Stock Market Efficiency Corporate Finance 26

Stock market efficiency: Introduction What is efficiency? The value of an efficient market Random walks Weak-form efficiency Semi-strong form efficiency

What is meant by efficiency? In an efficient capital market, security (for example shares) prices rationally reflect available information If new information is revealed about a firm, it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement No trader will be presented with an opportunity for making a return on a share greater than a fair return for the riskiness associated with that share, except by chance Stock market efficiency does not mean that investors have perfect powers of prediction The current share price level is an unbiased estimate of its true economic value based on the information revealed

Efficiency? Market efficiency does not mean that share prices are equal to true value at every point in time Errors that are made in pricing shares are unbiased; price deviations from true value are random There is an equal chance of our being too pessimistic at £7 as being too optimistic Prices are set by the forces of supply and demand Hundreds of analysts and thousands of traders Example: BMW announces a prototype electric car

What efficiency does not mean Prices do not depart from true economic value You will not come across an investor beating the market in any single time period No investor following a particular investment strategy will beat the market in the long term

Types of efficiency 1 Operational efficiency 2 Allocational efficiency 3 Pricing efficiency

New information (an electric car announcement by BMW) and alternative stock market reactions – efficient and inefficient

The value of an efficient market 1 To encourage share buying 2 To give correct signals to company managers Managers need to be assured that the implication of a decision is accurately signalled to shareholders and to management through the share price The rate of return investors demand on securities Information communicated to the market 3 To help allocate resources

Random walks

A share price pattern disappears as investors recognise its existence

The three levels of efficiency 1 Weak-form efficiency. Share prices fully reflect all information contained in past price movements 2 Semi-strong form efficiency. Share prices fully reflect all the relevant publicly available information 3 Strong-form efficiency. All relevant information, including that which is privately held, is reflected in the share price

Weak-form tests There will be no mechanical trading rules based on past movements which will generate profits in excess of the average market return (except by chance) A simple price chart Head & Shoulder’s pattern

A ‘line and breakout’ pattern

Weak-form tests The filter approach The Dow theory Focus on the long-term trends and to filter out short-term movements The Dow theory

Weak form efficiency - general conclusion The evidence and the weight of academic opinion is that the weak form of the EMH is generally to be accepted Benjamin Graham: “One principle that applies to nearly all these so-called ‘technical approaches’ is that one should buy because a stock or the market has gone up and should sell because it has declined… the exact opposite of sound business sense everywhere else… we have not known a single person who has consistently or lastingly made money by thus ‘following the market”’

Return reversal De Bondt and Thaler (1985) Shares that had given the worst returns over a three-year period outperformed the market by an average of 19.6 percent in the next 36 months Chopra et al. (1992) Extreme prior losers outperform extreme prior winners by 5–10 per cent per year during the subsequent five years Arnold and Baker (2005) Loser shares outperformed winner shares by 14 percent per year

Cumulative market-adjusted returns for UK share portfolios constructed on the basis of prior five-year returns Source: Arnold and Baker (2007).

Market-adjusted buy-and-hold five-year test-period returns for loser minus winner strategies for each of the 39 portfolio formations Source: Arnold and Baker (2007).

Price (return) momentum Jegadeesh and Titman (1993): a strategy that selects shares on their past six-month returns and holds them for six months, realises a compounded return above the market of 12.01 per cent per year on average Possible explanations: Investors underreacting to new information Investors overreacting during the test period Rouwenhorst (1998) showed price momentum in 12 developed country stock markets Liu et al. (1999) Hon and Tonks (2003) Arnold and Shi (2005) Tested the strategy over the period 1956 to 2001 While on average, winners outperform losers by up to 9.92 percent per year the strategy is fairly unreliable

Price momentum Portfolios are constructed on six-month prior-period returns and held for six months. Buy-and-hold monthly returns over the six months for the winner portfolio minus the loser portfolio. Each portfolio formation is shown separately Source: Arnold and Shi (2005).

Moving averages Brock et al. (1992) If investors (over the period 1897 to 1986) bought the 30 shares in the Dow Jones Industrial Average when the short- term moving average of the index (the average over, say, 50 days) rises above the long-term moving average (the average over, say, 200 days) they would have outperformed the investor who simply bought and held the market portfolio ‘However, transaction costs should be carefully considered before such strategies can be implemented’ (Brock et al. 1992) The trading rules did not work in the 10 years following the study period (Sullivan et al. 1999)

Semi-strong form tests Is worthwhile expensively acquiring and analysing publicly available information? Fundamental analysts try to estimate a share’s true value based on future business returns Majority of the early evidence (1960s and 1970s) supported the hypothesis Some academic studies which appear to suggest that the market is less than perfectly efficient

Semi-strong form tests Information announcements Ball and Brown (1968) Seasonal, calendar or cyclical effects The weekend effect The January effect Hour of the day effect Cease to exist High transaction costs Accusation of ‘data-snooping’

Small firms Studies in the 1980s found that smaller firms’ shares outperformed in the USA, Canada, Australia, Belgium, Finland, the Netherlands, France, Germany, Japan and Britain Perhaps the researchers had not adequately allowed for the extra risk of small shares, beta Some researchers have argued that small firms suffer more in recessions Proportionately more expensive to trade in small companies’ shares ‘Institutional neglect’

The small-cap reversal in the United States and the United Kingdom Source: Dimson, E., Marsh, P. and Staunton, M. (2002) Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton, NJ, and Oxford: Princeton University Press.

Underreaction Investors are slow to react to the release of information in some circumstances ‘Post-earnings-announcement drift’ Bernard and Thomas (1989): cumulative abnormal returns (CARs) continue to drift up for firms that report unexpectedly good earnings and drift down for firms that report unexpectedly bad figures for up to 60 days after the announcement. The abnormal return in a period is the return of a portfolio after adjusting for both the market return in that period and risk

The cumulative abnormal returns (CAR) of shares in the 60 days before and the 60 days after an earnings announcement Source: Bernard, V. and Thomas, J., 1989.

Underreaction Other areas of research into underreaction Ikenberry et al. (1995) share prices rise on the announcement that the company will repurchase its own shares Michaely et al. (1995) found evidence of share price drift following dividend initiations and omissions Ikenberry et al. (1996) found share price drift after share split announcements Jegadeesh and Titman (1993) found that trading strategies in which the investor buys shares that have risen in recent months produce significant abnormal returns Chan et al. (1996) confirm an underreaction to past price movements (a ‘momentum effect’) and also identify a drift after earnings surprises

Value investing Low price-earning ratio shares The evidence generally indicates that these shares generate abnormal returns Basu (1975, 1977, 1983), Keim (1988), Lakonishok et al. 1994) Levis (1989), Gregory et al. (2001, 2003) Dispute whether it is the small-size effect that is really being observed Reinganum (1981), and Banz and Breen (1986) Levis (1989), and Gregory et al. (2001), concluded that low PERs were a source of excess returns Investors place too much emphasis on short-term earnings data The tendency for extreme profit and growth trends to moderate ‘to revert to the mean’ (Little (1962), Fuller et al. (1993), Dremen (1998)) Lakonishok et al. (1994) found that low PER shares are actually less risky than the average

Value investing Shares that sell at prices which are a low multiple of the net assets per share seem to produce abnormal returns Many studies have concluded that shares offering a higher dividend yield tend to outperform the market High sales-to-price ratio firms perform better than low sales-to-price firms Cash flow to price ratio (Lakonishok et al. (1994)) Costs of issue/arrangement Bubbles

Lecture review An efficient market Types of efficiency The benefits of an efficient market Random walk Weak-form efficiency Semi-strong form efficiency