Market efficiency

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Market efficiency

• Specific meaning of the term market efficiency
  in financial economics security prices fully
  reflect all available information
• So this is Informational Efficiency
• Realistically an efficient market is one in
  which information is quickly incorporated into
  the price.
• Tests of market efficiency refer (since Fama,
  1970) to three progressively more demanding
  concepts
• Weak form
• Semi-strong form
• Strong form

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Market efficiency tests

• The difference between the three lies in what
  information is taken into account
• Weak form is all info from past prices
  incorporated?
• Semi-strong is all publicly available info
  incorporated?
• Strong form is all info, public or private,
  incorporated?

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Market efficiency

• Weak form no additional info from past prices
• tests of return predictability
• Semi-strong all publicly available info
  incorporated
• event studies
• Strong form all info, public or private,
  incorporated
• event studies
• NB if strong form is true, then the value of
  security analysis becomes suspectthough someone
  must be doing it

4
Return on equity of takeover targets around date
of takeover attempt
Keown-Pinkerton, 1981, cited in BKM
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Market efficiency

• Two aspects, both of which are relevant
• Stock picking
• Timing (especially for the market as a whole)

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Tests of return predictability

• Time patterns
• Monday 33 (1962-78)
• January 5 (small firms)
• 3 (large firms)
• Why? Tax losses? (but worked before 1917)

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Tests of return predictability

• Prediction from past returns
• (a) Correlation / regression
• (best to use residual from CAPM or APT model to
  eliminate role of time-varying risk-premia)
• Quite a few show significant, albeit small,
  correlations especially small shares)

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Tests of return predictability

• Prediction from past returns
• (b) Runs tests
• Ignore size of changes and just look at positive
  versus negative (avoids overemphasis on unusual
  extreme events)

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Tests of return predictability

• Prediction from past returns
• (c) Filter rules
• Such as
• buy when the stock has increased by (say) 0.5
  from its previous low
• sell when stock has fallen by (say) 0.5 from its
  previous high.
• (Based on the idea that small fluctuations dont
  mean news big fluctuations do)

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Tests of return predictability

• Prediction from past returns
• (d) Momentum
• For the next month, hold only the stocks that
  have appreciated over the past year
• (or could do this for shorter-term fluctuations)
• Used to generate good returns, though high
  transactions costs. Has faded
• Similar relative strength stocks that are
  high relative to recent average

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Tests of return predictability

• Prediction from past returns
• Most of these tests show small inefficiencies,
  (especially at very high frequencies seconds)
• Most could not be exploited profitably by
  investors because of transactions costs
• (Transactions costs include the bid-ask spread
  employed by specialists to defend themselves
  against better-informed investors)

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Tests of return predictability

• Returns and firm characteristics
• The Size Effect (small cap have high returns)
• Market-to-book (value firms have high returns)
• Earnings-to-price (high earnings firms have high
  returns)
• (These could all be factor-mimicking
  characteristics capturing additional dimensions
  of risk )

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Tests of return predictability

• Returns and firm characteristics
• The Size Effect
• 20 extra return on very small vs. large,
  1936-77
• (risk-adjusted by CAPM)
• Only affects lowest quintile of firms
• Most of it happens in January!

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Size effect
Ibbotson, cited in BKM
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Small firm portfolios
Cochrane, EP 99
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Tests of return predictability

• Returns and firm characteristics
• Why the size effect?
• Maybe beta poorly measured
• Small stocks rarely traded leads to bias in
  beta estimate
• Shrinking firm may have out-of-date beta
• Is CAPM a good enough risk adjuster?
• Using other risk factors (though not size) in an
  APT
• reduced the size factor a lot (11 to lt2)
• Key factor here risk-premium on corporate bonds
• relative to govt bonds

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Tests of return predictability

• Returns and firm characteristics
• Why the size effect?
• Transactions costs especially high
• Compensation for liquidity
• Impossible to profit from effect?

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Tests of return predictability

• Returns and firm characteristics
• The Book-to-market effect
• Gap of 8 per annum between highest and lowest
  deciles of firms ranked by the ratio of their
  book value to market value
• (high B/M predicts high return)
• Maybe value firms are close to bankruptcy but
  recovered so these firms are not a hedge for
  recession, hence high yield
• Value (high B/M) and Growth (low B/M) stocks
• (These terms not quite synonymous with B/M)
• The Earning-to-price effect
• But this seems to have no independent effect
  after size and market-to-book taken account of.
• The neglected firm effect

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Book to market effect
French, cited in BKM
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Tests of return predictability

• Returns and firm characteristics
• Questions to ask about any of these anomalies
• Is it real? (Data-mining)
• Are we just missing another factor (especially
  one correlated with investors consumption/welfare
  )
• (i.e. firm characteristics correlated with a
  risk-factor that the market prices but we have
  omitted)
• Mis-estimate of beta (or other factor loadings)?
• Transactions costs?
• Risk premia changing over time?
• (CAPM/APT use stable ?s)
• Truly inefficient?