Download an efficient market

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 10
Market Efficiency
Lecture Agenda
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Learning Objectives
Important Terms
The Importance of Market Efficiency
Market Efficiency Defined
The Efficient Market Hypothesis
Empirical Evidence Regarding Market Efficiency
Implications of EMH
Summary and Conclusions
– Concept Review Questions
CHAPTER 10 – Market Efficiency
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Learning Objectives
1. What is meant by market efficiency
2. How to differentiate among different levels of
efficiency
3. How to use the concepts in this chapter to judge
corporate decisions
4. How the concepts in this chapter are used in
regulating market activity
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Important Chapter Terms
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Abnormal returns
Allocational efficiency
Anomalies
Buy side analysts
Disclosure
Efficient market
Efficient market
hypothesis (EMH)
Event study
Informational efficiency
Material facts
Momentum
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Operational efficiency
Random walk hypothesis
Securities law
Sell side analysts
Semi-strong form efficient
market hypothesis
Size effect
Strong form efficient market
hypothesis
Technical analysis
Weak form efficient market
hypothesis
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The Importance of Market Efficiency
• Understanding how securities are valued
provides guidelines to managers about how
they should manage businesses on behalf of
shareholders
• The discount rate that represents shareholders’
required rate of return is established as a result
of benchmark rates in the capital markets, such
as the risk-free rate (RF) and the market risk
premium.
• Do market prices reflect the actions of
managers?
– If they do, then managers must learn what actions
they should take
in order
toEfficiency
fulfill their legal and
CHAPTER
10 – Market
managerial responsibilities to shareholders.
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The Importance of Market Efficiency
Three Elements to Market Efficiency
• Operational Efficiency
– Transactions costs are low, thereby enhancing trading
of securities
• Allocational Efficiency
– There are enough securities to efficiently allocate risk
• Informational Efficiency
– Market prices fairly and quickly reflect all available
information
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The Importance of Market Efficiency
Informational Efficiency
• The closer the link between managers’ actions
and the value of the firm, the more
informationally efficient the capital market
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The Importance of Market Efficiency
Securities Laws Affecting Public-Issuers of Securities
• The closer the link between managers’ actions and the
value of the firm, the more informationally efficient the
capital market
• Securities laws in Canada reflect the belief that there is
(or should be) a strong connection between information
and stock prices and these laws reflect a number of
common principles related to parties, transactions, and
access to information:
– Continuous disclosure of all material information about the
firm
– Fair and equal treatment of all market participants through
disclosure requirements that ensure all participants have
simultaneous access to the same information about
publicly-traded firms
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Asymmetric Information
• Asymmetric information is when one party to a
transaction has access to more a complete and
accurate set of facts than the other party.
– When this condition exists, it is possible for the party
with better information to use that at their own
personal gain, and at the expense of the other.
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Asymmetric Information
An Example – The Used Car!
• An example of asymmetric information from everyday life might be
the situation between a buyer and seller of a used car in a private
transaction
– The seller has intimate knowledge of recent car history including past owners,
collisions, repairs, and problems
– The buyer (presuming no expertise as a mechanic) has only limited skills of
observation and investigation to inform the purchase decision
• It is possible, in the absence of rules and regulations, for the seller
to take advantage of the buyer because of information asymmetry
• This means the buyer is likely to pay more for the car than the car is
worth; the seller reaps the rewards of superior information
– In some provinces, before such a transaction can occur, a sellers information
package must be obtained from the Ministry of Transportation. This package will
include an estimate of wholesale and retail price of the used car, and a list of
past owners; this is an example of government regulation to try to reduce the
information advantage sellers have over buyers
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Disclosure and Market Efficiency
The Asymmetric Information Challenge
• If informational advantages were widely permitted,
and if there were a persistent advantage of some
market participants over others, the credibility of
the markets would be shaken
• Under such circumstances, many people would
choose not to invest in securities, choosing, instead
to put their money into managed deposits, or worse,
choosing to hide their money under a pillow.
