Capital Market Efficiency
The concepts
Topics
• What if you figure a stock price moving
pattern?
• Some formal definitions
• Implications of Market efficiency
Hypothesis
• Price modeling
• Empirical studies
What if?
Definitions
Implications
Price
Empirics
What if
• What if you have figured the following:
– Buy if out of the 20 trading days for the past
month, stock XYZ has been rising for more
than 2/3 of the times.
– Sell if out of the 20 trading days for the past
month, stock XYZ has been falling for more
than 2/3 of the times.
– Follow this rule strictly, return is “abnormally
high”.
What if?
Definitions
Implications
Price
Empirics
Stock price reflects information
• If you have spotted XYZ’s stock pattern that guarantee you
pure profit, what should you do?
• You should definitely exploit it. (How? Borrow as much as you
can to invest.)
• The process of exploiting it actually makes the opportunity
vanishes because:
• You would bid up XYZ stock price when you think it is hot.
Higher prices mean lower expected return.
• You would also likely bid down XYZ stock price when you
think it is cold. Lower prices mean higher expected return.
• In short, the fact that you have figured out a stock price
movement is very likely to be reflected by the stock price.
• The more greedy (which is rational, more precisely, is the
higher the ability for you to raise fund) you are, the faster your
pattern will be eliminated.
What if?
Definitions
Implications
Price
Empirics
Stock Price
Price movement pattern
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
If it were possible to make
big money simply by
finding “the pattern” in the
stock price movements,
everyone would do it and
the profits would be
competed away.
Sell
Sell
Buy
Buy
Time
What if?
Definitions
Implications
Price
Empirics
The army
• Imagine not only you, there exists an “army” of intelligent,
well-informed security analysts, arbitragers, traders, who
literally spend their lives hunting for securities which are
mispriced or following a price moving pattern based on
currently available information.
• They have high-tech computers, subscription to professional
database, up-to-date information on thousands of firms, stateof-the-art analytical technique, etc.
• These people can assess, assimilate and act on information,
very quickly.
• In their intense search for mispriced securities, professional
investors may “police” the market so efficiently that they drive
the prices of all assets to fully reflect all available information.
What if?
Definitions
Implications
Price
Empirics
Implications
• Competition for finding mispriced securities is fierce.
• Such competition always kills the “sure-profit” pattern
because were there one, it would have been exploited by
someone who first spotted it. Thus, roughly speaking,
“no arbitrage” should hold.
• The first one does make profit, but
net profit ≠ gross profit
• The “very first” one is not likely to be you.
• The implications:
– stock prices should have reflected all available
information.
– stock prices should be unpredictable.
What if?
Definitions
Implications
Price
Empirics
Unpredictability
• Prices are unpredictable in the sense that
stock prices should have reflected “all
available information”.
• Thus if stock prices change, it should be
reacting only to “new information”.
• The fact that information is new means
stock prices are unpredictable.
What if?
Definitions
Implications
Price
Empirics
Market efficiency
• If all past information is incorporated in the price
then it should be impossible to consistently beat
the market using technical analysis and the like.
• Definition 1:
– Eugene Fama defined Market Efficiency as the state
where "security prices reflect all available
information.“
• Definition 2:
– Financial markets are efficient if current asset prices
fully reflect all currently available relevant information.
What if?
Definitions
Implications
Price
Empirics
What is the right question?
• If new information becomes known about a
particular company, how quickly do market
participants find out about the information and buy
or sell the securities of the company based on the
information?
• How quickly do the prices of the securities adjust to
reflect the new information?
• The issue is not merely black or white. We know that
the market should neither be strictly efficient nor
strictly inefficient. The question is one of degree.
• We should ask “ how efficient the market really is?”
What if?
Definitions
Implications
Price
Empirics
Subsets of available information
For a given stock
All Available Information
including inside or private
information
All Public Information
Information
in past stock
prices
What if?
Definitions
Implications
Price
Empirics
3 forms of market efficiency
hypothesis
Since we are more interested in how
efficient is the capital market, we define
the following 3 forms of market
efficiency hypothesis:
All Available Information
including inside or private
information
“A market is efficient if it reflects ALL
available information”
All Public Information
[1] Strong-form
Information
in past stock
prices
- ALL available info
[2] Semi-strong form
- ALL available info
[3] Weak-form
- ALL available info
What if?
Definitions
Implications
Price
Empirics
3 forms of market efficiency hypothesis
• Weak-form
“Stock prices are assumed to reflect any information that
may be contained in the past history of the stock price
itself.”
– For example, suppose there exists a seasonal pattern in stock
prices such that stock prices fall on the last trading day of the
year and then rise on the first trading day of the following year.
Under the weak-form of the hypothesis, the market will come to
recognize this and price the phenomenon away.
– Anticipating the rise in price on the first day of the year, traders
will attempt to get in at the very start of trading on the first day.
