Lecture 10 - The Efficient Market Hypothesis

Question 1

What do corporations rely on to value entire businesses?

Answer 1

Comparables and the dividend discount model.

Question 2

Major investment management companies also use dividend discount models to estimate the value of…

Answer 2

Common stocks and compare those estimates with stock market prices.

Question 3

In each case, the investor is…

Answer 3

Betting that once others have realised that a stock is undervalued, its price will shoot up and they will earn their profits.

Question 4

Why would a corporate financial manager, who is more concerned with issuing and purchasing securities, care whether investors are ‘beating’ the market?

Answer 4

If even professional investors cannot consistently find undervalued stocks, then financial managers should generally assume that market prices provide a good estimate of intrinsic value.

Question 5

The same applies when a financial manager is setting the firm’s exchange rate policy or deciding on an issue of debt…

Answer 5

If it is impossible to identify when a currency or a bond is wrongly valued, then the financial manager should trust market prices rather than engage in risky attempts to ‘beat the market’.

Question 6

What do investors do instead of search for superior investment returns?

Answer 6

They simply buy and hold index funds or exchange traded portfolios (ETFs) that track the entire stock market.

Question 7

Why is it so difficult to earn superior returns?

Answer 7

In financial markets, competition is intense. Competition drives out easy profits for traders and investors who seek mispriced securities. Every investor’s aim is to uncover undervalued stocks. If you uncover a stock that appears to be a bargain, it stands to reason that others will as well and there will be a wave of buying that pushing up its price. This buying pressure will eliminate the original bargain opportunity. New information is typically incorporated into stock prices in seconds or minutes.

Question 8

The price that emerges from this competition is likely to reflect…

Answer 8

The information and views of all the market participants. In this case it is not enough to have better information than any one of your competitors; to earn superior returns, you need to have better information that all of them combined.

Question 9

If a stock is fairly priced…

Answer 9

It will reflect all existing information and respond only to new information. New information however, is necessarily anticipated. Therefore, the resulting change in the stock price must be a surprise and cannot be predicted from earlier changes in the stock price. So in a market where stocks are fairly valued, their prices will wander randomly. Stocks will be equally likely to offer a high or low return on any particular day, regardless of what occurred on previous days.

Question 10

What is a random walk?

Answer 10

Successive changes in the value of your stake are independent and determined by the flip of a fair coin. That is, the odds of making money each week are the same, regardless of the value at the start of the week or the pattern of heads and tails in previous weeks. If a stock’s price follows a random walk, the odds of an increase or decrease during any day, month or year do not depend at all on the stock’s previous price moves. In this case, the patterns that investors sometimes see in stock prices are a mirage, and the historical path of prices gives no useful information about the future - just a long series of recorded heads and tails gives no information about the next toss.

Question 11

Who found that there no predictable pattern in stock price changes?

Answer 11

Maurice Kendall in 1953.

Question 12

How can this be put more technically?

Answer 12

There is no systematic correlation between one movement and subsequent ones.

Question 13

Statistically speaking, the movement of stock prices is…

Answer 13

Random. Skewed positive over the long term.

Question 14

What would happen if there was a predictable cycle of stock price changes?

Answer 14

As stocks are a bargain at their current level, investors will rush to buy and in doing so will push prices up. They will stop buying only when stocks are fairly priced. Thus, as soon as a cycle becomes apparent to investors, they immediately eliminate it by their trading.

Question 15

What is an efficient market?

Answer 15

Market in which prices reflect all available information. By this they mean that the competition to find misvalued stocks is intense. So when new information comes out, investors rush to take advantage of it and thereby eliminate any profit opportunities. As a result, each new change in the price of a stock is independent of earlier changes. Professional investors express the same idea when they say that there are no free lunches on Wall Street. It is very difficult to detect undervalued stocks and to beat the market consistently.

Question 16

An efficient capital market is one in which asset prices…

Answer 16

Fully and instantaneously reflect all available information. If information is fully reflected in security prices then firms should expect to receive the fair value for securities they sell. Firms cannot profit from fooling investors in an efficient market. Investors are unable to make abnormal returns on the basis of available information and trading rules will be of little value to an investor.

Question 17

What is the weak form of the hypothesis?

Answer 17

It maintains that stock prices follow a random walk, so that it is impossible to make superior returns just from a study of past price changes. Price changes are essentially independent from one period to the next. Security prices reflect all past information, including the historical sequence of prices, trading volume data and other market generated information. This implies that past rates of return and other market data have no relationship with future rates of return.

Question 18

What is the semi strong form of the hypothesis?

Answer 18

It maintains that public information is impounded in the stock price, so that it is impossible to earn superior returns by a study of information that is also available to other investors. Researchers have tested this hypothesis by looking at how rapidly prices incorporate different types of news. Security prices reflect all publicly available information, including accounting statements and economic activity. Investors cannot act on new public information after its announcement and expect to earn above average, risk adjusted returns.

Question 19

What is the strong form of the hypothesis?

Answer 19

This holds that no group of investors with whatever information and skill sets that they possess can earn consistently superior returns. Even professional managers do not generally outperform the market. Security prices reflect all information - public and private. No group of investors should be able to earn abnormal rates of return by using privately available information. This assumes perfect markets in which all information is cost free and available to everyone at the same time. Therefore, all analysts are redundant, or in other words, nobody can beat the market.

Question 20

What is technical analysis?

Answer 20

Analysis that relies on the past history of prices, is of little or no value in assessing future changes in security prices. Technical analysts are investors who attempt to identify undervalued stocks by searching for patterns in past stock prices. They forecast stock prices based on watching fluctuations in historical prices.

Question 21

Why technical analysis fails?

Answer 21

Investor behaviour 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.

Question 22

What is fundamental analysis?

