FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTER NINE CHAPTER NINE Market Efficiency Market Efficiency

Learning Objectives 1.Compare and contrast the three forms of market efficiency. 2.Define and compare fundamental analysis and technical analysis. 3.Discuss the random walk hypothesis and its implications for investors. 4.Explain the role of information in market efficiency and what this means to investors. 5.Discuss the empirical evidence about market efficiency and draw some conclusions.

Market Prices Whether a stock price is “right” depends on whether the market has chosen the proper discount rate and whether future cash flow expectations are correct Whether a stock price is “right” depends on whether the market has chosen the proper discount rate and whether future cash flow expectations are correct Efficient market – a market that gets future expectations and prices “right” Efficient market – a market that gets future expectations and prices “right” Information efficiency – implies proper forecasting and pricing Information efficiency – implies proper forecasting and pricing

Market Efficiency Efficient markets hypothesis (EMH) – states that markets are efficient, with market prices reflecting all available information at any given time Efficient markets hypothesis (EMH) – states that markets are efficient, with market prices reflecting all available information at any given time Three common forms of market efficiency include: Three common forms of market efficiency include: 1.Weak form – states that stock prices fully reflect all information contained in past prices and volumes of trading

Market Efficiency 2.Semi-strong form – suggests security prices adjust rapidly reflecting all available public information 3.Strong form – implies share prices reflect all public information and relevant information such as insider trading

Trading Strategies Fundamental analysis – uses economic, industry, and company data to estimate a fundamental value for a stock Fundamental analysis – uses economic, industry, and company data to estimate a fundamental value for a stock Technical analysis – uses recent patterns in stock price movements to determine what to buy and what to sell Technical analysis – uses recent patterns in stock price movements to determine what to buy and what to sell

Random Walk Hypothesis RWH argues that technical and fundamental analysis are not accurate analysing tools RWH argues that technical and fundamental analysis are not accurate analysing tools RWH suggests that stock price movements are unpredictable RWH suggests that stock price movements are unpredictable

Implications of the EMH For the investor, the EMH implies: For the investor, the EMH implies: 1.Since all publicly available information is reflected in current prices, there is no point in researching individual investments 2.Investment advisors advice is of no value 3.Timing regarding when to buy or sell is irrelevant

Implications of the EMH For corporate financial officers, the EMH implies: For corporate financial officers, the EMH implies: 1.Timing of a security issue is unimportant 2.It does not make sense to “play” interest rates 3.Since investors always get the price of stocks “right,” managers should pay attention to changes in the firm’s securities

Conceptual Arguments Regarding Market Efficiency Three major conceptual reasons why financial markets are efficient are: Three major conceptual reasons why financial markets are efficient are: 1.Investor rationality 2.Arbitrage 3.Competition or new entry

Empirical Evidence 1. Weak form evidence January effectJanuary effect Weekend effectWeekend effect 2. Semi-strong form evidence The average professional fund manager does not outperform the market bench market on a risk adjusted basisThe average professional fund manager does not outperform the market bench market on a risk adjusted basis 3. Strong form evidence Corporate insiders earned abnormal returns on their stock transactionsCorporate insiders earned abnormal returns on their stock transactions

Financial Panics and Stock Market Crashes The most damaging evidence against market efficiency is the repeated manias, panics, and crashes throughout the history of financial markets such as: The most damaging evidence against market efficiency is the repeated manias, panics, and crashes throughout the history of financial markets such as: - The Great Crash of The Great Crash of Black Monday of Black Monday of 1987

Summary 1.Various degrees of market efficiency, such as weak, strong, and semi-strong forms can be distinguished. Weak form efficiency implies that market prices incorporate all the information that can be inferred from previous price movements.Weak form efficiency implies that market prices incorporate all the information that can be inferred from previous price movements. Semi-strong form efficiency implies that market prices incorporate all publicly available information.Semi-strong form efficiency implies that market prices incorporate all publicly available information. Strong form efficiency implies that all existing information is incorporated in current prices.Strong form efficiency implies that all existing information is incorporated in current prices.

Summary 2.As in any other areas of business, consistently superior returns can only be achieved through sustainable competitive advantage. 3.The random walk theory postulates that stock price movements are inherently unpredictable. 4.For investors, the existence of efficient markets implies that no benefits are to be derived from researching individual securities since all available information is already reflected in the price.

Summary 5. Both investors and corporate managers must pay careful attention to the concepts of market efficiency. “Playing the market” and reliance on expert advice may often not provide the consistent returns claimed or desired.