The efficient market hypothesis and random walks
- 1. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Efficient Market Hypothesis CHAPTER 8
- 2. 8-2 8.1 RANDOM WALKS AND THE EFFICIENT MARKET HYPOTHESIS
- 3. 8-3 Efficient Market Hypothesis (EMH) Do security prices reflect information Do security prices reflect information Why look at market efficiency Why look at market efficiency – Implications for business and corporate Implications for business and corporate finance finance – Implications for investment Implications for investment
- 4. 8-4 Random Walk - stock prices are random Random Walk - stock prices are random – Randomly evolving stock prices are the Randomly evolving stock prices are the consequence of intelligent investors consequence of intelligent investors competing to discover relevant information competing to discover relevant information Expected price is positive over time Expected price is positive over time Positive trend and random about the trend Positive trend and random about the trend Random Walk and the EMH
- 5. 8-5 Security Security Prices Prices Time Time Random Walk with Positive Trend
- 6. 8-6 Why are price changes random Why are price changes random – Prices react to information Prices react to information – Flow of information is random Flow of information is random – Therefore, price changes are random Therefore, price changes are random Random Price Changes
- 7. 8-7 Figure 8.1 Cumulative Abnormal Returns Before Takeover Attempts
- 8. 8-8 Figure 8.2 Stock Price Reaction to CNBC Reports
- 9. 8-9 EMH and Competition Stock prices fully and accurately reflect Stock prices fully and accurately reflect publicly available information publicly available information Once information becomes available, Once information becomes available, market participants analyze it market participants analyze it Competition assures prices reflect Competition assures prices reflect information information
- 10. 8-10 Versions of the EMH Weak Weak Semi-strong Semi-strong Strong Strong
- 11. 8-11 8.2 IMPLICATIONS OF THE EMH
- 12. 8-12 Types of Stock Analysis Technical Analysis Technical Analysis - using prices and volume - using prices and volume information to predict future prices information to predict future prices – Weak form efficiency & technical analysis Weak form efficiency & technical analysis Fundamental Analysis Fundamental Analysis - using economic and - using economic and accounting information to predict stock prices accounting information to predict stock prices – Semi strong form efficiency & fundamental analysis Semi strong form efficiency & fundamental analysis
- 13. 8-13 Active Management Active Management – Security analysis Security analysis – Timing Timing Passive Management Passive Management – Buy and Hold Buy and Hold – Index Funds Index Funds Implications of Efficiency for Active or Passive Management
- 14. 8-14 Even if the market is efficient a role Even if the market is efficient a role exists for portfolio management: exists for portfolio management: – Appropriate risk level Appropriate risk level – Tax considerations Tax considerations – Other considerations Other considerations The Role of Portfolio Management in an Efficient Market
- 15. 8-15 8.3 ARE MARKETS EFFICIENT
- 16. 8-16 Magnitude Issue Magnitude Issue – Actions of intelligent investment managers are the Actions of intelligent investment managers are the driving force driving force Selection Bias Issue Selection Bias Issue – The outcomes we observe have been preselected in The outcomes we observe have been preselected in favor of failed attempts favor of failed attempts – Cannot evaluate the true ability of portfolio Cannot evaluate the true ability of portfolio managers managers Lucky Event Issue Lucky Event Issue Empirical Tests of Market Efficiency
- 17. 8-17 Weak-Form Tests: Patterns in Stock Returns Returns over short horizons Returns over short horizons – Very short time horizons small magnitude of Very short time horizons small magnitude of positive trends positive trends – 3-12 month some evidence of positive 3-12 month some evidence of positive momentum momentum Returns over long horizons – pronounced Returns over long horizons – pronounced negative correlation negative correlation Evidence on Reversals Evidence on Reversals
