Moving on

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Moving on

• Efficient Markets, Valuation and Earnings
  Estimation

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Efficient Markets

• Dominant theme in literature for past four
  decades
• No doubt youve seen a description before in your
  academic travels.
• In finance, it has a very specific meaning
• Efficient Capital Markets
• Security prices fully reflect all available
  information

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Efficient Markets contd

• Efficient Capital Markets
• Security prices fully reflect all available
  information
• Lets be clear, this is a very strong hypothesis!
• A necessary condition for this hypothesis to hold
  is that the cost of information acquisition and
  trading must be zero.
• Since these are clearly positive, we must make
  some adjustments

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Efficient Markets contd

• A more realistic definition
• Prices reflect information until the marginal
  costs of obtaining information and trading no
  longer exceed the marginal benefit.
• Note some differentiation between investors will
  be present
• For instance, whose to say transaction costs are
  all the same?
• Therefore, situations will differ among
  investors, but even so, MC MB is what we want
  for all, regardless.

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EMH efficient market hypothesis

• Historically, the EMH has been divided into three
  categories - - each deals with a different type
  of information
• Tests include
• Weak form
• tests whether all information contained in
  historical prices is fully reflected in current
  prices
• Semistrong form
• Tests whether publicly available information is
  fully reflected in current stock prices
• Strong form
• Tests whether all information, private or public,
  is fully reflected in security prices and whether
  any type of investor can make an excess profit

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EMH contd

• Most tests of the EMH reflect how fast
  information is incorporated
• They tend not to deal with whether it is
  correctly incorporated in prices
• We will subscribe to the version that prices
  reflect fundamental values, as market rationality
• Rather than concentrate on the tests themselves,
  we will concentrate on more of the intuitive
  appeal of information assimilation

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Example 1

• Assume a firm announces that earnings will be
  three times larger than expected next year with
  no additional investment on the part of the firm.
  
• Furthermore, suppose that there have been
  fundamental changes in the company that imply
  that this increase in the level of earnings is
  permanent.
• Finally assume that investors believe this
  announcement.

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Example 1 Analysis

• What should happen?
• Clearly, share prices should increase, since the
  company has increased in value
• What should happen according to EMH?
• First, EMH does not deny the usefulness of this
  information
• Nor does it deny that prices should increase
• What the EMH is concerned with is under what
  conditions an investor can earn excess returns on
  this security.

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Example 1 Analysis

• Assume that after the announcement, the price
  gradually increases over the week in response to
  the announcement.
• Investors examining the price sequence would
  observe that the price was moving away from that
  level at which it had been previously traded
• If investors purchased securities when they
  started to trade away from historical prices,
  they would purchase the security a day or two
  after the announcement.

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Example 1 Analysis

• So what?
• If the investor did this, they would benefit from
  part of the price increase, since it takes one
  week to increase fully, and make excess returns
• EMH is concerned with whether this is a
  possibility
• So, can excess returns be made?
• Well, if returns are not predictable from past
  returns, then new information is incorporated in
  the security prices sufficiently fast and it is
  likely that excess returns cannot be made.

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Example 1 Analysis

• Consider a second scenario.
• Assume investor hears of the improved prospects
  and believes it.
• The investor immediately buys shares of the
  company in anticipation of a price increase.
• Aside The first scenario dealt with the weak
  form of the EMH test, this scenario is dealing
  with the semistrong form.
• The semistrong form is testing whether the above
  strategy can lead to excess profits

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Example 1 Analysis

• Can this publicly available information lead to
  excess profits?
• Since the information is public, both buyers and
  sellers hear the announcement and reassess the
  value of the security
• This reassessment leads to a change (increase, in
  this case) in the price.
• NOTE this new price need not be an equilibrium
  price. It may take a few weeks before investors
  can fully assess the impact of the change in firm
  conditions
• As a result, the price may be very volatile in
  the short run

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Example 1 Analysis

• The point?
• An investor who buys the security after the
  announcement may be paying too little or too much
  for the security
• If the semistrong form holds, then over a large
  number of similar situations the investor would
  be paying on average about what the securities
  are worth
• In short, no excess profit would be available on
  the basis of the announcement

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EMH Remarks

• Why should we care about the EMH?
• In short, it has strong implications for security
  analysis
• For example, if empirical tests show that the
  future cant be predicted from past return, then
  trading rules based on an examination of the
  sequence of past prices are worthless.
• If the semistrong tests were supported, then
  trading rules based on publicly available
  information are suspect
• If strong tests are supported, then the value of
  security analysis itself would be suspect

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EMH Remarks

• In short a better understanding of the workings
  of efficient market tests should provide guidance
  for those interested in going into this line
  work especially, in determining what types of
  analysis are useful
• Therefore, rather than get bogged down in the
  empirical testing and extremely large amount of
  studies done, were going to examine the EMH
  based on its ability to inform the analyst or
  personal investor

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Market Rationality and Informational Efficiency

• Informational Efficiency
• The speed with which information is incorporated
  in the share price
• Market Rationality
• How accurately prices reflect investors
  expectations about the present value of future
  cash flows
• NOTE much of the evidence on informational
  efficiency bears on market rationality, as well
• For example, if prices can be shown to respond to
  noneconomic variables such as stock splits, this
  would powerful evidence against market
  rationality
• For a reason why, see next slide

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Market rationality

• If markets exhibit rationality, there should be
  no systematic differences between share prices
  and the value of the security based on the
  present value of the cash flow to security
  holders
• Therefore, the existence of excess returns as a
  function of firm characteristics and time patters
  in security returns provides evidence against
  market rationality
• Examples size effect, the market/book effect,
  the January effect, the day of the week effect,
  etc.

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Informational Efficiency

• For informational inefficiency it is necessary to
  show that a profitable trading strategy
  (including trading costs) can be constructed to
  exploit the anomaly
• Of course, the mere presence of a persistent
  anomaly calls into question market rationality
• Examination of these characteristics has been
  done through volatility tests, stock market
  crashes, and test of market overreaction.
• We will examine the stock market crash of October
  1987

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Example Market Crash of Oct. 1987

• In one day in October 1987 the stock market
  declined by 23
• NOTE on the Friday, before this dramatic drop,
  the market also substantially declined
• Therefore, for markets to be rational, peoples
  expectations had to undergo substantial changes
  on Friday and Monday
• How well did the EMH deal with this event?

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1987 Crash contd

• First off, researchers have searched tirelessly
  in an attempt to find news items that could have
  led to a major revision in expectations
• It is hard to argue that anything in the news led
  to such a large change in expectations
• Explanations such as panic, failure of the
  trading mechanisms, and formula trading are
  usually given as reasons for the crash.
• This is a direct challenge to market rationality,
  which the EMH purports to support

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1987 Crash contd

• Of course, some have suggested that it is
  possible that formula trading and market
  structure combined to allow a crash to occur
• Once it did, people reevaluated their fundamental
  values because of the crash
• Hence, the rather dramatic drop
• NOTE the crash is not a challenge for
  informational efficiency, since it has yet to be
  shown that it was predictable

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Questions to think about

• If the market is semistrong form efficient, must
  it be weak form efficient?
• Is the betting market at roulette an efficient
  market?