R-B-Ch.6 Efficent Capital Markets - Points to Refresh

Efficient Capital Markets

In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security

Whether markets are efficient has been extensively researched and remains controversial

Why Should Capital MarketsBe Efficient?

The premises of an efficient market
A large number of competing profit-maximizing participants analyze and value securities, each independently of the others
New information regarding securities comes to the market in a random fashion
Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information

Alternative Efficient Market Hypotheses (EMH)

Random Walk Hypothesis – changes in security prices occur randomly
Fair Game Model – current market price reflect all available information about a security and the expected return based upon this price is consistent with its risk

Efficient Market Hypothesis (EMH) - divided into three sub-hypotheses depending on the information set involved

Weak-Form EMH - prices reflect all security-market information (used by technical analysis)
Semistrong-form EMH - prices reflect all public information (used by fundamental analysis)
Strong-form EMH - prices reflect all public and private information

Weak-Form EMH

Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
This implies that past rates of return and other market data should have no relationship with future rates of return

Semistrong-Form EMH

Current security prices reflect all public information, including market and non-market information
This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions

Strong-Form EMH

Stock prices fully reflect all information from public and private sources
This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return
This assumes perfect markets in which all information is cost-free and available to everyone at the same time

Tests and Results of Weak-Form EMH

Statistical tests of independence between rates of return

Autocorrelation tests have mixed results
Runs tests indicate randomness in prices

Comparison of trading rules to a buy-and-hold policy is difficult because trading rules can be complex and there are too many to test them all
Filter rules yield above-average profits with small filters, but only before taking into account transactions costs
Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy

Results generally support the weak-form EMH, but results are not unanimous

Tests of the Semistrong Form of Market Efficiency

Two sets of studies
Time series analysis of returns or the cross section distribution of returns for individual stocks
Event studies that examine how fast stock prices adjust to specific significant economic events


Test results should adjusted a security’s rate of return for the rates of return of the overall market during the period considered
Arit = Rit - Rmt
where:
Arit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t

Time series tests for abnormal rates of return
short-horizon returns have limited results
long-horizon returns analysis has been quite successful based on
dividend yield (D/P)
default spread
term structure spread
Quarterly earnings reports may yield abnormal returns due to
unanticipated earnings change

Quarterly Earnings Reports
Large Standardized Unexpected Earnings (SUEs) result in abnormal stock price changes, with over 50% of the change happening after the announcement
Unexpected earnings can explain up to 80% of stock drift over a time period
These results suggest that the earnings surprise is not instantaneously reflected in security prices

The January Anomaly
Stocks with negative returns during the prior year had higher returns right after the first of the year
Tax selling toward the end of the year has been mentioned as the reason for this phenomenon
Such a seasonal pattern is inconsistent with the EMH


Other calendar effects
All the market’s cumulative advance occurs during the first half of trading months
Monday/weekend returns were significantly negative
For large firms, the negative Monday effect occurred before the market opened (it was a weekend effect), whereas for smaller firms, most of the negative Monday effect occurred during the day on Monday (it was a Monday trading effect)


Predicting cross-sectional returns
All securities should have equal risk-adjusted returns
Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns
These tests involve a joint hypothesis and are dependent both on market efficiency and the asset pricing model used

Price-earnings ratios and returns
Low P/E stocks experienced superior risk-adjusted results relative to the market, whereas high P/E stocks had significantly inferior risk-adjusted results
Publicly available P/E ratios possess valuable information regarding future returns
This is inconsistent with semistrong efficiency

Price-Earnings/Growth Rate (PEG) ratios
Studies have hypothesized an inverse relationship between the PEG ratio and subsequent rates of return. This is inconsistent with the EMH
However, the results related to using the PEG ratio to select stocks are mixed


The size effect (total market value)
Several studies have examined the impact of size on the risk-adjusted rates of return
The studies indicate that risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms
Firm size is a major efficient market anomaly
Could this have caused the P/E results previously studied?



Summary on the Semistrong-Form EMH

Evidence is mixed
Strong support from numerous event studies with the exception of exchange listing studies

Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient
Dividend yields, risk premiums, calendar patterns, and earnings surprises
This also included cross-sectional predictors such as size, the BV/MV ratio (when there is expansive monetary policy), E/P ratios, and neglected firms.

Tests and Results of Strong-Form EMH

Strong-form EMH contends that stock prices fully reflect all information, both public and private
This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits



Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers

Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
Insiders must report to the SEC each month on their transactions in the stock of the firm for which they are insiders
These insider trades are made public about six weeks later and allowed to be studied

Corporate insiders generally experience above-average profits especially on purchase transaction
This implies that many insiders had private information from which they derived above-average returns on their company stock

Studies showed that public investors who traded with the insiders based on announced transactions would have enjoyed excess risk-adjusted returns (after commissions), but the markets now seem to have eliminated this inefficiency (soon after it was discovered)

Other studies indicate that you can increase returns from using insider trading information by combining it with key financial ratios and considering what group of insiders is doing the buying and selling

Specialists have monopolistic access to information about unfilled limit orders
You would expect specialists to derive above-average returns from this information
The data generally supports this expectation

Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks
This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendations

Value Line (VL) publishes financial information on about 1,700 stocks
The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform the market
Firms ranked 5 substantially underperform the market
Changes in rankings result in a fast price adjustment

Some contend that the Value Line effect is merely the unexpected earnings anomaly due to changes in rankings from unexpected earnings
There is evidence in favor of existence of superior analysts who apparently possess private information

Trained professionals, working full time at investment management
If any investor can achieve above-average returns, it should be this group
If any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct
Most tests examine mutual funds
New tests also examine trust departments, insurance companies, and investment advisors
Risk-adjusted, after expenses, returns of mutual funds generally show that most funds did not match aggregate market performance


Conclusions Regarding the Strong-Form EMH

Mixed results, but much support
Tests for corporate insiders and stock exchange specialists do not support the hypothesis (Both groups seem to have monopolistic access to important information and use it to derive above-average returns)
Tests results for analysts are concentrated on Value Line rankings
Results have changed over time
Currently tend to support EMH
Individual analyst recommendations seem to contain significant information
Performance of professional money managers seem to provide support for strong-form EMH

Implications of Efficient Capital Markets

Overall results indicate the capital markets are efficient as related to numerous sets of information
There are substantial instances where the market fails to rapidly adjust to public information