Download EMH Lecture

Are Markets Rational?
Part 1
Adapted from Haugen, Ch. 15:
“The Wrong 20-Yard Line”
References
• Reilly & Brown, Ch. 7 – “Efficient Capital Markets”
• Haugen, Ch. 15 – “The Wrong 20-Yard Line”
• Mauboussin (www.capatcolumbia.com) – “Shift
Happens”
• Hagstrom, Ch. 8 – “The Market as a Complex Adaptive
System”
• Rubinstein (Financial Analysts Journal, 2001) –
“Rational Markets: Yes or No? The Affirmative Case”
• Fortune (3 Dec. 2002) – “Is the Market Rational?”
Forms Of EMT
• Weak Form
–
–
–
–
Prices reflect all historical information
Price changes follow a random walk
“Tests of Return Predictability”
Technical Analysis
• Semi-Strong Form
– Prices reflect all public information
– “Event Studies”
– Fundamental Analysis
• Strong Form
– Prices reflect all public and private information
– “Tests for Private Information”
– Insider Trading
Weak Form EMH
• Supported by:
– Studies on Autocorrelation
– Tests of Filter Rules
• Contradicted by:
– Seasonality
• January Effect
• Day-of-the-Week Effect
– Long-term overreaction/reversal patterns
Semi-Strong Form EMH
• Supported by:
– Most Event Studies
• Contradicted by:
– Various Accounting Anomalies
• Size Effect
• M/B Effect
– Neglected Firm Effect
Summary on
Semi-Strong Form EMH
• Market seems to do a relatively good job at
adjusting a stock’s valuation for certain types of
new information
• Determining how much the new info. will change the
stock’s value and then adjusting the price by an
equivalent amount
This is what event studies examine
• But it seems to have problems developing an
overall valuation for a stock in the first place
• E.g., What is the correct value for IBM as a whole is a
very difficult question to answer, but how much IBM’s
value should change if it is awarded a specific new
contract is much easier to determine
Strong Form EMH
• Supported by:
– Under-performance of most fund managers
• Most are beaten by the market averages
• Contradicted by:
– Returns following insider purchases
– Value Line effect
– Consistent outperformance of some fund managers
• Notably, Warren Buffett and the “Superinvestors of Grahamand-Doddsville”
Fund Managers
• Trained professionals, working full time at
investment management
• If any investor can achieve above-average returns,
it should be this group
• If any non-insider can obtain inside information, it
would be this group, due to the extensive
management interviews that they conduct
• But, Peter Lynch criticism:
– “have blinders on”
• Also …
Fund Managers
• Quote from “Wall Street:”
– “Do you want to know why fund managers can’t beat
the S&P 500? Because fund managers are sheep … and
sheep get slaughtered.”
• Problems Fund Managers Face:
– Administrative expenses and trading costs
– Agency problems that contribute to poor performance
– Compensation structure that encourages “sheep-like”
behavior
Tests and Results of EMH
• Many results tend to support EMH
– Event studies
– Performance of most fund managers
• But many other results tend to contradict EMH
– Performance of Buffett
– Numerous anomalies & long-run overreaction/reversals
• So, are markets efficient (or rational) or not?
– Need to examine whether markets can be beaten, after
adjusting for risk
– But, how should you model and measure risk? CAPM?
APT?
Tests and Results of EMH
• Tests face a joint hypothesis problem
– Results are dependent on both of two factors:
– Market efficiency
• Is the stock’s price equal to its true value?
– Asset pricing model used (CAPM, APT, etc.)
• What is the stock’s true value?
• So, are the markets efficient or rational?
– Ultimately, can never answer definitively
– Mauboussin’s view (“Shift Happens”): stock market as a
chaotic or complex adaptive system
– Haugen’s view follows …
Haugen’s Trilogy
 “The
New Finance”
 “Beast
 “The
on Wall Street”
Inefficient Stock Market”
“The New Finance”
• Focuses on the market’s major systematic error:
– Fails to appreciate the strength of competitive forces in a
market economy
– Over-estimates the length of the “short run”
– Over-reacts to records of success and failure for individual
companies
– Drives the prices of successful companies too high