• This would significantly reduce the number of
market participants, and the amounts of money
invested in the markets
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Disclosure and Market Efficiency
The Asymmetric Information Challenge
• The result would be: less market efficiency; lower
security prices, infrequent trading of securities
• Ultimately, the capital market would not be able to
channel sufficient surplus funds to underwrite
economic activity such as plant expansions,
research and development, etc. In the end,
companies would lack capital, and increasingly
become inefficient and ineffective in their markets.
Jobs would be lost and the standard of living of all
would decline
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Defining Market Efficiency
• An efficient market is a market that reacts
quickly and relatively accurately to new public
information, which results in prices that are
correct, on average
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Market Efficiency
Requisite Conditions
For markets to operate efficiently some conditions must
exist:
1. A large number of rational, profit-maximizing investors exist,
who actively participate in the market by analyzing, valuing,
and trading securities. The markets must be competitive,
meaning no one investor can significantly affect the price of the
security through their own buying or selling.
2. Information is costless and widely available to market
participants at the same time.
3. Information arrives randomly and therefore announcements
over time are not serially connected.
4. Investors react quickly and fully (and reasonably accurately) to
the new information, which is reflected in stock prices.
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Efficient Market Hypothesis (EMH)
• The efficient market hypothesis is the theory
that markets are efficient and therefore, in its
strictest sense, implies that prices accurately
reflect all available information at any given time
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Efficient Market Hypothesis (EMH)
• Weak form EMH is the theory that security
prices reflect all market data, referring to all
past price and volume trading information
• Implication:
– If weak form efficient, historical trading data will
already be reflected (discounted) in current prices and
should be of no value in predicting future price
changes
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Efficient Market Hypothesis (EMH)
• Semi-strong form EMH is the theory that all publicly
known and available information is reflected in security
prices
• Assumes the weak-form set of information as well as all
public information pertinent to the security such as:
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Earnings
Dividends
Corporate investments,
Management changes
• Implication:
– If semi-strong efficient, it is futile to analyze public information
such as earnings projections and financial statements in an
attempt to identify underpriced or overpriced securities
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Efficient Market Hypothesis (EMH)
• Strong form EMH is the theory that stock prices
fully reflect all information, which includes both
public and private information
• Implications:
– Stock prices are fairly priced.
– It is not possible to use public information to identify
over-priced or under-priced stocks
– It is not possible to use insider information to identify
over-priced or under-priced stocks
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Efficient Market Hypothesis (EMH)
Tests of EMH
• All tests of the EMH try to demonstrate that using a
particular source of information allows an investor to
consistently earn ‘abnormal’ returns
• Abnormal returns are percentage returns that are
greater than a naïve buy-and-hold strategy where the
investor passively buying a market index portfolio such
as the S&P/TSX 60 composite index
In other words, can an active investment strategy, using
a particular trading rule or source of information,
generate greater risk-adjusted returns than a passive,
naïve, yet achievable, investment strategy?
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Empirical Evidence on Market Efficiency
Anomalies
• Anomalies are exceptions to a rule or theory
– An identified anomaly may not violate the theory,
especially if it cannot be exploited profitably after
transactions costs and taxes, or if it cannot be
exploited consistently
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Empirical Evidence on Market Efficiency
Weak Form Evidence
• The Random Walk Hypothesis states prices
follow a random walk with price changes over
time being independent of one another
– This hypothesis is logical if information arrives
randomly, as it should, and if investors react quickly to
it
• Tests of weak form efficiency include:
– Serial correlation tests
– Runs (or signs tests)
– Testing of trading rules used by technical analysts
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Empirical Evidence on Market Efficiency
Weak Form Evidence - Anomalies
Anomalies that contest weak form market efficiency are:
– Investors have been found to overreact to new information and
this leads to stock prices over-shooting and undershooting their
intrinsic value and this results in stock price reversals favouring
in some cases, contrarian trading strategies
– Evidence of momentum in stock returns (See Figure 10-1)
– Evidence of seasonal patterns in stock returns including the
January effect, the January effect for smaller firms, the day-ofthe week effect (average negative Monday returns statistically
different than the other trading days of the week), and the
tendency for returns to be higher on the last trading day of each
month
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Weak Form Evidence
Momentum in Canadian Stock Returns, 1980 - 1999
FIGURE 10-1
January 1980 – December 1999
Six-Month Holding Period Returns (%)
25
20.7
6
20
14.75
15
6.10
5.9
9
10
5
0
Top 30
Bottom 30
Top-Bottom
CHAPTER 10 – Market Efficiency
TSX
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Empirical Evidence on Market Efficiency
Weak Form Evidence - Conclusion
• The anomalies identified are very difficult and
risky to exploit:
– Transactions costs reduce or eliminate the economic
advantage
– The anomalies don’t happen consistently enough to
make them a reliable source of abnormal returns
In conclusion, the capital markets appear to be weak
form efficient.
