Professor Megginson FIN 5043 BAD 5283

1
Chapter 10
Market Efficiency And Modern Financial Management
Professor MegginsonFIN 5043 / BAD 5283
Spring Semester 2006
2
Efficient Markets
In an efficient market, prices rapidly
incorporate all relevant information.
The Efficient Markets Hypothesis (EMH) was
first formally proposed in 1970 by Eugene Fama.
What are the three forms of market efficiency?
3
Economic Definitions Of Efficiency
4
Three Forms Of Market Efficiency
5
Weak Form of Market Efficiency
Weak form Stock price changes are not
predictable based on past changes.
6
Simulated Real Price MovementsWhich Is Which?
Simulated market levels for 52 weeks
Actual DJIA closing prices for 52 weeks
Source Harry V. Roberts, Stock Market
Patterns and Financial Analysis
Methodological Suggestions, Journal of Finance
14 (March 1959), pp. 1-10.
7
Potential Returns From An Overreaction Strategy
8
Semi-strong Form Efficiency and Fundamental
Analysis
Recall the definition of efficient markets In an
efficient market, prices rapidly incorporate all
relevant information.
Prices move so fast in response to public
information that trading on it profitably is
nearly impossible!
9
Survivorship Bias And Measured Returns On Mutual
Funds
If anyone could beat the market, its the pros
who devote all of their time and energy to that
effort.
Malkiel (1995) pointed out critical bias in
studies that show superior performance of fund
manager survivorship bias.
10
Survivorship Bias Measured Mutual Fund Returns
Malkiel JF 95
11
Implications Of Semi-Strong Form Efficiency
Most studies show managers under-perform SP 500,
even before taking account of expenses.

• Superstar investors (Warren Buffett, Peter
  Lynch) are the exception rather than the norm.

Other tests show prices react efficiently to new
information.

• Studies also find that purely accounting rule
  changes that do not affect cash flow have no
  impact on stock prices.

12
Event Studies
Suppose in the month of July (2003) 6 firms
report earnings early in the day on the following
dates
In event time, the earnings announcement date is
day 0.
13
Event Studies
The positive bump on day 0 implies that the
earnings news was, on average for these firms,
better than expected!
Because the line is flat after day 0, this means
that the market fully incorporated the earnings
news on the event dayno additional upward or
downward price trend is seen.
14
How Do Markets React To Corporate Announcements?

• Some announcements are good news causing stock
  prices to rise, on average
• Dividend initiations increases, share R/P
• Leverage increasing transactions
• Cash acquisitions, spin-offs divestitures
• Some debt offerings, bank loan renewals
• Control-concentrating events (blockholder)

15
How Do Markets React To Corporate Announcements?

• Following announcements received as bad news
• Dividend cuts or suspensions (disastrous)
• Adoption/proposing anti-takeover defenses
• Any equity financing (including convertibles)
• Merger financed with new stock issue
• Any focus-decreasing transactions
  (diversification strategies)

16
Evidence Against Semi-strong Form Efficiency
Many people feel that bubbles form quite
frequently in financial asset prices Japanese
stock prices late 1980s, NASDAQ prices through
March 2000.
17
Were Internet Values A Bubble?
18
Bubble Or Rational Value? U.S. Stock Prices vs
Earnings, 1871-2000
19
Bubble or Rational Price? U.S. Stock Prices vs
P/E Ratios, 1871-2000
20
Behavioral Finance
Argues that market participants suffer from
systematic psychological biases that result in
sub-optimal decisions
Investors underreact to new information that
contradicts prior beliefs (e.g., dramatic change
in earnings).
Investors overreact to a string of similar
information (e.g., investors expect recent trends
to continue).
Investors are overly confident in their ability
to identify misvalued stocks.
21
The Underreaction Phenomenon
Stock-price momentum
The line that is going upward is showing the
returns on a group of stocks that have (in month
0) reported unexpectedly high earnings. The line
that is trending down is showing the returns on a
group of stocks that have (in month 0) reported
unexpectedly low earnings.
0
Cumulative Abnormal Return
-5 -4 -3 -2 -1 0 1 2
3 4 5
Time (months)
Investors are under reacting to the recent good
(bad) earnings news.
Subsequent news after the announcement continues
to be good (bad), so investors didnt fully
realize how good (bad) the initial announcement
was.
22
The Overreaction Phenomenon
The line that trends up and then reverses
represents returns on stocks that have performed
very well for the last several years, and vice
versa for the other line.
The time period we are looking at here is
long--several years--and investors are
overreacting to a perceived long-term trend.
This is distinct from the previous slide where
investors were--over a much shorter time
span--underreacting to brand new information.
23
The Strong Form Of Market Efficiency
Prices should reflect all information, public and
private.

• Usually tested by seeing if corporate insiders
  earn superior returns on their trades in company
  stock
• Evidence suggests insiders can beat the market.

Insiders decision to trade at corporate level
may be informative.

• If they think stock price too high, they will
  sell new stock.
• If they think stock price too low, they can
  re-purchase shares.
• Stock prices can affect their decision to use
  cash or stock in mergers.

24
Corporate Communications Policy
Market efficiency has clear implications for how
a manager should communicate with investors.
Assume your actions and words have consequences.

• Try to predict how a particular announcement will
  be interpreted by investors and be ready to
  respond if they actually respond differently.
• Dont withhold info that will likely come out
  anyway.

Do not discuss publicly information that should
be kept private.
25
Corporate Communications Policy
Honesty is the Best Policy

• Managers who convey good and bad information
  honestly and and who do not try to fool the
  market will be believed, while managers with
  reputations for deception will not be.

Listen to Your Stock Price

• Two types of information that markets convey to
  managers
• (1) reactions to specific corporate
  announcements
• (2) movements in the firms stock price
  relative to the overall market over extended
  periods of time
• Both types of information can be very informative
  to the manager.

26
Market Efficiency
Financial markets tend to be more efficient and
competitive than product markets. Three forms of
market efficiency weak form, semi-strong form,
strong form Empirical research found that major
financial markets are weak-form and
semistrong-form. Market efficiency research
helps financial managers in formulating their
communication policy.