Their attempts to get in will cause the increase in price to occur
in the first minutes of the first day. Intelligent traders will then
recognize that to beat the rest of the market, they will have to get
in late on the last day. The consequences, therefore, is the
elimination of the pattern as price in the last trading day should
be bid up.
What if?
Definitions
Implications
Price
Empirics
3 forms of market efficiency hypothesis
• Semi-strong-form
“Stock prices are assumed to reflect any information that is
publicly available.”
– These include information on the stock price series, as well as
information in the firm’s accounting reports, the reports of
competing firms, announced information relating to the state of
the economy, and any other publicly available information
relevant to the valuation of the firm.
What if?
Definitions
Implications
Price
Empirics
3 forms of market efficiency hypothesis
• Strong-form
“Stock prices are assumed to reflect ALL information,
regardless of them being public or private.”
– Under this form, those who acquire insider information act on it,
buying or selling the stock. Their actions affect the price of the
stock, and the price quickly adjusts to reflect the insider
information.
What if?
Definitions
Implications
Price
Empirics
3 forms of market efficiency hypothesis
• If Weak-form of the hypothesis is valid:
– Technical analysis or charting becomes ineffective. You
won’t be able to gain abnormal returns based on it.
• If Semi-strong form of the hypothesis is valid:
– No analysis will help you attain abnormal returns as long
as the analysis is based on publicly available information.
• If Strong-form of the hypothesis is valid:
– Any effort to seek out insider information to beat the
market are ineffective because the price has already
reflected the insider information. Under this form of the
hypothesis, the professional investor truly has a zero
market value because no form of search or processing of
information will consistently produce abnormal returns.
What if?
Definitions
Implications
Price
Empirics
Why do we care about capital
market efficiency?
•
•
•
•
•
As an analyst
As an investment manager
As a corporate financial manager
As a marketing manager
As an accounting manager
What if?
Definitions
Implications
Price
Empirics
Why do we care about capital
market efficiency?
• As an analyst
– If market is efficient, what is your marginal
contribution for the securities firm that hire you? It
should be zero, because you are not able to spot
mispriced securities to produce additional increment
of return on the portfolios that you are managing.
Heat Debate.
– Analysts’ total contribution to the society should be
big. Because in scouting the capital market, they
essentially make sure asset prices are effective as
signals to others.
• If the market is truly efficient
=> 0<Total contribution ≠ marginal contribution=0
What if?
Definitions
Implications
Price
Empirics
Why do we care about capital
market efficiency?
• As an investment manager
– Investment decisions of the managers of any firms
are based to a large extent on signals they get from
the capital market.
– If the market is efficient, the cost of acquiring capital
will accurately reflect the prospects for each firm.
– This means the firms with the most attractive
investment opportunities will be able to obtain capital
at a fair price which reflects their true potential.
– The “right” investment will be made, and the society is
said to be “allocationally-efficient”. Everyone’s better
off.
What if?
Definitions
Implications
Price
Empirics
Why do we care about capital
market efficiency?
• As a corporate financial manager
– To raise capital, you consider getting debt- or equityfinancing.
– If the market is efficient, you know that equity-financing
requires a rate of return which is “fair” because the price
has already reflected all available information.
– If the market is efficient, you would never feel your firm’s
stock being under- or over-valued at any point in time. In
essence, there is no timing decision to issuing equity.
– More profoundly, if market is efficient, every alternative
way of raising capital would require the same rate of return
for the same project. And no one capital-raising method is
superior than the other.
What if?
Definitions
Implications
Price
Empirics
Why do we care about capital
market efficiency?
• As a marketing manager
– You may consider advertising at the Wall Street
Journal about how impressive your company has
done throughout the past few years.
– If the market is efficient, there is no need to do that.
Because your stock price has already reflected those.
There is absolutely no impact for the ad on the stock
price. And placing an ad is like burning money.
– Another interpretation is that, “ads don’t easily fool
investors.”
What if?
Definitions
Implications
Price
Empirics
Why do we care about capital
market efficiency?
• As an accounting manager
– Will change in accounting procedures (e.g., different
depreciation methods: straight-line vs accelerated)
impact the company’s stock price?
– No if the market is semi-strong efficient. Because
informed, rational analysts will adjust the different
accounting procedures used by different firms and
assess prospects based on standardized numbers.
– Thus, the adjustment in accounting technique will
have no effect on the opinions of those analysts or on
the stock price of the firm.
What if?
Definitions
Implications
Price
Empirics
Expected return-risk
• The market efficiency hypothesis says nothing about the
structure of stock prices. However, what is abnormal return?
Abnormal return = actual return – expected return
• This means we have to know what exactly is expected return.
• That’s why we may use a pricing model.
• e.g.,CAPM, to find a risk-adjusted return that the market will
be rewarding.)
• Defining abnormal return inherently involves assuming a
pricing model. If we find abnormal returns, we conclude that
the market is inefficient. But then, we can also say that the
pricing model we used is invalid.
