FINANCIAL ADMINISTRATION OF THE FIRM FIN 5043930

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Chapter 10
Market Efficiency Modern Financial Management
Professor John ZietlowMBA 621
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Market Efficiency Modern Financial Management

• Introduction to market efficiency
• Key feature of modern economic thought market
  workings
• Efficiency in financial versus product markets
• Why financial markets tend to be more competitive
  efficient
• What is an efficient market?
• The three forms of market efficiency
• The three forms of market efficiency
• Weak form, semi-strong form, and strong-form
  efficiency
• What does market efficiency imply for corporate
  financial management?
• How do markets process firm-specific information
  releases?
• How should managers communicate with investors
  analysts?

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Financial Versus Product Markets

• Many examples of corporations creating value
  through real asset investments
• RD, product innovations, marketing programs
  create value
• Few product markets (except commodities) approach
  perfect competition standard
• Manufactured goods face barriers to entry
  (branding, capital requirements, physical
  distribution costs)
• Far fewer opportunities to create value through
  purely financial activities
• Financial markets much larger, more competitive,
  more transparent, more homogeneous than product
  markets
• Innovations cannot be patented easily immitated
• Arbitrage is easy safe keeps relative prices
  in line
• Much harder to create value thru purely financial
  activities

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What Is An Efficient Market?

• Most people equate efficiency with
  competitiveness
• For product markets, this is reasonably correct
• For financial markets, efficiency is less
  clear-cut
• Three ways to define efficiency of financial
  markets
• Informational efficiency most important for
  financial markets
• Allocative efficiency Measures whether financial
  markets allocate capital to its highest and best
  use.
• Operational efficiency (aka technical
  efficiency) Measures whether outputs are produced
  at lowest possible input cost.
• Informational efficiency Measures whether
  markets react fully and instantaneously to new
  information.
• The Efficient Markets Hypothesis (EMH) first
  formally proposed in 1970 by Eugene Fama
• Described how financial markets process
  information, and defined three forms of
  informational efficiency.

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Economic Definitions Of Efficiency
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Three Forms Of Market Efficiency
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Were Internet Values A Bubble?
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Random Walks And Technical Analysis

• Even weak form (WF) market efficiency suggests
  that stock price changes are not predictable
  based on past changes
• Expressed mathematically as
• Pt Pt-1 Expected return Random error
• The random component not predictable, so if WF
  efficiency holds, stock prices should follow a
  random walk
• Could be a pure random walk, or a random walk
  with drift
• WF efficiency alone enough to make technical
  analysis useless--and empirical testing supports
  this
• Figure shows how investor behavior tends to
  eliminate cyclical patterns in stock prices
• Figure shows two widely believed technical
  patterns
• Another implication stock price changes should
  be serially uncorrelated, and tests show very low
  corr for most stocks

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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.
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Technical Analysis PatternsDouble Tops
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Technical Analysis PatternsDouble Bottoms
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Technical Analysis PatternsHead And Shoulders
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Technical Analysis PatternsInverse Head And
Shoulders
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Potential Returns From An Overreaction Strategy
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Implications Of Semi-Strong Form Efficiency

• Semi-strong form (SSF) efficiency says prices
  reflect all publicly available information.
  Several ways to test
• Event studies measure market response to a
  corporate announcement by lining dates up in
  event time
• Measure cumulative abnormal returns (CAR) after
  event announcement on day t0
• Another test of SSF efficiency is to see if
  mutual fund managers can out-perform SP 500
  after expenses
• Most studies show managers under-perform SP 500,
  even before taking account of expenses
• Superstar fund managers (Warren Buffett, Peter
  Lynch) identified due to severe selection bias
  Malkiel, JF 1995
• Other tests show prices react efficiently to new
  information
• Also find that purely accounting rule changes
  that do not affect cash flow--or which can be
  predicted--have no impact

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Survivorship Bias And Measured Returns On Mutual
Funds, 1982-1991 Malkiel JF 95
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Can Security Analysts Beat The Market?Portfolio
Returns Based on Analysts Forecasts
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How Do Markets React To Corporate Financing
Announcements?

