Chapter 13: The Efficiency of Capital Markets

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Chapter 13 The Efficiency of Capital Markets

• Why is market efficiency important?
• The various categories of the Efficient Markets
  Hypothesis (EMH)
• The evidence for market efficiency
• Speculative bubbles

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Concept of Market Efficiency

• Prices in informationally efficient capital or
  financial markets should reflect all available
  information.
• Current market prices should represent a fair and
  unbiased forecast or estimate of the intrinsic or
  fundamental value of the firm, i.e., the Present
  Value of all future expected cash flows.
• In an efficient market, market prices respond
  instantaneously to new and material information
  and fully reflect that information. Delayed
  responses (under-reaction and overreaction) to
  new information would suggest that markets are
  inefficient.

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Market Efficiency driven by competition among
investors

• A normal return on an investment is a return that
  is consistent with the systematic risk of the
  investment.
• Assuming that the CAPM is the correct asset
  pricing model, then a return estimated from the
  CAPM is assumed to be a normal return.
• Everyone that invests obviously wants to make
  above normal returns on investments.
• Therefore, much analysis, using common or public
  information sources, is performed by investors in
  order to identify mispriced stocks and bonds.
• Due to intense competition among investors, it
  should become difficult to earn above normal
  returns.
• Be suspicious of anyone that promotes some
  investment technique that purportedly earns above
  normal returns. If the method really worked,
  then any rational person would keep the technique
  undisclosed!

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Information and forms of the Efficient Markets
Hypothesis (EMH)

• Three (nested) information sets are used to
  define three degrees or levels of market
  efficiency
• (1) Weak-form efficiency
• (2) Semistrong-form efficiency
• (3) Strong-form efficiency
• (1) above is a subset of (2), and (2) above is a
  subset of (3).

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Three forms of the Efficient Markets Hypothesis
(EMH)

• (1) Weak-form efficiency asset prices should
  reflect all historical market related information
  such as past prices, returns, trading volume, or
  trends in volume or prices.
• Investors should not be able to generate or earn
  abnormal returns using this information.
• Stock prices should follow what appears to be a
  random walk, i.e., successive price changes are
  uncorrelated.
• If this form of market efficiency holds, then
  technical analysis should not work.

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Three forms of the Efficient Markets Hypothesis
(EMH)

• (2) Semistrong-form efficiency asset prices
  should reflect all information that is publicly
  available, i.e., earnings, dividends, analyst
  forecasts, historical market data, public
  expectations of the future, etc.
• The market's reaction to new and material
  information should be both instantaneous and
  unbiased, i.e., no systematic pattern of either
  over or underreaction.
• In addition, the market reacts to unexpected
  information, i.e., news that changes our
  forecasts of cash flows or risk.
• Most fundamental analysis should not work, unless
  someone is superior in interpreting information.

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Three forms of the Efficient Markets Hypothesis,
continued

• (3) Strong-form efficiency asset prices should
  reflect all private and public information.
• We know that insider information is very valuable
  to most that choose to (usually illegally) act
  upon this information, so the market is certainly
  not strong form efficient, based on what we
  observe.
• What does the actual empirical evidence suggest
  concerning market efficiency? Most empirical
  evidence suggests that the U.S. stock market is
  largely semistrong-form efficient.
• Extreme profit opportunities would exist for
  anyone that could persistently and successfully
  exploit publicly available information, hence the
  intense competition among investors should
  largely winnow away the mispriced stocks.

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Implications of a market that is largely
semistrong efficient

• On average, stocks should trade at their
  intrinsic value. Deviations from intrinsic value
  should be random.
• The market stock price deviations from the true
  or intrinsic value cannot be identified using
  publicly available information.
• As many stocks should be 20 overpriced as there
  are stocks that are 20 underpriced.
• These deviations from intrinsic value can, of
  course, often be identified by using inside or
  private information since we assume that capital
  markets are not strong-form efficient.

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Implications of a market that is largely
semistrong efficient

• If stock analysis did not exist, then markets
  would be very inefficient, and thus extremely
  profitable opportunities would exist.
• In our real world, the intense competition among
  investors and analysts will largely eliminate
  most mispriced stocks.
• Prices increase over time, as investors expect
  compensation for systematic risk.

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Empirical evidence concerning the weak-form
market efficiency

• Most tests indicate that past returns (and other
  market data) cannot be exploited to generate
  future abnormal returns.
• Often, in the absence of transactions or trading
  costs, some strategies appear to work. However,
  when transactions costs are then incorporated,
  the strategy does not work.
• In an economics context, much of this information
  is available at no or little cost. Is it easy to
  earn above normal returns on costless
  information? It should be difficult!

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Empirical evidence concerning the semistrong-form
market efficiency

• Event studies
• Stock prices appear to react appropriately to
  most material corporate events or announcements
• Performance of actively managed mutual funds
• In any given year, most actively managed funds do
  not outperform a simple market index fund and
  most that do will not repeat the performance the
  following year.
• Value Line Investment Survey
• VL ranks stocks future prospects on a 1 (best)
  to 5 (worst) scale. On paper, stocks ranked as 1
  or 2 appear to overperform. However, VLs two
  actively managed mutual funds have consistently
  underperformed the market!

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Observations contrary to the EMH

• Size effect
• Small firms appear to outperform, after adjusting
  for risk. However, small firms dont really add
  up to much.
• Value (low market/book ratio) versus glamour
  (high market/book ratio)
• Low market-to-book equity firms appear to
  outperform.
• Long-term studies
• Some studies show that the market underreacts to
  some events and overreacts to others, and
  abnormal returns can be earned over 1 to 5 year
  horizons. For example, IPO firms were shown to
  underperform after going public however, more
  recent studies show that they dont.

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Where you may find deviations from the EMH

• Firms having little or no analyst coverage, e.g.,
  neglected firms.
• Typically a characteristic of many small firms.
• Such firms have limited investor interest and are
  not widely held by investors.
• Firms that are subject to short-sale constraints
• If pessimists cannot participate fully in the
  market by short selling those stocks they feel
  are overvalued, then the optimists may be driving
  the price of the stock. Such stocks may become
  overpriced.

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Speculative Bubbles ? periods of irrational
exuberance in markets

• Some examples in history of speculative bubbles
• Dutch tulip bulb craze of early 1600s
• South Sea bubble in Britain in early 1700s
• Electric related stocks in 1880s
• U.S. stock market of late 1920s
• Radio bubble of late 1920s
• Tronics bubble of early 1960s
• Nifty fifty bubble of early 1970s (large firm
  bubble!)
• Japanese stock market bubble of 1980s
• Internet and dotcom bubble of late 1990s and 2000

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Speculative Bubbles

• The bigger fool theory of speculation
• Those that buy in the mania feel like a fool, but
  they believe an even bigger fool will purchase
  the asset from them in the near future. People
  arent buying based on actual value.
• In each bubble, one often hears such phrases
• This time its different
• The old rules no longer apply
• Were living in a new economy
• Bubbles often occur in new (and perceived as
  exciting) industries where true fundamentals are
  difficult to ascertain. The Internet bubble was
  a prime example.

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Japanese stock market bubble of late 1980s
(Nikkei 225 index)
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Cisco Systems stock during the Internet bubble
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Nasdaq Composite Index during Internet bubble
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Philadelphia Stock Exchange Internet Index during
Internet bubble
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The U.S. stock market bubble of the late 1920s
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The radio bubble and stock market bubble of the
late 1920s