Market Efficiency: Finance Week 09

CLASS NOTES
WEEK IX
MARKET EFFICIENCY
Reading Assignment: BMA 13
Alex Kane 1 IPCOR421 Finance
How we think of time-series processes
• The value of any RV (random variable) in a time series,
here price of a security, P(t), can be represented by:
P(t+1) = E(P) + e(t+1),
where E(P) is the expectation at time t for the price
at time t+1, and e(t+1) is a (zero-mean) surprise
• This useful decomposition is just a tautology -- it
is true by definition of expectation, E(P), and tells
us nothing about the process of prices
• In analyzing time series we ask: What do we know
about E(P) and e(t+1)?
Two alternative time series
• Consider two alternative time series of daily prices
2. P(t+1) = P* + e(t+1),
where E(P)=P* is a known value that doesn’t
change from day to day
3. P(t+1) = P(t) + e(t+1).
Here, E(P)=P(t) is changing daily. The
expectation for the next-day price is today’s
price (this is called a random walk)
The two specifications tell vastly
different stories
• With the first specification, no matter what the
price today, we expect it to revert to P* tomorrow
• This means that if P(t)>>P*, we can say P(t) is
abnormally high. Similarly if P(t)<<P*, it is
abnormally low
• With the second specification, E[P(t+1)]=P(t),
Declaring today’s price is “abnormal” would be
insincere, since we expect it to stay where it is
More on P(t+1)=P*+e(t+1)
• We call such a series “stationary” because its
location stays the same over time.
• We say the price is “mean reverting” because it goes
back to the mean. Here we expect it to revert to the
mean immediately (in one day)
• The series: E[P(t+1)] = P* + 0.5[P*–P(t)], is also
mean reverting (stationary). Each day, yesterday’s
surprise is expected to be cut in half. No matter
how small the number in place of 0.5 is, sooner or
later the price will revert to P*. Hence, still
stationary
More on P(t+1)=P(t)+e(t+1)
• This series is non-stationary (not mean reverting), as the
location changes each day permanently -- there is no
indication the price will revert to any “normal” level
• By permanently we mean that at time t, E[P(t+h)]=P(t),
no matter how far in the future (h) we look
• No matter how high or low the level P(t) has drifted to,
we expect it to stay at that level
• Clearly, the notion of “high” or “low” prices is
meaningless. If we were serious about such adjectives,
we would expect the price to get back to what we think
is “normal”
Which rule would we like prices to follow?
• A stationary price is more pleasing. However slow
the mean reversion may be, it makes sense to us
that, sooner or later, prices will revert to what we
consider “reasonable”
• For example, if NASDAQ index drifts to very high
levels (5000), its P/E ratio will become “irrational”
and we would feel the index “must” come down
soon to where P/E is “reasonable”
• The fly in the ointment is that any degree of mean
reversion implies predictability
Why predictability trumps stationarity
• Suppose prices are “pleasing” in that they are mean
reverting to some extent, and P(t)= NASDAQ is “high”
• Investors know that, sooner or later, NASDAQ will drift
back to P*
• How can we expect any rational investor to hold on to a
NASDAQ portfolio? Surely investors will sell it the
moment they consider the index to be too high
• In such environment, rational investors won’t let the price
drift away from “normal,” say a reasonable P/E, even for
an instant. Therefore: P(t) = P* always. We must
conclude that P* changes daily, and E[P(t+1)]=P(t)
always. Conclusion: investor rationality => non-
stationarity
Suppose investors are rational
• We know already that prices will be non-stationary, that is, no
mean reversion. Hence, changes from P(t) will be unpredictable
• What else?