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Empirical Evidence on Semi-strong Efficiency
Semi-Strong Form Evidence
• Tests of the Semi-strong Form of EMH include:
– Event (announcement) studies including ‘earnings
surprises’ and corporate announcements to examine
the impact of particular events on stock prices
– Examination of the performance of investors to see if
they can use publicly available information to
consistently generate abnormal returns
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Empirical Evidence on Semi-strong Efficiency
Event Studies
•
Event studies examine stock returns to determine the
impact of a particular event on stock prices, in particular,
what happens to the stock price, before, during and
following the event
Figure 10-2 illustrates the price adjustment process for:
(A) – an efficient market
(B) - overreaction in an efficient market
(C) - slow reaction in an efficient market
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Events include:
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company-specific announcements such as stock splits,
takeover announcements, dividend changes, accounting
changes.
Economy-wide changes such as unexpected interest rate
changes
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Empirical Evidence on Semi-strong Efficiency
Efficient (A) and Inefficient Markets (B) and (C)
FIGURE 10-2
Stock Price
B
A
C
$23
$20
t
Time
Announcement Date
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Empirical Evidence on Semi-strong Efficiency
Typical Event Study Results
• Most event studies have shown that stock prices
change before the announcement, as demonstrated
in Figure 10-3
• These results demonstrate that an investor cannot
move quickly enough at the time an event occurs
(announcement is made) to profit from the change,
so this speaks to market efficiency in the semistrong form,
On the other hand…
• This evidence does not provide support for the
strong form of the EMH because some investors are
profiting from private information about impending
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price changes. CHAPTER 10 – Market Efficiency
Empirical Evidence on Semi-strong EMH
Typical Event Study Result for Good News Event
FIGURE 10 - 3
Stock Price
B
A
C
$23
$20
t
Time
Announcement Date
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Semi-strong Anomalies
Earnings Surprises
• Several studies have confirmed a lag exists when
earnings either exceed or fall short of concensus
earnings estimates
– Largest positive earnings surprises displayed superior
subsequent performance
– Low or negative earnings surprises displayed poor
subsequent performance
• The substantial adjustments after the
announcement date contradicts the semi-strong
form of the EMH
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Semi-strong Anomaly Tests on Investors
• These are tests to determine whether investors can use
publicly-available information to obtain abnormal
returns.
• The strongest evidence of semi-strong market efficiency
is the fact that professional fund managers with all the
training, expertise, technological capability and access
to data do not outperform the market on a risk-adjusted
basis, on average.