– Drives the prices of unsuccessful companies too low
• So:
– Successful firms tend to experience negative earnings
surprises down the road
– Unsuccessful firms tend to benefit from positive earnings
surprises
Changing Investor Opinion as to the
Length of the Short Run
• Prior to 1924
- Stock valuation based on current normalized earnings.
• 1925
- E. L. Smith advises stock valuation based on future
growth - New Era Theory.
- Growth stocks start to take off, followed by Crash of ’29
- Leads to development of Graham & Dodd approach
• 1934
- Graham and Dodd dispute New Era Theory’s views on
growth and valuation.
- Lessons learned until Go-go years of ’60’s
• 1960’s
- Growth stock investing makes comeback.
But …
• Successful growth stock investing requires
some degree of persistence in earnings
growth,
• while the speed of mean-reversion in earnings
growth appears to be quite fast.
• If, in general, it is faster than the market
expects, cheap (expensive) stocks should
tend to grow faster (slower) than expected.
• If this happens, cheap stocks should tend to
out-perform expensive stocks.
The Relative Performance of Portfolios Equallyweighted in the Cheap and Expensive Quartiles
• The difference in cumulative return of value
stocks relative to growth stocks is measured
over rolling 5-year periods.
• The relative performance appears to cycle
over time.
• Cheap (value) stocks out-perform more often
than not.
Rolling Annualized Average 5-year Difference
Between the Returns to Value and Growth Composites
50%
30%
20%
-10%
-20%
Year
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
0%
1974
10%
1973
Relative Difference
40%
Seasonal Returns to Value and Growth Portfolios
14%
12%
Average
Monthly
Return
10%
Prior Losers
January
Feb. - Dec.
8%
6%
4%
2%
0%
1 2
3 4
5 6
7 8
9 10
11 12
13 14
15 16
17 18
19 20
What has Over-estimation of the Length of the Short Run
Done to Risk and Return?
• Cheap (expensive) stocks tend to have
surprisingly high (low) realized returns
• Cheap (expensive) stocks tend to have low
(high) volatility, because little (much) is
expected of them
• Investors may expect higher returns from
expensive stocks but they may be repeatedly
surprised by disappointing earnings reports
• Thus, the relationship between risk and return
appears to be upside-down
How Long Have Risk and Return Been Upside Down?
• If it’s caused by an over-estimation of the
short run, it should begin with the
renaissance of growth stock investing at
the end of the 1950’s.
• What has been the relative performance
between the low-volatility stock portfolio
and the market index over time?
Cumulative Difference in Return Between
Low Volatility Portfolio and S&P 500
Cumulative
Difference
25%
15%
5%
-5%
-15%
-25%
-35%
1928
1938
1948
1958
1968
1978
1988
The Relationship Between the Perceived and True Growth Horizon
and Average Growth Rates
• Define the growth horizon (or growth
duration, see Ch. 20) as the length of time a
typical stock takes to mean-revert to the
average rate of earnings growth.
• The evidence indicates that the perceived
horizon is longer than the true horizon.
The Relationship Between the Perceived and True Growth Horizon
and Average Growth Rates
• The true horizon tends to be relatively
constant, but investor perceptions may
change.
• If investors perceive that relative
differences in growth will persist for longer
periods, growth stocks may out-perform.
• Changes in the perceived horizon may
create a cycle in growth/value performance.
Rolling Annualized Average 5-year Difference
Between the Returns to Value and Growth Composites
50%
30%
20%
-10%
-20%
Year
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
0%
1974
10%
1973
Relative Difference
40%
“Beast on Wall Street”
 2nd
book in trilogy
 Focuses
 Three
on stock volatility
components of volatility
Three Components of Stock Volatility
 Event-driven
volatility
 Error-driven volatility
 Price-driven volatility
High-wire Act at the Financial Circus
The wire
The aerialists
Movements in
balance bars
The economy
Different stocks
Movements in
stock prices
Components of the Movements
in the Balance Bars