Answer 22

This uses economic and accounting information to predict stock prices. Fundamental analysts are investors who attempt to find mispriced securities by analysing fundamental information, such as accounting data and business prospects. They research the value of stocks using NPV and other measurements of cash flow. If the analyst relies on publicly available earnings and industry information, their evaluation of the firm’s prospect is not likely to be significantly more accurate than other rival analysts.

Question 23

Even if we can spot patterns, we need to have returns that…

Answer 23

Beat our transaction costs. Many statisticians and psychologists believe that people want to see patterns even when faced with pure randomness. People claiming to see patterns in stock price movements are probably seeing optical illusions.

Question 24

General view that emerges is that the market supports…

Answer 24

Semi strong form efficiency. Studies suggest that markets may even have some foresight into the future with news leaking in advance of public announcements.

Question 25

What is event studies?

Answer 25

Empirical analysis of stock price behaviour surrounding a particular event. Such events are then tested for evidence of under-over reaction and early-delayed reaction. These include dividend increases and decreases, earnings announcements, mergers and new issues of stock.

Question 26

What is the momentum factor?

Answer 26

Researchers who have looked at stock market returns over long periods have found a tendency for price rises to persist for some 6 to 9 months and then to revert. Investors refer to this persistence of returns as momentum.

Question 27

What is the book to market factor?

Answer 27

Value stocks are defined as those with a high ratio of book to market value. Growth stocks are defined as those with a low ratio of book to market value. Value stocks have provided a higher return than growth stocks. This can be explained by the fact that value stocks have extra risks that we have not yet identified or learnt how to measure. If so, investors may have demanded the higher returns as compensation for these risks.

Question 28

What tells us that valuing common stocks from scratch is always going to be imprecise?

Answer 28

The extreme sensitivity of price to even minor changes in assumptions.

Question 29

This conclusion has two consequences what are they?

Answer 29

First, investors find it easier to price a common stock relative to yesterday's price or relative to today's price of comparable securities. In other words, they generally take yesterday's price as correct, adjusting upward or downward on the basis of today's information. If information arrives smoothly, then, as time passes, investors become increasingly confident that today's price level is correct. When investors lose confidence in the benchmark of yesterday's price, there may be a period of confused trading and volatile prices before a new benchmark is established. Second, most of the tests of market efficiency are concerned with relative prices and focus on whether there are easy profits to be made. It is almost impossible to test whether stocks are correctly valued because no one can measure true value with any precision.

Question 30

Explain size effect as a market anomaly.

Answer 30

Empirical studies show that the stocks issued by small companies earned higher rates of return, on average, than stocks issued by large companies. The small firm effect is not stable from year to year.

Question 31

Explain the neglected firm effect as a market anomaly.

Answer 31

The tendency of investment in stocks of less well-known firms to generate abnormal returns. Neglected firms earn higher returns as compensation for risk associated with limited information.

Question 32

What is the calendar effect as a market anomaly?

Answer 32

The weekday effect is that the stock market tends to fall on Mondays and then rise for the rest of the week. The holiday effect is that returns on the day before the holiday weekends was 9 to 13 times larger than the average daily return. The January effect is that the average stock’s return in January is more than 5 times larger than the mean monthly return obtained by averaging overall 12 months of the year.

Question 33

What is a bubble?

Answer 33

Every now and again investors seem to be caught up in a speculative frenzy, and asset prices then reach levels that (at least with hindsight) cannot easily be justified by the outlook for profits and dividends. It seems difficult to believe that expected future cash flows could ever have been sufficient to justify the initial price run ups. Most bubbles become obvious only after they have burst. A drop of this magnitude for no apparent reason is inconsistent with market efficiency.

Question 34

How do attitudes to risk affect prices and fundamental values?

Answer 34

When making risky decisions, people are particularly loath to incur losses, even if those losses are small. Losers are liable to regret their actions and kick themselves for having been so foolish. To avoid this unpleasant possibility, individuals will tend to shun those actions that may result in loss. Once investors have suffered a loss, they may be even more cautious not to risk a further loss. Conversely, just as gamblers are known to be more willing to take large bets when they are ahead, so investors may be more prepared to run the risk of a stock market dip after they have experienced a period of substantial gains. Such behaviour could lead to a stock price bubble.

Question 35

How do beliefs about probabilities affect prices and fundamental values?

Answer 35

Psychologists have found that when judging possible future outcomes, individuals commonly look back to what has happened in recent periods and then assume that this is representative into the future and forget the lessons learned from the more distant past. The temptation is to project recent experience into the future and to forget the lessons learned from the more distant past. For example, an investor who places too much weight on recent events may judge that glamorous growth companies are very likely to continue to grow rapidly, even though very high rates of growth cannot persist indefinitely. A second common bias is overconfidence. Most investors think that they are better than average stock pickers. Out of two speculators who trade with one another, only one of them can make money from the deal; for every winner there must be a loser. Presumably, investors are prepared to continue trading because each is confident that it is the other one that is worse off.

Question 36

How does sentiment affect prices and fundamental values?

Answer 36

Efficient markets bring to mind absolutely rational investors on the lookout for every possible profit opportunity. However, investors are real people that are subject to emotion. If the sentiment of large groups of investors varies in tandem, it potentially could have a noticeable impact on the economy, optimism or pessimism. Sentiment is offered as another reason why stock bubbles might develop. An improvement in sentiment can lead to an increase in stock prices.

Question 37

It is relatively easy for statisticians to spot anomalies with the benefit of hindsight and for psychologists to provide an explanation for them. It is much more difficult for investment manager to...

Answer 37

Spot and invest in mispriced securities in real time. In regard to the efficient market theory, there is one clear lesson; trust market prices unless you have a clear advantage that ensures the odds are in your favour.