• Studies show the following announcements are
  taken to be good news causing stock prices to
  rise, on average
• Dividend initiations and increases, share
  repurchases
• Leverage increasing transactions (i.e.,
  debt-for-equity swaps)
• Acquisitions paid for with cash, spin-offs
  divestitures
• Some new debt offerings--especially bank loan
  renewals
• Control-concentrating events (new blocholder
  announced)
• Following announcements received as bad news
• Dividend cuts or suspensions (catastrohpic news)
• Adoption/proposal of anti-takeover defenses
• Any type of equity financing (including
  convertibles)
• Merger financed with new stock issue
• Any focus-decreasing transactions
  (diversification strategies)

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The First Event Study--Stock Splits
Average stock price response to the event of a
stock split. The stock prices are lined up In
event time, where the month of the stock split
is t0. Because all of the information in the
stock split is incorporated into stock prices by
the event date, there is on average no tendency
for prices to change after the split.
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How Do Markets Process Accounting Other
Information Releases?

• Managers often obsess about accounting policies
  and other things that do not affect cash flow
• LIFO vs FIFO accounting, FASB 52, capitalization
  of leases all did not affect stock prices.
• Studies show acctg rules that dont impact
  taxable profits--or which are already
  disclosed--dont impact stock prices.
• Other accounting rules/policies are extremely
  important to market participants
• Any policies that impact taxable earnings
• Rules governing accounting for stock options and
  pooling vs purchase treatment of MA currently
  very controversial
• Basic rule Assume investors cannot be
  consistently fooled by accounting gimmicks

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Contrary Evidence About Semi-Strong Form
Efficiency

• Not all empirical evidence totally supports
  market efficiency
• Small Firm effect small firms out-perform large,
  and most of 5 excess return occurs in January
  (January effect)
• Temporal anomalies January effect (all firms),
  Monday effect
• Value vs glamour stocks High book-to-market
  (value) stocks out-perform low book-to-market
  (glamour) stocks
• Many people feel that bubbles form quite
  frequently in financial asset prices
• South Sea Company, Tulip Mania early examples
• Japanese stock prices late 1980s
• NASDAQ prices through March 2000
• Though issue remains unresolved, mass of evidence
  strongly supports SSF market efficiency

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The Strong Form Of Market Efficiency

• Says prices should reflect all information--public
  private
• Usually tested by seeing if corporate insiders
  earn superior returns on their trades in company
  stock
• Evidence suggests insiders can beat the market,
  but those who trade on SEC filings by insiders
  cannot
• Trading by insiders can be legal Insider
  trading is illegal, but can be highly profitable
• Insiders ability to earn superior returns on
  stocks suggest their 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
• Can affect their decision to use cash or stock in
  mergers
• Also some evidence that managers can time new
  issues
• Loughran Ritter show IPOs and SEOs severely
  under-perform after issuance

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Bubble Or Rational Value? U.S. Stock Prices
Versus Earnings, 1871-2000
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Bubble Or Rational Value? U.S. Stock Prices
Versus P/E Ratios, 1871-2000
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Theoretical Models of Overreaction And
Underreaction
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How To Devise A Corporate Communications Policy

• Market efficiency has clear implications for how
  a wise manager should communicate with
  investors
• Press coverage can be both bane benefit
• Fortune 500 CEOs give more public speeches than
  politicians
• Assume Your Actions ( 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.
  True for both good bad news.
• Dont withhold info that will likely come out
  anyway.
• Loose Lips Sink Corporate Ships
• Do not discuss publicly information that should
  be kept private, or to prematurely disclose
  sensitive information.
• Try not to comment on earnings speculation unless
  necessary--then say as little as possible

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How To Devise A Corporate Communications Policy
(Continued)

• Honesty is the Best Policy
• Managers who convey good and bad information
  honestly--and who do not try to fool the market
  --will be believed, while managers with
  reputations for deception will not be.
• Managers also develop reputations for maximizing
  or squandering shareholder wealth.
• Listen to Your Stock Price
• There are essentially two types of information
  that markets convey to managers (1) reactions to
  specific corporate announcements, and (2)
  movements in the firms stock price relative to
  the overall market over extended periods of time.
  Both can be very informative to the sentient
  manager.
• The company is always for sale
• Unless you own 100 of the stock, you should
  always be ready to sell to a bidder if the price
  is high enough