Event-driven
The best moves in the bars humanly possible

Error-driven
Over- and under-reactions to shocks in the wire

Price-driven
Aerialists interacting with each other
The Types of Volatility Contrasted
• Event-driven and error-driven volatility are caused by
investors [over]reacting to specific information that could
be expected to affect stock values
• Price-driven volatility, on the other hand, works in the
opposite direction – it is caused by investors reacting to
what is happening in the stock market itself
– i.e., there is a reassessment of stock valuations solely as a
consequence of changes in stock prices …
– rather than stock prices changing as a consequence of changes
in stock valuations that are being driven by outside information
• This is similar to Keynes’ and Graham’s views
• “We have reached the third degree where we
devote our intelligence to anticipating what
average opinion expects the average opinion to
be.”
– Keynes
• “For stock speculation is largely a matter of A
trying to decide what B, C, and D are likely to
think – with B, C, and D trying to do the same.”
– Graham and Dodd
Synthesis
The results of many old studies,
when considered together, point
to startling new conclusions.
Contentions

Price-driven volatility is the largest of the
three components.

Price-driven volatility is explosive.

Price-driven volatility is an important drag
on long-run economic growth.

Explosions in Price-driven volatility
create disruptions in economic activity.

For example. the Great Crash of 1929
helped cause the Great Depression.
Mysteries of the Stock Market

Too much stock volatility
(Shiller, American Economic Review, 1981)
Market Price and Perfect Forecast Price: Constant Discount Rates
34
Pt / Et30
30
P/E 30
26
22
18
14
PFt / Et30
10
6
1900
1910
1920
1930
1940
1950
Year
1960
1970
1980
1990
Mysteries of the Stock Market

Too much stock volatility

Volatility too unstable
(Haugen, Talmor, and Torous,
Journal of Finance, 1991)
Volatility Shifts Over 8-week Trading Periods

HTT find (with 99% confidence) 402 cases where
volatility becomes significantly larger or smaller
between the first and second 4-week blocks.
Realization of Risk Premiums Following the
Price-level Adjustments

Following the price-adjustments to volatility
changes, subsequent stock returns are, on
average, 460 basis points higher following
volatility increases. (The higher required returns
are apparently realized.)

Interestingly, only 10% of the shifts have an
associated cause traceable in the media.
Mysteries of the Stock Market
Too much stock volatility
 Volatility too unstable
 Unconnected market
(Cutler, Poterba, and Summers, Journal of

Portfolio Management, 1989)
Percentage Changes in Stock
Prices on 49 Historic Days
Examples:
Pearl Harbor Attacked
Roosevelt Dies
Bay of Pigs
John Kennedy Assassinated
Robert Kennedy Assassinated
Chernobyl
-4.37%
1.07%
.47%
-2.81%
-.49%
-1.06%
Percentage Changes in Stock
Prices on Historic Days


