Chapter 10 Market Efficiency and Behavioral Finance Professor XXXXX Course Name / # © 2007 Thomson South-Western

2 2 2 Efficient Financial Markets  Informational efficiency  Allocative efficiency  Operational efficiency  Efficient markets hypothesis (EMH): asserts that financial asset prices fully reflect all available information.

3 3 3 Efficient Financial Markets  Behavioral finance: asserts that because traders in financial markets are human beings, they are subject to all the foibles and fads that bedevil human judgment in other spheres of life.  Human errors do not simply “cancel out” in markets, but cause prices to deviate far from “fundamental value” in ways that market competition does not immediately eliminate.

4 4 4 Three Forms Of Market Efficiency Weak Form Financial asset (stock) prices incorporate all historical information into current prices. Past stock price changes cannot help you predict future price changes. Semi-strong Form Stock prices incorporate all publicly available information (historical and current). Information in an SEC filing is incorporated into a stock price as soon as it is made public. Strong Form Stock prices incorporate all information, private as well as public. Prices react as soon as new information is generated.

5 5 5 Forms of Market Efficiency  Weak-form efficiency:  Prices will be unpredictable and will change only in response to new information.  This means prices follow a random walk. and

6 6 6 Forms of Market Efficiency  Semi-strong-form efficiency: asserts that asset prices incorporate all publicly available information.  The level of asset prices should correctly reflect all pertinent historical, current, and predictable future information that investors can obtain from public sources.  Asset prices should change fully and instantaneously in response to relevant new information.

7 7 7 Semi-strong Form Efficiency and Fundamental Analysis Recall the definition of efficient markets: In an efficient market, prices rapidly incorporate all relevant information. Semi-strong form efficiency uses “all public information” as its definition of “information.” Examples Earnings announcementsAnnual reports SEC filingsNews reports Prices move so fast in response to public information that trading on it profitably is nearly impossible!

8 8 8 Forms of Market Efficiency  Strong-form efficiency: asset prices reflect all information, public and private

9 9 9 The Strong Form Of Market Efficiency Prices should reflect all information, public and private.  Usually tested by seeing if corporate insiders earn superior returns on their trades in company stock  Evidence suggests insiders can “beat the market.” Insiders’ decision to trade at corporate level may be informative. –If they think stock price too high, they will sell new stock. –If they think stock price too low, they can re-purchase shares. –Stock prices can affect their decision to use cash or stock in mergers.

10 Forms of Informational Market Efficiency

11 Empirical Evidence on Market Efficiency  Tests for return predictability  Tests of simple trading rules  Tests of the effectiveness of technical analysis  Tests for return predictability  Tests of the performance of newly issued shares

12 Event Studies Suppose in the month of July (2003) 6 firms report earnings early in the day on the following dates: Firm Earnings announcement date Day +1 1 Tues Wed Thur Fri Wed Thur Fri Mon Tues Wed Thur In event time, the earnings announcement date is day 0.

13 Event Studies Event Time (in days) 10% -10% 0% 5% -5% Cumulative Abnormal Return The actual return minus the expected return Abnormal return Abnormal Return Could just be the market index return for the day, or the market index return times the beta of the firm reporting the earnings announcement The positive bump on day 0 implies that the earnings news was, on average for these firms, better than expected! Because the line is flat after day 0, this means that the market fully incorporated the earnings news on the event day…no additional upward or downward price trend is seen.

14 Simple Trading Rule Tests  Positive serial correlation  Negative serial correlation  “Anomalies”  day-of-the-week effect  small-firm effect  January effect

15 Tests for the Effectiveness of Technical Analysis  Most empirical research contradicts the usefulness of technical analysis and supports weak-form market efficiency.  But in a recent study researchers asked whether any of the standard pricing patterns can be identified statistically (rather than visually).  they find that several technical patterns are in fact observed much more frequently than chance would predict.

16 Tests for the Effectiveness of Technical Analysis

17 Tests for Stock Market Underreaction  Whether stock prices underreact to important but infrequent corporate events  Whether stock prices tend to systematically undereact to certain types of routine information disclosures, particularly earnings announcements and recommendations by security analysts  Whether buying prior-period “winners” or selling prior-period “losers” is profitable - these momentum studies have been by far the most numerous and important

18 Tests for Stock Market Overreaction  Value stock phenomenon: stocks in the “loser” portfolio trade at low prices relative to earnings, dividends, and other measures of fundamental value.  Study results were distorted by some very large percentage gains (up to 3,500%) on some very low-priced stocks  Potential profits identified by the overreaction studies are simply too large to be credible.

19 Tests For Rapid Price Adjustment Stock Splits

20 Tests For Private Information  Tests of the Profitability of Insider Trading  Tests of Mutual Fund Investment Performance  Tests of Pension Fund and Hedge Fund Investment Performance  Tests of the Stock-Picking Abilities of Security Analysts

21 The Behavioral Finance Critique Of Market Efficiency  Behaviorists claim that financial markets are irrationally volatile.  Prone to recurring bubbles, fads, and information cascades  An information cascade occurs when a piece of “information” rapidly travels through a large group of market participants, influencing trading behavior and being accepted as correct—whether it is or not.  All three of these phenomena, if they in fact exist, are inconsistent with market efficiency.

22 Behavioral Finance Argues that market participants suffer from systematic psychological biases that result in sub- optimal decisions Investors underreact to new information that contradicts prior beliefs (e.g., dramatic change in earnings). Investors overreact to a string of similar information (e.g., investors expect recent trends to continue). Investors are overly confident in their ability to identify misvalued stocks.

23 The Underreaction Phenomenon Time (months) 0 Cumulative Abnormal Return The line that is going upward is showing the returns on a group of stocks that have (in month 0) reported unexpectedly high earnings. The line that is trending down is showing the returns on a group of stocks that have (in month 0) reported unexpectedly low earnings. Stock-price momentum Investors are under reacting to the recent good (bad) earnings news. Subsequent news after the announcement continues to be good (bad), so investors didn ’ t fully realize how good (bad) the initial announcement was.

24 The Overreaction Phenomenon The line that trends up and then reverses represents returns on stocks that have performed very well for the last several years, and vice versa for the other line Time (years) 0 Cumulative Abnormal Return Stock-price momentum The time period we are looking at here is long--several years--and investors are overreacting to a perceived long-term trend. This is distinct from the previous slide where investors were--over a much shorter time span--underreacting to brand new information.

25 Theoretical Underpinnings Of Behavioral Finance  No fully developed model of behavioral finance, but behaviorists have explained how markets might be less than fully efficient

26 Theoretical Underpinnings Of Behavioral Finance

27 Assessing Behavioral Finance and Market Efficiency  Behaviorists present persuasive evidence that price bubbles occur, and somewhat less-compelling evidence that the U.S. stock market was grossly overvalued near the turn of the century.  On balance, investors and managers are wise to take the efficient markets hypothesis seriously.  Even though the quantity of evidence challenging the EMH has grown in recent years, stock prices and prices of other financial assets are still largely unpredictable

28 What Does Market Efficiency Imply For Corporate Financing?  How do markets process accounting and other information releases?  How do markets respond to corporate financing announcements?  How can managers devise a corporate “communications” policy?  Assume that your words and actions have consequences  Assume that loose lips sink corporate ships  Consider honesty to be the best policy  Listen to your stock price