1. Market Efficiency And Modern Financial Management Professor XXXXX Course Name / Number

2. 2 Efficient Markets In an efficient market, prices rapidly incorporate all relevant information. The “Efficient Markets Hypothesis” (EMH) was first formally proposed in 1970 by Eugene Fama. What are the three forms of market efficiency? Financial markets are much larger, more competitive, more transparent, more homogeneous than product markets. Much harder to create value through financial activities

3. 3 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.

4. 4 Weak Form of Market Efficiency Weak form: Stock price changes are not predictable based on past changes. Stock prices follow a random walk. Could be a pure random walk, or a “random walk with drift” Technical analysis Search of profitable trading strategies based on recurring patterns in stock prices Under the weak form of efficiency theory, technical analysis is useless.

5. 5 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!

6. 6 Survivorship Bias And Measured Returns On Mutual Funds If anyone could “beat the market”, it’s the pros who devote all of their time and energy to that effort. Selectivity (stock-picking ability) Timing (the ability to time market turns) A large number of publications investigate investment performance of mutual fund managers. Malkiel (1995) pointed out critical bias in studies that show superior performance of fund manager: survivorship bias. Only the returns of the companies still in existence at the end of the analyzed period are included in analysis.

7. 7 Implications Of Semi-Strong Form Efficiency Most studies show managers under-perform S&P 500, even before taking account of expenses. –“Superstar” investors (Warren Buffett, Peter Lynch) are the exception rather than the norm. Other tests show prices react efficiently to new information. –Studies also find that purely accounting rule changes that do not affect cash flow have no impact on stock prices.

8. 8 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 7-8-03Wed 7-9-03 2 Thur 7-9-03 Fri 7-10-03 3 Wed 7-16-03Thur 7-17-03 4Fri 7-18-03 Mon 7-21-03 5 Tues 7-22-03Wed 7-23-03 6 Thur 7-23-03 In event time, the earnings announcement date is day 0.

9. 9 Event Studies -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 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.

10. 10 Evidence Against Semi-strong Form Efficiency Small firm effect Small firms out-perform large especially in January (January effect). Temporal anomalies January effect (all firms), Monday effect Value versus glamour stocks High book-to-market (value) stocks out- perform low book-to-market (glamour) stocks. Many people feel that “bubbles” form quite frequently in financial asset prices: Japanese stock prices late 1980s, NASDAQ prices through March 2000.

11. 11 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.

12. 12 The Underreaction Phenomenon -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 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.

13. 13 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. -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 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.

14. 14 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.

15. 15 Corporate “Communications” Policy Market efficiency has clear implications for how a manager should “communicate” with investors. Assume your actions and words have consequences. –Try to predict how a particular announcement will be interpreted by investors and be ready to respond if they actually respond differently. –Don’t withhold info that will likely come out anyway. Do not discuss publicly information that should be kept private.

16. 16 Corporate “Communications” Policy Honesty is the Best Policy –Managers who convey good and bad information honestly and and who do not try to fool the market will be believed, while managers with reputations for deception will not be. Listen to Your Stock Price –Two types of information that markets convey to managers: (1) reactions to specific corporate announcements (2) movements in the firm’s stock price relative to the overall market over extended periods of time –Both types of information can be very informative to the manager.

17. Financial markets tend to be more efficient and competitive than product markets. Three forms of market efficiency: weak form, semi- strong form, strong form Empirical research found that major financial markets are weak-form and semistrong-form. Market efficiency research helps financial managers in formulating their communication policy. Market Efficiency