Average absolute return
over 49 historic days
1.46%
Average absolute return
over all other days
.56%
(standard deviation: .82%)
“Events” Associated with the Five Largest
One-day Percentage Changes in Stock Prices
Worry over dollar
(10/19/87)
-20.47%
Deficit talks in Wash.
(10/21/87)
9.10%
Fear of deficit
(10/26/87)
-8.28%
No reason for decline
(09/03/46)
-6.73%
Roll-back of steel prices (05/28/62)
-6.68%
Haugen vs. Mauboussin
• Note that the previous observation is
consistent with Mauboussin’s hypothesis of
the financial markets as a complex adaptive
system
• Nonlinearity causes stock price movements
to bear little relation to specific definable
causes
“The Inefficient Stock Market”
• 3rd book in Haugen’s trilogy
• Focuses on expected return factor models
– Attempt, in part, to exploit error-driven volatility
• Positive payoff to cheapness results from market’s overreaction to
success and failure
• Positive payoff to intermediate term momentum results from the
market’s underreaction to positive and negative earnings surprises in
individual earnings reports
– Also exploit the distortions in the structure of stock prices
brought about by price-driven volatility
It’s Tough to Beat the Market
•
•
It the market is so inefficient, why isn’t
beating it “like taking candy from a baby?”
Two reasons:
1. Many professional investors are victims of their
own agency problems
2. More importantly, a gale of unpredictable pricedriven volatility stands between investors and the
“candy”
It’s Tough to Beat the Market
1.
Professional investors are victims of agency problems
–
–
–
2.
Easier to make a “story” for growth stocks than for value stocks
Worry about “benchmark risk” rather than total risk
Portfolio managers need to keep up with market on a fairly steady basis
or risk losing their jobs
Gale of unpredictable price-driven volatility stands between
investors and consistent profits
–
–
–
Price-driven volatility is unpredictable, increasing the element of chance
in stock returns
Even after maximizing predictability of stock returns, only 10% of
differences in monthly stock returns can be explained by model
Overvalued growth stocks can always go up even more before finally
“coming down to earth”
The Wrong 20-Yard Line
• Spectrum of market efficiency equivalent to
positions on a football field
– At one end zone, perfectly efficient markets
– At other end, completely inefficient markets
The Wrong 20-Yard Line
Near efficient markets end zone (the left end zone):
• All volatility is event-driven
• Models based on rational economic behavior do a
good job of explaining and predicting market
pricing
• No under- or over-valued stocks, so no role for
active investment
– No inefficiencies for active managers to exploit
– Fact that fund managers tend to underperform the
market taken as evidence that markets are efficient
The Wrong 20-Yard Line
Near the other endzone (the right end zone):
• All volatility is price-driven
• Market pays no attention whatsoever to
fundamentals
• Market, in the short-term, is in a state of
complete and unpredictable chaos
The Wrong 20-Yard Line
As we move from the left to the right end zone:
• Models based on rational economic behavior begin to
lose power
• As you cross midfield, behavioral models begin to
dominate
– Note: under these models, markets have biased reactions to
real economic events, but they do still react to real economic
events
• As you move to the extreme right, even behavioral
models lose power, and the market reacts only to its
own events (at least in the short run)
– Aerialists pay no attention to the wire whatsoever
The Wrong 20-Yard Line
Active managers would perform best when the market is
near the 60-yard line:
• Too close to the efficient markets end zone, and there are
no inefficiencies for the active managers to exploit
• Too close to the inefficient markets end zone, and
unpredictable, price-driven volatility begins to dominate,
making it nearly as impossible for active managers to beat
the market as at the right end zone
– Best way to do well in this case would be by buying future
dividend streams at relatively cheap prices, cf., Warren Buffett
• Lack of clear success by active managers indicates only
that we are near one of the end zones, not which one we
are near
The Wrong 20-Yard Line
Most finance professors:
• Believe the markets are close to the efficient markets
end zone, maybe at the 20-yard line
Haugen believes:
• Price-driven volatility is unstable
• When it explodes, the markets may approach the 10or even the 5-yard line
• When it recedes, the markets may cross the 50-yard
line into the other end of the field
• But, on average, the markets are more likely to reside
near the right-end 20-yard line
The Triumph
• Finance needs to go back and forth between theory and
empirical findings
– Can’t remain stuck on the theory of Modern Finance
– Need to move on to a new paradigm
• Haugen’s suggestion – The New Finance
– Built on a foundation of statistics, econometrics, and
psychology
– Look at what works, not just at what theory says should work
– Allows for an integration of evidence contradicting the efficient
markets hypothesis
My Opinion
• As far as their descriptions of how markets work,
Haugen and Mauboussin are not inherently that
different
• Where they differ is in terms of their interpretation
– are the markets efficient or not?
• But, “efficiency” deals with the issue of price vs.
value
• This requires an answer to the question, what is
the true value of a stock?
My Opinion
• But this question can never be categorically answered :
– “The question of value presupposes an answer to the question, of
value to whom, and for what?”
– E.g., the value of Apple stock would be different to Steve Jobs
than to any other investor
• Related issue – what is information?
– “Information is that which causes changes” – Claude Shannon
(father of information theory)
– So, if something causes the markets to move, then by definition,
it must be information, and vice versa
– From this perspective, the market is neither efficient nor
inefficient, it just is
My Opinion
Important question:
• Not whether or not the markets are efficient – this is
a side issue – but how investors should act, given
how the markets work
• Unfortunately, there is a dichotomy between the
short run and the long run:
– Over the long run, value-type strategies perform best
– But, over the short run, growth stocks may rack up stellar
performance records
– Key question – can you sit through the sometime shortrun underperformance of value stocks in order to get the
long-run benefits they yield?