– Investors will bid on a stock no more than what they believe
is the intrinsic value
– To arrive at the intrinsic value, investors will use all available
information
• Conclusion
– market price, P(t), will reflect all available information
– Any price change must be a surprise, driven by NEW
information
Market (informational) efficiency
• We define an efficient market as one where prices
reflect all available information
• In this market, prices are always equal to intrinsic
values (derived from all available information)
P(t) = PV(future CFs, discounted at appropriate rate)
• Prices must be non-stationary
• The expected rate of return on any asset is the
appropriate discount rate for future cash flows
• No abnormal profits can be expected, that is,
NPV=0, since expected returns equal the
appropriate rate
Do we care about market efficiency?
• Most people see market efficiency as an issue of
distributive justice
– No investor can expect a greater profit than any other
investor; everyone expects to earn the “appropriate” rate
of return (that is, equal rate when adjusted for risk)
• The major reason efficient markets are valuable
– Since capital will flow into industries with high expected
returns relative to risk, and out of industries with low
risk-adjusted expected returns, then,
– when prices reflect all available information, the capital
flows will make for the optimal allocation of capital to
new investments
Stock price and capital allocation
• In general, as equity prices in an industry rise, more
investment will take place and vice versa
• Hence, when stocks are overpriced, investment in
these companies will be too high, so that marginal
investments will have negative NPV. When stocks
are underpriced, too little investment takes place,
positive NPV will be lost
• In sum, inefficient capital markets lead to inefficient
allocation of capital to new investments (see
example last slides)
Can markets be perfectly efficient?
• Unfortunately, they cannot. This can be proved
mathematically
• The reason is that in perfectly efficient markets
there is no incentive for anyone to conduct security
analysis, since investors are better off choosing a
passive investment rather than pay for an active one
• When none conducts security analysis, nothing
holds down prices to intrinsic values
• The question is therefore: How near to efficiency
are capital asset prices?
How markets come closer to efficiency
• The first target of research into profit opportunities would
be “cheap” ways of discovery
• Example: regress, P(t+1) = a + b*P(t) +e(t+1).
Significant deviations from a=0, b=1, imply opportunities
for abnormal profits
• Next would come more expensive research
• Example: conduct macro analysis to predict overall market
movements, resulting in profits from market timing
• Once such methods become widely known and used, prices
will move to eliminate these profit opportunities and come
closer to informational efficiency
When does this process stop
• As analysts exhaust low cost, available to all
methods of analysis, what remains are research
methods that require talent (intellectual property)
and significant resources
• This aspect suggests there will be outfits (employed
talent and resources) with abnormally high returns
• Such outfits will proceed as long as uncovered profit
opportunities exceed marginal cost
• Remaining inefficiencies will be hard to uncover as,
by design, only few know how to uncover them
Levels of efficiency
• The idea that improved efficiency eliminates “cheap” profit
opportunities first, leads to segment the EMH (efficient
market hypothesis) to three levels of information that can
lead to abnormal profits
– The weak form: information about past prices only
(technical analysis)
– The semi-strong form: any publicly available info
(fundamental analysis)
– The strong form: inside information (illegal in most
markets). However, when issuing new shares, this issue
becomes legitimately relevant since management has
inside info
• We expect markets to, at least, pass weak form EHM tests
Difference in efficiency across markets
• As markets grow and become more transparent (e.g., better
accounting), it becomes easier and more profitable to
conduct sophisticated analysis
• Hence, such markets will automatically be closer to
efficiency than others
• Example: emerging markets used to be all the rage.
