Capital Market Efficiency The concepts. Topics What if you figure a stock price moving pattern? Some formal definitions Implications of Market efficiency

Capital Market EfficiencyThe concepts

Topics

• What if you figure a stock price moving pattern?

• Some formal definitions

• Implications of Market efficiency Hypothesis

• Price modeling

• Empirical studies

What if? Definitions Implications Price Empirics

What if

• What if you have figured the following:– Buy if out of the 20 trading days for the past

month, stock XYZ has been rising for more than 2/3 of the times.

– Sell if out of the 20 trading days for the past month, stock XYZ has been falling for more than 2/3 of the times.

– Follow this rule strictly, return is “abnormally high”.


Stock price reflects information• If you have spotted XYZ’s stock pattern that guarantee you

pure profit, what should you do?• You should definitely exploit it. (How? Borrow as much as you

can to invest.)• The process of exploiting it actually makes the opportunity

vanishes because:• You would bid up XYZ stock price when you think it is hot.

Higher prices mean lower expected return.• You would also likely bid down XYZ stock price when you

think it is cold. Lower prices mean higher expected return.• In short, the fact that you have figured out a stock price

movement is very likely to be reflected by the stock price. • The more greedy (which is rational, more precisely, is the

higher the ability for you to raise fund) you are, the faster your pattern will be eliminated.


Price movement pattern


Sto

ck P

rice

Time

Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.

If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.

Sell

Sell

Buy

Buy

The army• Imagine not only you, there exists an “army” of intelligent,

well-informed security analysts, arbitragers, traders, who literally spend their lives hunting for securities which are mispriced or following a price moving pattern based on currently available information.

• They have high-tech computers, subscription to professional database, up-to-date information on thousands of firms, state-of-the-art analytical technique, etc.

• These people can assess, assimilate and act on information, very quickly.

• In their intense search for mispriced securities, professional investors may “police” the market so efficiently that they drive the prices of all assets to fully reflect all available information.


Implications• Competition for finding mispriced securities is fierce.• Such competition always kills the “sure-profit” pattern

because were there one, it would have been exploited by someone who first spotted it. Thus, roughly speaking, “no arbitrage” should hold.

• The first one does make profit, but net profit ≠ gross profit

• The “very first” one is not likely to be you.• The implications:

– stock prices should have reflected all available information.

– stock prices should be unpredictable.


Unpredictability

• Prices are unpredictable in the sense that stock prices should have reflected “all available information”.

• Thus if stock prices change, it should be reacting only to “new information”.

• The fact that information is new means stock prices are unpredictable.


Market efficiency

• If all past information is incorporated in the price then it should be impossible to consistently beat the market using technical analysis and the like.

• Definition 1:– Eugene Fama defined Market Efficiency as the state

where "security prices reflect all available information.“

• Definition 2:– Financial markets are efficient if current asset prices

fully reflect all currently available relevant information.


What is the right question?

• If new information becomes known about a particular company, how quickly do market participants find out about the information and buy or sell the securities of the company based on the information?

• How quickly do the prices of the securities adjust to reflect the new information?

• The issue is not merely black or white. We know that the market should neither be strictly efficient nor strictly inefficient. The question is one of degree.

• We should ask “ how efficient the market really is?”


Subsets of available informationFor a given stock


Information in past stock prices

All Public Information

All Available Information including inside or private information

3 forms of market efficiency hypothesis


Information in past stock prices

All Public Information

All Available Information including inside or private information

Since we are more interested in how efficient is the capital market, we define the following 3 forms of market efficiency hypothesis:

“A market is efficient if it reflects ALL available information”

[1] Strong-form

- ALL available info

[2] Semi-strong form


[3] Weak-form


3 forms of market efficiency hypothesis• Weak-form

“Stock prices are assumed to reflect any information that may be contained in the past history of the stock price itself.”

– For example, suppose there exists a seasonal pattern in stock prices such that stock prices fall on the last trading day of the year and then rise on the first trading day of the following year. Under the weak-form of the hypothesis, the market will come to recognize this and price the phenomenon away.

