Underreaction
• Investors are slow to react to the release of information in some
circumstances
• ‘Post-earnings-announcement drift’
• Bernard and Thomas (1989): cumulative abnormal
returns
(CARs) continue to drift up for firms that report
unexpectedly good
earnings and drift down for firms that
report unexpectedly bad figures for
up to 60 days after
the announcement.
• The abnormal return in a period is the return of a portfolio
after
adjusting for both the market return in that period
and risk
The cumulative abnormal returns (CAR) of shares in the 60 days before and the 60
days after an earnings announcement
Source: Bernard, V. and Thomas, J., 1989.
Underreaction
• Other areas of research into underreaction
• Ikenberry et al. (1995) share prices rise on the announcement
that the company will repurchase its own shares
• Michaely et al. (1995) found evidence of share price drift
following dividend initiations and omissions
• Ikenberry et al. (1996) found share price drift after share
split announcements
• Jegadeesh and Titman (1993) found that trading strategies in
which the investor buys shares that have risen in recent
months produce significant abnormal returns
• Chan et al. (1996) confirm an underreaction to past price
movements (a ‘momentum effect’) and also identify a drift
after earnings surprises
Value investing
• Low price-earning ratio shares
– The evidence generally indicates that these shares generate abnormal
returns Basu (1975, 1977, 1983), Keim (1988), Lakonishok et al. 1994)
– Levis (1989), Gregory et al. (2001, 2003)
– Dispute whether it is the small-size effect that is really being observed
Reinganum (1981), and Banz and Breen (1986)
– Levis (1989), and Gregory et al. (2001), concluded that low PERs were
a source of excess returns
• Investors place too much emphasis on short-term earnings data
• The tendency for extreme profit and growth trends to moderate ‘to revert to
the mean’
– (Little (1962), Fuller et al. (1993), Dremen (1998))
• Lakonishok et al. (1994) found that low PER shares are actually less
risky than the average
Value investing
• Shares that sell at prices which are a low multiple of the
net assets per share seem to produce abnormal returns
• Many studies have concluded that shares offering a
higher dividend yield tend to outperform the market
• High sales-to-price ratio firms perform better than low
sales-to-price firms
• Cash flow to price ratio (Lakonishok et al. (1994))
• Costs of issue/arrangement
• Bubbles
Lecture review
• An efficient market
• Types of efficiency
• The benefits of an efficient market
• Random walk
• Weak-form efficiency
• Semi-strong form efficiency