• After expenses, average professional fund manager
performance is substantially worse than their
performance benchmarks (by as much as 50 to 200 basis
points)
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Semi-strong Anomaly Tests on Investors
Investment Styles
• Tests to determine whether investors can use publiclyavailable information to obtain abnormal returns have
shown that ‘value’ investment styles have consistently
outperformed ‘growth’ styles
• Value stocks are those that have:
– below-average price-to-earnings (P/E) and market-to-book (M/B)
ratios, and
– above-average dividend yields
• Growth stocks are those that investors are prepared to
pay a premium price for because expected future growth
in earnings and share price and have:
– above-average P/E and M/B ratios, and
– below-average dividend yields
(Figure 10-4 shows the relative performance of the two investment styles from 1982
to 2006)
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Empirical Evidence on Semi-strong Efficiency
Growth and Value Stocks in Canada
FIGURE 10-4
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Semi-strong Anomalies
Small Firm Effect
• Figure 10-5 depicts the returns on Canadian small cap
stocks versus the broad market
• Over this period small caps outperformed the broader
index providing an annual return of 16.25% versus
11.91%
– Smaller cap stock returns are much more volatile (24.8% versus
15.12%), and
– Transactions costs are greater for small cap stocks
Therefore, attempting to capitalize on the small firm effect is not a
‘free lunch’
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Empirical Evidence on Semi-strong EMH
S&P/TSX Composite Index versus Small Cap Stocks in Canada
FIGURE 10-5
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Semi-strong Anomalies
Value Line Investment Survey Effect
– Value Line Investment Survey is a widely followed
stock publication that ranks a large universe of stocks
from 1 (best) to 5 (worst)
– Substantial evidence suggests that stocks ranked 1 or
2 experience superior performance over the following
12 months…and those in lower-ranked categories
perform poorly.
• These findings contradict the semi-strong EMH
• However, again, transactions costs make it difficult to profit
from this anomaly
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Empirical Evidence on Market Efficiency
Semi-Strong Form Evidence - Conclusions
• Most studies support the semi-strong form of
the EMH
• A number of anomalies (or exceptions) have
been identified including:
– The “value” investment style has consistently
outperformed the “growth” style
– The “size effect” that shows that small market cap
stock tend to outperform large cap stocks on a riskadjusted return basis
– The Value Line Investment Survey effect
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Empirical Evidence on Strong Form Efficiency
Strong Form Evidence
• The strong form asserts that prices reflect all public
and private information
• If a market is strong-form efficient, then insiders
could not profit from inside information not known
by the public
• Tests of this hypothesis include determining
whether any group of investors has information that
allows them to earn abnormal profits consistently
– Several studies found consistent abnormal profits
– Others found only slightly better than average returns
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Empirical Evidence on Strong Form Efficiency
Strong Form Evidence - Conclusions
On balance, evidence does not support the strong
form of the EMH
It should be noted that insider trading laws do restrict
the ability of insiders to act and therefore, profit
from their inside information, so this is one reason
why evidence may be muted of the ‘degree’ of
advantage insiders enjoy under current law
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Summary of Empirical Evidence
1. Weak form efficiency is very well supported, and it is
reasonable to conclude that markets are weak form
efficient, although a few anomalies do exist.
2. Semi-strong form efficiency is well supported;
however, more contradictory evidence exists for this
version of the EMH than for the weak form.
3. Strong form efficiency is not very well supported by
the evidence, and it is reasonable to conclude that
markets are not strong form efficient in the strictest
sense.
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Implications of Market Efficiency
• Empirical Evidence suggests:
– Markets reach quickly and relatively accurately to new
public information
– Market prices are correct on average
• Markets may not be perfectly efficient, but they
are relatively efficient
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Implications of Market Efficiency
Implications for Investors
1. Technical analysis is not likely to be rewarded.
2. Fundamental analysis is also unlikely to be
successful at generating abnormal profits after
transactions costs, research costs and taxes.
3. Active trading strategies are unlikely to outperform
“passive” buy-and-hold strategies…favouring index
mutual funds or exchange-traded funds (ETFs)
4. Investors should focus on the basics of good
investing by defining investment goals in terms of
expected return and acceptable risk levels.
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Implications of Market Efficiency
Implications for Corporate Officers
1. Timing of security issues or share repurchases in
unimportant because prices are correct on average.
2. Management should monitor the price of the firm’s
securities to see whether price changes reflect new
information or short-run momentum and/or
overreaction.
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Summary and Conclusions
In this chapter you have learned:
– That an efficient market is one that reacts quickly and
relatively accurately to new information, and
therefore its prices are correct on average.
– That the Efficient Market Hypothesis (EMH) is tested
in three forms; weak, semi-strong and strong.
– That empirical evidence suggests that markets are
reasonably efficient, but not perfectly so.
– Investors and corporate officers should modify their
behaviours and expectations in light of the evidence
of market efficiency.
CHAPTER 10 – Market Efficiency
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Copyright
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
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own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
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