However, as they grew, partly because of large capital flows
resulting from discovered inefficiencies, and as
transparency improved, they lost much of their luster
• Still, large differences in efficiency across markets remain
Discovering inefficiencies
• Making profits from discovered inefficient prices requires
taking extra risk
• By construction, you must reduce diversification in order to
tilt your portfolio to use mispriced securities
• Therefore, you can evaluate an active strategy only if you
assume some model of asset pricing that predicts risk-return
relationship
• An extra difficulty is created: any test of efficiency is a
joint test: (1) is there inefficiency (2) is the model used to
test the hypothesis valid and reliable
• It’s possible that we will reject efficiency because our
model isn’t valid
Abnormal returns and CAR
• Joint normality of asset rates of return leads to a
linear relationship (see Week 9 slides)
ri – rf = alpha + beta*(rM–rf) + e, where rM is
the benchmark Pf and rf the risk-free rate
• When the CAPM/APT are valid, alpha = 0
• Accordingly, if we take the difference, date-by-
date: ri(t)–rf(t)–beta*[(rM(t)–rf(t)], we should get
e(t). The CAR (cumulate abnormal returns) over
successive dates: t=1,…,T: Σe(t), should approach
zero (and so should their average = Σe(t)/T)
CAR and market efficiency
• The average CAR of returns on an asset over a
sample period makes for the estimate of alpha
• A significant non zero alpha (average CAR)
contradicts the joint hypothesis of CAPM/APT
and market efficiency (EMH)
• The test is more powerful the smaller the
variance of e(t)
• Therefore, tests with portfolios that diversify
most of e(t) and reduce its variance, rather than
individual assets with high Var(e), are preferred
Recorded anomalies
• A number of anomalies were recorded over the
years. The major ones are:
– Size: smaller stocks have positive average CAR
– BE/ME: larger ratios (value) stocks have positive CAR
(negative for low-ratio stocks = growth or glamour
stocks)
– IPOs (initial public offerings)
– Turn of the year returns (returns in early January)
– Momentum strategies (use the inadequate speed of
adjustment of stock prices to new information)
Inadequacy of beta as measure of risk
• Size and BE/ME help explain rates of return
• This is believed to result from inadequate
measurement of risk by beta (the market factor)
alone
• This is believed to be an issue of CAPM/APT mis-
specification, rather than market inefficiency
• The CAPM/APT specification can be improved by
– Add factors (size and BE/ME Pfs)
– Improve measurement of betas (econometrics) by
allowing the coefficients to vary over time
– Separate betas for cash flows and capital gains
IPOs
• For a long time, it was taken for a fact that investment in
IPOs leads to abnormal returns. Hence, IPO returns
were considered a significant anomaly
• Part of this anomaly, early gains, is explained by market
structure -- practices of investment banking. Recent
auction-based IPOs seem to eliminate this phenomenon
• Long term losses on IPOs appear to be explained away
by the BE/ME phenomenon of the return deficiency of
growth stocks (Newly issued stocks are mostly growth
firms)
• In general, it appears that anomalies tend to disappear
over time, providing some evidence that “cheap” profit
opportunities cannot last
The January effect: A weak-form anomaly!
• Records show most of the market annual risk premiums
were achieved in early January
• This was more so for small stocks. Hence, a Pf long small
and short large stocks would have earned abnormal returns
• Rationale: Investors sell stocks for tax reasons prior to Jan.
1, depressing prices. These stocks rise to normal levels in
early Jan. (The tax selling is indeed a good idea! Sell
matched losers with winners to wipe out capital gain tax
liabilities and obtain the allowed loss offset)
• Still, it appears this phenomenon is fading -- but small
number of years (data) makes such inference difficult
Momentum strategies
• The general idea is that investors do not adjust
portfolio demand promptly on the heels of new
information -- sometime they over-react, other
times they are too slow to react
• The most prominent example is earning
announcements: investors have consistently
under-reacted to surprise announcements and
were slow to revise forecasts of earnings
• Portfolios that take advantage of these anomalies
have consistently outperformed the market
Behavioral finance
• For years, behaviorists (pioneers were the late Tversky,
and Nobel laureates Kahanman and Allais) showed that
people confront risky prospects with irrational behavior
(prospect theory)
• Discovery of momentum anomalies led behaviorists to
declare they emanate from such behavior
• Counter arguments invoke the role of arbitrageurs
(APT) in eliminating such easy profit opportunities
• The jury is still out, but the popularity of these ideas is
evident by the curriculum of CFA programs that now
prominently include behavioral finance
The true story of “irrational exuberance”
• Date NASD
12/5/96 Irrational exuberance speech 1300
12/6/96 A day later 1288
12/13/96 A week later 1285
12/5/97 A year later (r=25.7%) 1634
12/6/99 Three years later (irr=39.8%) 3546
3/10/00 Highest NAD ever (irr=51.9%) 5049
10/9/02 Lowest NASD since (irr= –2.5%) 1114
6/1/07 Last Friday (3pm) (irr = 6.4%) 2613
• Soros: “The best gains come at the tail end of a boom”
• From the speech to today, IRR still better than T-bills.