– Anticipating the rise in price on the first day of the year, traders will attempt to get in at the very start of trading on the first day. Their attempts to get in will cause the increase in price to occur in the first minutes of the first day. Intelligent traders will then recognize that to beat the rest of the market, they will have to get in late on the last day. The consequences, therefore, is the elimination of the pattern as price in the last trading day should be bid up.


3 forms of market efficiency hypothesis• Semi-strong-form

“Stock prices are assumed to reflect any information that is publicly available.”

– These include information on the stock price series, as well as information in the firm’s accounting reports, the reports of competing firms, announced information relating to the state of the economy, and any other publicly available information relevant to the valuation of the firm.


3 forms of market efficiency hypothesis• Strong-form

“Stock prices are assumed to reflect ALL information, regardless of them being public or private.”

– Under this form, those who acquire insider information act on it, buying or selling the stock. Their actions affect the price of the stock, and the price quickly adjusts to reflect the insider information.


3 forms of market efficiency hypothesis• If Weak-form of the hypothesis is valid:

– Technical analysis or charting becomes ineffective. You won’t be able to gain abnormal returns based on it.

• If Semi-strong form of the hypothesis is valid:– No analysis will help you attain abnormal returns as long

as the analysis is based on publicly available information.

• If Strong-form of the hypothesis is valid:– Any effort to seek out insider information to beat the

market are ineffective because the price has already reflected the insider information. Under this form of the hypothesis, the professional investor truly has a zero market value because no form of search or processing of information will consistently produce abnormal returns.


Why do we care about capital market efficiency?

• As an analyst

• As an investment manager

• As a corporate financial manager

• As a marketing manager

• As an accounting manager



• As an analyst– If market is efficient, what is your marginal

contribution for the securities firm that hire you? It should be zero, because you are not able to spot mispriced securities to produce additional increment of return on the portfolios that you are managing. Heat Debate.

– Analysts’ total contribution to the society should be big. Because in scouting the capital market, they essentially make sure asset prices are effective as signals to others.

• If the market is truly efficient => 0<Total contribution ≠ marginal contribution=0



• As an investment manager– Investment decisions of the managers of any firms

are based to a large extent on signals they get from the capital market.

– If the market is efficient, the cost of acquiring capital will accurately reflect the prospects for each firm.

– This means the firms with the most attractive investment opportunities will be able to obtain capital at a fair price which reflects their true potential.

– The “right” investment will be made, and the society is said to be “allocationally-efficient”. Everyone’s better off.



• As a corporate financial manager– To raise capital, you consider getting debt- or equity-

financing. – If the market is efficient, you know that equity-financing

requires a rate of return which is “fair” because the price has already reflected all available information.

– If the market is efficient, you would never feel your firm’s stock being under- or over-valued at any point in time. In essence, there is no timing decision to issuing equity.

– More profoundly, if market is efficient, every alternative way of raising capital would require the same rate of return for the same project. And no one capital-raising method is superior than the other.



• As a marketing manager– You may consider advertising at the Wall Street

Journal about how impressive your company has done throughout the past few years.

– If the market is efficient, there is no need to do that. Because your stock price has already reflected those. There is absolutely no impact for the ad on the stock price. And placing an ad is like burning money.

– Another interpretation is that, “ads don’t easily fool investors.”



• As an accounting manager– Will change in accounting procedures (e.g., different

depreciation methods: straight-line vs accelerated) impact the company’s stock price?

– No if the market is semi-strong efficient. Because informed, rational analysts will adjust the different accounting procedures used by different firms and assess prospects based on standardized numbers.

– Thus, the adjustment in accounting technique will have no effect on the opinions of those analysts or on the stock price of the firm.


Expected return-risk• The market efficiency hypothesis says nothing about the

structure of stock prices. However, what is abnormal return?Abnormal return = actual return – expected return

• This means we have to know what exactly is expected return.• That’s why we may use a pricing model. • e.g.,CAPM, to find a risk-adjusted return that the market will

be rewarding.)• Defining abnormal return inherently involves assuming a

pricing model. If we find abnormal returns, we conclude that the market is inefficient. But then, we can also say that the pricing model we used is invalid.

• The challenge here is: testing market efficiency inevitably involves testing a joint hypothesis:– H0 : both market is efficient and the pricing model is valid.– H1: EITHER market is inefficient OR the pricing model is

invalid.