- 18. 8-18 Predictors of Broad Market Returns Fama and French Fama and French – Aggregate returns are higher with higher Aggregate returns are higher with higher dividend ratios dividend ratios Campbell and Shiller Campbell and Shiller – Earnings yield can predict market returns Earnings yield can predict market returns Keim and Stambaugh Keim and Stambaugh – Bond spreads can predict market returns Bond spreads can predict market returns
- 19. 8-19 P/E Effect P/E Effect Small Firm Effect (January Effect) Small Firm Effect (January Effect) – Invest in low-capitalization stocks Invest in low-capitalization stocks – Earn excess returns Earn excess returns Semi-Strong Tests: Market Anomalies
- 20. 8-20 Figure 8.3 Returns in Excess of Risk- Free Rate and in Excess of the SML
- 21. 8-21 Semi-Strong Tests: Market Anomalies (Con’t) Neglected Firm Neglected Firm – Small firms tend to be neglected by large Small firms tend to be neglected by large institutional traders institutional traders Book-to-Market Ratios Book-to-Market Ratios – Beta seems to have no power to explain Beta seems to have no power to explain average security returns average security returns
- 22. 8-22 Figure 8.4 Average Annual Return as a Function of Book-to-Market
- 23. 8-23 Semi-Strong Tests: Market Anomalies (Con’t) Post-Earnings Announcement Drift Post-Earnings Announcement Drift – There is a large abnormal return on the There is a large abnormal return on the earnings announcement day earnings announcement day
- 24. 8-24 Figure 8.5 Cumulative Abnormal Returns in Response to Earnings Announcements
- 25. 8-25 Strong-Form Tests: Inside Information The ability of insiders to trade profitability The ability of insiders to trade profitability in their own stock has been documented in in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and studies by Jaffe, Seyhun, Givoly, and Palmon Palmon SEC requires all insiders to register their SEC requires all insiders to register their trading activity trading activity
- 26. 8-26 Interpreting the Evidence Risk Premiums or market inefficiencies— Risk Premiums or market inefficiencies— disagreement here disagreement here – Fama and French argue that these effects can Fama and French argue that these effects can be explained as manifestations of risk stocks be explained as manifestations of risk stocks with higher betas with higher betas – Lakonishok, Shleifer, and Vishney argue that Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient these effects are evidence of inefficient markets markets
- 27. 8-27 Figure 8.6 Return to Style Portfolio as a Predictor of GDP Growth
- 28. 8-28 Interpreting the Evidence (Con’t) Anomalies or Data Mining Anomalies or Data Mining – Rerun the computer database of past returns Rerun the computer database of past returns over and over and examine stock returns over and over and examine stock returns along enough dimensions: along enough dimensions: Simple chance may cause some criteria to appear Simple chance may cause some criteria to appear to predict returns to predict returns
- 29. 8-29 8.4 MUTUAL FUND AND ANALYST PERFORMANCE
- 30. 8-30 Stock Market Analysts Do analysts add value—mixed evidence Do analysts add value—mixed evidence – Womack study found that positive changes Womack study found that positive changes are associated with increased stock prices of are associated with increased stock prices of about 5% about 5% – Negative changes result in average price Negative changes result in average price decreases of 11% decreases of 11% – Are prices change due to analysts’ information Are prices change due to analysts’ information or through pressure brought on by the or through pressure brought on by the recommendations themselves recommendations themselves
- 31. 8-31 Mutual Fund Managers Some evidence of persistent positive and Some evidence of persistent positive and negative performance negative performance Potential measurement error for Potential measurement error for benchmark returns benchmark returns – Style changes Style changes – May be risk premiums May be risk premiums Superstar phenomenon Superstar phenomenon
- 32. 8-32 Figure 8.7 Estimates of Individual Mutual Fund Alphas
- 33. 8-33 Table 8.1 Performance of Mutual Funds Based on Three-Index Model
- 34. 8-34 Figure 8.8 Persistence of Mutual Fund Performance
- 35. 8-35 Table 8.2 Two-Way Table of Managers Classified by Risk-Adjusted Returns over Successive Intervals