• The challenge here is: testing market efficiency inevitably
involves testing a joint hypothesis:
– H0 : both market is efficient and the pricing model is valid.
– H1: EITHER market is inefficient OR the pricing model is
invalid.
What if?
Definitions
Implications
Price
Empirics
4 basic traits of efficiency
•
An efficient market exhibits certain behavioral
traits. We can examine the real market to see if
it conforms to these traits. If it doesn’t, we can
conclude that the market is inefficient.
1.
2.
3.
4.
What if?
Act to new information quickly and accurately
Price movement is unpredictable (memory-less)
No trading strategy consistently beat the market
Investment professionals not that professional
Definitions
Implications
Price
Empirics
Stock price ($)
1) Act to news quickly & accurately
Days relative to announcement day
-t
0
+t
The timing for a positive news
What if?
Definitions
Implications
Price
Empirics
Stock price ($)
1) Act to news quickly & accurately
Days relative to announcement day
-t
0
+t
If the market is efficient,
1) at time 0, the positive news come, there is an immediate up in the
stock price to the RIGHT level. (i.e., the PINK path)
2) There is no delays in analyzing news and slowly reflecting in the stock
price like the ORANGE path does.
3) There is also no over-reaction like the BLUE path does, and then
subsequently adjustment back to the correct level.
What if?
Definitions
Implications
Price
Empirics
2) Memory-less price movement
If the market is efficient (WEAK-FORM),
1) The so-called “momentum” is nothing. (Google “Stock momentum”)
•
“momentum” is like, if once started on a downward slide, stock
prices develop a propensity to continue sliding. The expected
change in today’s price would, in fact, be related (correlated
positively) with the price changes in the past.
2) If the market is efficient, prices only move in response to “news”. More
precisely, “news” is any discrepancy between the public’s expectation
and the actual realized event. E.g, “If everyone expects Wal-Mart’s
sales to go up by 50%, and if the news announces that it did go up
by 50%, this is not a news. If it goes up by 30% instead, it is a news,
a negative one though.”
3) To detect “memory” or “momentum”, we try to see if
Cov(ΔPt, ΔPt-i) is significantly different from zero or not, for i ≠ 0
What if?
Definitions
Implications
Price
Empirics
3) No superior trading strategies
•
One way to test for market efficiency is to test whether a specific
trading rule or investment strategy, would have CONSISTENTLY
produced abnormally high return.
•
Problem about such test is:
1. What is abnormal return again? We run into the problem of joint
hypothesis testing again in order to find an expected return as
benchmark.
2. What kind of information you use to construct an investment
strategy? Can you be sure the information you are based on
really reflect what WAS available when the decision to invest
was made.
•
E.g., Last quarter’s earning is out around February of next
year. If a WINNING investment strategy says “invest in the
top 10 companies last year by Jan”, it is not an employable
strategy.
3. What is the cost of implementing a strategy?
What if?
Definitions
Implications
Price
Empirics
4) Professionals aren’t that professional
•
If professional investors consistently beat the market, we conclude
that the market is not that efficient.
•
If the market is really efficient, we should not see professionals
making abnormally high returns.
•
The puzzle is: “we do see professionals having amazing records.”
•
The answer is:
•
What if?
“Suppose we take a thousand people in a gigantic stadium.
Have them flip coins. Suppose “head” is winning and “tail” is
losing. There is no surprise to find a few individual “flippers” with
unbelievable records of success and failure. Those having 20
heads in a row goes on TV and showcase their exceptional
flipping skills. But we know they’re just plain lucky.”
Definitions
Implications
Price
Empirics
So what’s the value for portfolio management
•
If capital markets are efficient, should we just throw darts at the Wall
Street Journal instead of trying to rationally choose a stock portfolio?
•
The answer is a big NO.
What if?
•
As you have learnt, you need to have a well-diversified portfolio
that is tailored towards your risk-preference.
•
Depending on your age, your risk-preference, your current
situation, your tax bracket, and all other relevant factors, your
portfolio should be carefully constructed.
•
Don’t forget that there is value for diversification. There is value
for you to learn options. There is value for you to tailor a future
payoff profile specific to your own needs. Throwing darts to pick
stocks does not guarantee your specific needs are met.
Definitions
Implications
Price
Empirics
So what’s the value for portfolio management
•
What if?
The conclusion is:
•
capital market is neither purely efficient nor purely inefficient.
•
The right question to ask is “the degree of efficiency of capital
market.”
•
The more efficient capital market is, the better off the society.
•
But even if it is efficient, it doesn’t imply knowledge of finance is
useless. Because you have learnt diversification and portfolio
theory that is based on maximizing happiness.
•
Price movements are random. But it in NO way implies prices
are random. Prices reflect/incorporate available information. The
driving force to their random movements is that news comes
randomly.
Definitions
Implications
Price
Empirics