4 basic traits of efficiency

• An efficient market exhibits certain behavioral traits. We can examine the real market to see if it conforms to these traits. If it doesn’t, we can conclude that the market is inefficient.

1. Act to new information quickly and accurately

2. Price movement is unpredictable (memory-less)

3. No trading strategy consistently beat the market

4. Investment professionals not that professional


1) Act to news quickly & accurately


00 +t+t-t-t

The timing for a positive news

Days relative to announcement day

Sto

ck p

rice

($)

1) Act to news quickly & accurately


00 +t+t-t-t

Days relative to announcement day

Sto

ck p

rice

($)

If the market is efficient,

1) at time 0, the positive news come, there is an immediate up in the stock price to the RIGHT level. (i.e., the PINK path)

2) There is no delays in analyzing news and slowly reflecting in the stock price like the ORANGE path does.

3) There is also no over-reaction like the BLUE path does, and then subsequently adjustment back to the correct level.

2) Memory-less price movement


If the market is efficient (WEAK-FORM),

1) The so-called “momentum” is nothing. (Google “Stock momentum”)

• “momentum” is like, if once started on a downward slide, stock prices develop a propensity to continue sliding. The expected change in today’s price would, in fact, be related (correlated positively) with the price changes in the past.

2) If the market is efficient, prices only move in response to “news”. More precisely, “news” is any discrepancy between the public’s expectation and the actual realized event. E.g, “If everyone expects Wal-Mart’s sales to go up by 50%, and if the news announces that it did go up by 50%, this is not a news. If it goes up by 30% instead, it is a news, a negative one though.”

3) To detect “memory” or “momentum”, we try to see if

Cov(ΔPt, ΔPt-i) is significantly different from zero or not, for i ≠ 0

3) No superior trading strategies


• One way to test for market efficiency is to test whether a specific trading rule or investment strategy, would have CONSISTENTLY produced abnormally high return.

• Problem about such test is:

1. What is abnormal return again? We run into the problem of joint hypothesis testing again in order to find an expected return as benchmark.

2. What kind of information you use to construct an investment strategy? Can you be sure the information you are based on really reflect what WAS available when the decision to invest was made.

• E.g., Last quarter’s earning is out around February of next year. If a WINNING investment strategy says “invest in the top 10 companies last year by Jan”, it is not an employable strategy.

3. What is the cost of implementing a strategy?

4) Professionals aren’t that professional


• If professional investors consistently beat the market, we conclude that the market is not that efficient.

• If the market is really efficient, we should not see professionals making abnormally high returns.

• The puzzle is: “we do see professionals having amazing records.”

• The answer is:

• “Suppose we take a thousand people in a gigantic stadium. Have them flip coins. Suppose “head” is winning and “tail” is losing. There is no surprise to find a few individual “flippers” with unbelievable records of success and failure. Those having 20 heads in a row goes on TV and showcase their exceptional flipping skills. But we know they’re just plain lucky.”

So what’s the value for portfolio management


• If capital markets are efficient, should we just throw darts at the Wall Street Journal instead of trying to rationally choose a stock portfolio?

• The answer is a big NO.

• As you have learnt, you need to have a well-diversified portfolio that is tailored towards your risk-preference.

• Depending on your age, your risk-preference, your current situation, your tax bracket, and all other relevant factors, your portfolio should be carefully constructed.

• Don’t forget that there is value for diversification. There is value for you to learn options. There is value for you to tailor a future payoff profile specific to your own needs. Throwing darts to pick stocks does not guarantee your specific needs are met.

So what’s the value for portfolio management


• The conclusion is:

• capital market is neither purely efficient nor purely inefficient.

• The right question to ask is “the degree of efficiency of capital market.”

• The more efficient capital market is, the better off the society.

• But even if it is efficient, it doesn’t imply knowledge of finance is useless. Because you have learnt diversification and portfolio theory that is based on maximizing happiness.

• Price movements are random. But it in NO way implies prices are random. Prices reflect/incorporate available information. The driving force to their random movements is that news comes randomly.

Documents

Capital Market Efficiency The concepts. Topics What if you figure a stock price moving pattern? Some formal definitions Implications of Market efficiency