Predictions with no date are of little value
Event Studies
• Suppose we can date (t) the arrival of a significant
packet of new information, one that we know should
affect security prices
• We can calculate CAR from well before the event date
(t–h), through t and well after (t+h)
• The chart of an efficient market will show about zero
CAR up to t, a one time jump to a new level at t, and
zero changes thereafter
• CAR changes prior to t suggest anticipation/leak
• Slow response of CAR at t and after suggests under-
reaction
• A large change of CAR at t and shortly after, followed
by a later retreat shows over-reaction
Results of three event studies (good news)
CAR
efficient
Time
t–h t t+h
slow reaction
Time
leak
Time
overreaction
Measuring intrinsic values
• The CAPM/APT suggests ways to estimate expected
return
• The model doesn’t tell the dollar value of an enterprise;
it only provides one piece of the puzzle
• To get intrinsic value we must use a discounted dividend
(or free CF) model
• In addition to the required rate we need to estimate
growth rates of current dividends/cash flows
• Intrinsic values are very sensitive to g, allowing for
difference of intrinsic values across investors and rapid
price changes of stock, the source of high volatility in
rates of return and difficulty in assessing efficiency
Summary of the lessons from EMH
1. Prices have no memory, only P(t) tells about the future
(history adds nothing)
2. Prices indicate intrinsic values
3. (from 2), price changes reveal required rates and
suggest value of announced policies
4. Prices are unaffected by “veils,” e.g., accounting
methods
5. Assets will be priced to reflect information about value
creation only -- not opportunities investors can obtain
by trading in financial markets
6. Financial assets (and portfolios) are perfect substitutes,
providing the same risk-return tradeoffs (mean/beta)
A challenging example of capital
allocation
• A corporation has 2 million shares outstanding, selling at
$5/share. Hence, current market value of the firm is $10 million
• The corporation surprisingly identifies a project that will pay
$12 million next year (only) for an investment of $8 million now
• Management believes the project risk requires 20%, that is,
NPV=$2 mil. Hence, they believe share value is (10+2)/2=$6
• Management has no cash on hand, cannot borrow any more, and
must finance the project by floating new shares
• Upon announcement of the project idea and required financing
(before flotation), the share price goes up to $x/share
• Will the corporation invest in the new project?
Answer to question
• With a price of $x/share, the corporation has to sell 8/x
million shares
• Current shareholders will then own a fraction: 2/(2+8/x) =
x/(x+4) of the corporate shares
• According to mgt’s assessment, the total value of the
company (when shares sold) will be 10+12/1.2=$20 mil
• Equity of current SH will have value of $20x/(x+4) mil
• Since current value is $10 mil, they will invest only if
20x/(x+4)>10, that is, x>$4. ($4 is the break-even price)
• At $4 they must sell 2 mil shares. At higher prices, they
will have to sell less shares and retain more value
What’s in it for new investors?
• A higher share price means lower expected return
• At $4/share, 2 million shares must be sold (N=4 mil)
and each share buys value of
4 = [10+12/(1+r)]/(2+2), implying: r=100%
• At $6 (the value management believes is right), 8/6
mil shares sold: 6=[10+12/(1+r)]/(8/6+2), r=20%
• Conclusion, the higher the expected return investors
assign to new projects, the higher they will bid for
share prices. When they bid higher prices,
corporations will invest more (at less than $4 this
corp will invest zero)

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