1 The Capital Markets and Market Efficiency Portfolio Construction, Management, & Protection, 5e, Robert A. Strong Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

2 No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn into pumpkins and mice. Warren Buffett

3 Introduction Capital market theory springs from the notion that: People like return People do not like risk Dispersion around expected return is a reasonable measure of risk

4 Role of the Capital Markets u Capital markets trade securities with lives of more than one year u Examples of capital markets New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Chicago Board of Trade Chicago Board Options Exchange (CBOE)

5 Economic Function u The economic function of capital markets facilitates the transfer of money from savers to borrowers e.g., mortgages, Treasury bonds, corporate stocks and bonds

6 Continuous Pricing Function u The continuous pricing function of capital markets means prices are available moment by moment Continuous prices are an advantage to investors Investors are less confident in their ability to get a quick quotation for securities that do not trade often

7 Fair Price Function u The fair price function of capital markets means that an investor can trust the financial system The function removes the fear of buying or selling at an unreasonable price The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

8 Efficient Market Hypothesis u Definition u Types of Efficiency u Weak Form u Semi-Strong Form u Strong Form u Semi-Efficient Market Hypothesis u Security Prices and Random Walks

9 Definition u The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair In an efficient market prices quickly and accurately adjust to reflect new information The EMH is perhaps the most important paradigm in finance

10 Types of Efficiency u Operational efficiency measures how well things function in terms of speed of execution and accuracy It is a function of the number of orders that are lost or filled incorrectly It is a function of the elapsed time between the receipt of an order and its execution

11 Types of Efficiency (cont’d) u Informational efficiency is a measure of how quickly and accurately the market reacts to new information It relates directly to the EMH The market is informationally very efficient –Security prices adjust rapidly and accurately to new information –The market is still not completely efficient

12 Weak Form u The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past The current price is a fair one that considers any information contained in the past price data Charting techniques are of no use in predicting stock prices

13 Definition (cont’d) Example Which stock is a better buy? Stock A Stock B Current Stock Price

14 Definition (cont’d) Example (cont’d) Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

15 Charting u People who study charts are technical analysts or chartists Chartists look for patterns in a sequence of stock prices Many chartists have a behavioral element

16 Runs Test u A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance A run is an uninterrupted sequence of the same observation A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number

17 Conducting A Runs Test

18 Semi-Strong Form u The semi-strong form of the EMH states that security prices fully reflect all publicly available information e.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

19 Semi-Strong Form (cont’d) u Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as: Stock splits Cash dividends Stock dividends u This means investors are seldom going to beat the market by analyzing public news

20 Semi-Strong Form (cont’d) u Burton Malkiel points out that two-thirds of professionally managed portfolios are consistently beaten by a low-cost index fund Suggests that securities are accurately priced and that in the long run returns will be consistent with the level of systematic risk taken

21 Strong Form u The strong form of the EMH states that security prices fully reflect all relevant public and private information u This means even corporate insiders cannot make abnormal profits by using inside information about their company Inside information is information not available to the general public

22 Semi-Efficient Market Hypothesis u The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others Less well-known companies are less efficiently priced The market may be tiered A neglected firm effect may exist

23 Security Prices and Random Walks u The unexpected portion of news follows a random walk News arrives randomly and security prices adjust to the arrival of the news –We cannot forecast specifics of the news very accurately

24 Anomalies u A financial anomaly refers to unexplained results that deviate from those expected under finance theory Especially those related to the efficient market hypothesis Many examples of financial anomalies are reported to exist

25 Low PE Effect u Stocks with low PE ratios may provide higher returns than stocks with higher PEs u Supported by several academic studies u Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)

26 Low-Priced Stocks u Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price u There is an optimum trading range

27 Small-Firm Effect u Investing in firms with low market capitalization will provide superior risk- adjusted returns u Supported by academic studies u Implies that portfolio managers should give small firms particular attention

28 Neglected-Firm Effect u Security analysts do not pay as much attention to firms that are unlikely portfolio candidates u Implies that neglected firms may offer superior risk-adjusted returns

29 Market Overreaction u The tendency for the market to overreact to extreme news Investors may be able to predict systematic price reversals u Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

30 January Effect u Stock returns are inexplicably high in January u Small firms do better than large firms early in the year u Especially pronounced for the first five trading days in January

31 January Effect (cont’d) u Possible explanations: Tax-loss trading late in December (Branch) The risk of small stocks is higher early in the year (Rogalski and Tinic)

32 Types of Firms in January 7.71%10.72%11.32%Neglected Non-S&P 500 Companies 5.03%6.87%7.62%Neglected 1.69%4.19%4.95%Moderately Researched -1.44%1.63%2.48%Highly Researched S&P 500 Companies Average January return after adjusting for systematic risk Average January return minus average monthly return in rest of year Average January return Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.

33 Day-of-the-Week Effect u Mondays are historically bad days for the stock market u Wednesday and Fridays are consistently good u Tuesdays and Thursdays are a mixed bag

34 Day-of-the-Week Effect (cont’d) u Should not occur in an efficient market Once a profitable trading opportunity is identified, it should disappear u The day-of-the-week effect continues to persist

35 Turn-of-the-Calendar Effect u The bulk of the return comes from the last trading day of the month and the first few days of the following month u For the rest of the month, the ups and downs approximately cancel out

36 Persistence of Technical Analysis u Technical analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices u Studies show the markets are efficient in the weak form u Literature based on technical techniques continues to appear but should be useless

37 Chaos Theory u Chaos theory refers to instances in which apparently random behavior is systematic or even deterministic u Econophysics refers to the application of physics principles in the analysis of stock market behavior e.g., an investment strategy based on studies of turbulence in wind tunnels