1. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.1 Discuss the meaning of the random walk hypothesis and provide a balanced judgement of the usefulness of past price movements to predict future share prices (weak-form efficiency) Provide an overview of the evidence for the stock market’s ability to take account of all publicly available information including past price movements (semi-strong efficiency) State whether stock markets appear to absorb all relevant (public or private) information (strong-form efficiency) Outline some of the behavioural-based arguments leading to a belief in inefficiencies Comment on the implications of the evidence for efficiency for investors and corporate management LEARNING OBJECTIVES

2. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.2 In an efficient capital market security (for example shares) prices rationally reflect available information. The current level is an unbiased estimate of its true economic value based on information revealed 1 The direction of the price share movement 2 The size of that movement 3 The absence of abnormal profit possibilities Most investors are too late. WHAT IS MEANT BY EFFICIENCY?

3. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.3 1 Operational efficiency 2 Allocational efficiency 3 Pricing efficiency TYPES OF EFFICIENCY

4. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.4 1 To encourage share buying 2 To give correct signals to company managers - feedback - required rate of return - disclosure 3 To help allocate resources THE VALUE OF AN EFFICIENT MARKET

5. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.5 Exhibit 14.1 New information (an electric car announcement by BMW) and alternative stock market reactions – efficient and inefficient Volvo share price Line 1 Slow reaction 4 Persistent inefficiency Efficient market Line 3Overreaction followed by deflation Line 2Anticipatory price movements (information leak) A B –10–50 Announcement date +5+10+11Days before (–) and days after (+) announcement Line BMW/ share price

6. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.6 Exhibit 14.2 Charts showing the movements on the FT 100 share index and a randomly generated index of prices. Which is which? RANDOM WALKS 80 90 100 110 120 130 140 150 Share index () b Weeks 80 90 100 110 120 130 140 150 160 170 180 Share index () a Weeks Share index

7. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.7 Exhibit 14.3 A share price pattern disappears as investors recognise its existence WHY DOES THE RANDOM WALK OCCUR? The price at any one time reflects all available information and it will only change if new information arises. Share price AB 6 monthsTime Movement expected by chartist Actual movement after ‘pattern’ is identified

8. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.8 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. THE THREE LEVELS OF EFFICIENCY

9. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.9 A simple price chart – chartists Exhibit 14.4 The ‘head and shoulders’ pattern WEAK-FORM TESTS Share price A B Time

10. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.10 Exhibit 14.5 A ‘line and breakout’ pattern Share price Break out Resistance line Time Support line

11. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.11 Focuses on the long-term trends and on filtering short- term movements. The Dow theory The stock market is characterised by three trends. The primary trend is the long-term move in share prices The intermediate trend runs for weeks or months Tertiary trends last for a few days The Filter approach Exhibit 14.6 The Dow theory Market index D A B C Time

12. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.12 Weak-form efficiency Weight of evidence: the weak form of efficiency is generally accepted. However, there are exceptions. Overreaction hypothesis –De Bondt and Thaler –Dissanaike –Chopra, Lakonishok and Ritter Simple trading rules

13. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.13 Is it worthwhile expensively acquiring and analysing publicly available information? Semi-strong efficiency undermines fundamental analysts. Information announcements Manipulation of earnings Seasonal, calendar or cyclical effects Small firms Underreaction/momemtum SEMI-STRONG FORM TESTS

14. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.14

15. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.15 SEMI-STRONG FORM TESTS Value investing –Price-earnings ratios –Share price low relative to the balance sheet assets (book-to-market ratio) –High dividends relative to the share price (high- yield shares) Bubbles Comment on the semi-strong efficiency evidence

16. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.16 THE VIEWS OF SCEPTICAL PRACTITIONERS PETER LYNCH BENJAMIN GRAHAM WARREN BUFFETT and CHARLES MUNGER

17. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.17 STRONG-FORM TESTS It is possible to trade shares on the basis of inside knowledge and thereby make abnormal profits Curbing insider dealing: –Criminal offence –Stock market rules –Information disclosure –No dealing at certain times

18. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.18 BEHAVIOURAL FINANCE EMH: –Investors are rational –Or, even if some are irrational, the actions of rational investors eliminate pricing anomalies Behavioural finance: –Investors frequently make systematic errors –These errors push share prices away from fundamental value

19. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.19 BEHAVIOURAL FINANCE Three lines of defence –Investors are rational –Even if some are not rational, their irrationally inspired trades of securities are random and therefore the effects of their irrational actions cancel each other out without moving prices away from their efficient level. –If the majority of investors are irrational in similar ways and therefore have a tendency to push security values away from the efficient level this will be countered by rational arbitrageurs who eliminate the influence of the irrational traders on prices. Noise trader risk Risky arbitrage

20. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.20 Some cognitive errors made by investors Overconfidence Representativeness Conservatism Narrow framing Ambiguity aversion Positive feedback and extrapolative expectations Regret Cognitive dissonance Availability heuristic Miscalculation of probabilities

21. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.21 1 Any share portfolio will perform as well as or better than a special trading rule designed to outperform the market 2 There should be fewer price fluctuations 3 Only a minority of investors are actively trading, most are passive, therefore efficiency cannot be achieved MISCONCEPTIONS ABOUT THE EFFICIENT MARKET HYPOTHESIS

22. 14 STOCK MARKET EFFICIENCY Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 14.22 1For the vast majority of people public information cannot be used to earn abnormal returns 2Investors need to press for a greater volume of timely information 3The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers IMPLICATIONS OF THE EMH FOR COMPANIES 1Focus on substance, not on short-term appearance 2The timing of security issues does not have to be fine-tuned 3Large quantities of new shares can be sold without moving the price 4Signals from price movements should be taken seriously IMPLICATIONS OF THE EMH FOR INVESTORS