Chapter 14
EFFICIENT CAPITAL MARKETS AND BEHAVIORAL
CHALLENGES
SLIDES
CHAPTER ORGANIZATION
14.1 Key Concepts and Skills
14.2 Chapter Outline
14.3 Can Financing Decisions Create Value?
14.4 Creating Value through Financing
14.5 A Description of Efficient Capital Markets
14.6 Foundations of Market Efficiency
14.7 Stock Price Reactions
14.8 Stock Price Reactions
14.9 The Different Types of Efficiency
14.10 Weak Form Market Efficiency
14.11 Why Technical Analysis Fails
14.12 Semistrong Form Market Efficiency
14.13 Strong Form Market Efficiency
14.14 Information Sets
14.15 What the EMH Does and Does NOT Say
14.16 The Evidence
14.17 Are Changes in Stock Prices Random?
14.18 What Pattern Do You See?
14.19 Event Studies
14.20 Event Studies
14.21 Event Studies: Dividend Omissions
14.22 Event Study Results
14.23 The Record of Mutual Funds
14.24 The Record of Mutual Funds
14.25 The Strong Form of the EMH
14.26 The Behavioral Challenge
14.27 Examples of Behavioral Biases
14.28 Independent Deviations from Rationality
14.29 Arbitrage
14.30 Empirical Challenges
14.31 Empirical Challenges
14.32 Reviewing the Differences
14.33 Implications for Corporate Finance
14.34 Implications for Corporate Finance
14.35 Why Doesn’t Everybody Believe?
14.36 Quick Quiz
14.1 Can Financing Decisions Create Value?
14.2 A Description of Efficient Capital Markets
Foundations of Market Efficiency
14.3 The Different Types of Efficiency
The Weak Form
The Semistrong and Strong Forms
Some Common Misconceptions about the Efficient Market Hypothesis
14.4 The Evidence
The Weak Form
The Semistrong Form
The Strong Form
14.5 The Behavioral Challenge to Market Efficiency
Rationality
Independent Deviations from Rationality
Arbitrage
14.6 Empirical Challenges to Market Efficiency
14.7 Reviewing the Differences
14.8 Implications for Corporate Finance
1. Accounting Choices, Financial Choices, and Market Efficiency
2. The Timing Decision
3. Speculation and Efficient Markets
4. Information in Market Prices
ANNOTATED CHAPTER OUTLINE
Slide 14.0 Chapter 14 Title Slide
Slide 14.1 Key Concepts and Skills
Slide 14.2 Chapter Outline
14.1. Can Financing Decisions Create Value?
We previously developed NPV as the proper way to evaluate
corporate finance decisions. The financing aspect of the business is
no different. For example, we can analyze the debt/equity mix
decision using the NPV criterion.
Slide 14.3 Can Financing Decisions Create Value?
It is important to note that the identification of positive NPV
projects is much more important in the overall value creation of the
firm; however, poor financing decisions can have severe
consequences. Good financing decisions may increase firm value,
but not to the extent as operational projects.
Financing value is primarily created by reducing costs and taking
advantage of subsidies (i.e., tax benefits).
Slide 14.4 Creating Value through Financing
14.2. A Description of Efficient Capital Markets
Efficient capital market – market in which current market prices
fully reflect available information. In such a market, it is not
possible to devise trading rules that consistently “beat the market”
after taking risk into account.
Efficient Markets Hypothesis (EMH) – modern U.S. stock markets are, in
general, efficient. An important implication of the EMH is that the
expected return on securities equals their risk-adjusted required
return.
Slide 14.5 A Description of Efficient Capital Markets
.A Foundations of Market Efficiency
Slide 14.6 Foundations of Market Efficiency
Rationality – all investors respond in a rationale way to new
information
Independent events – investor deviations are countervailing and
unrelated
Arbitrage– competition among investors (professionals) and traders makes a
market efficient.
Slide 14.7 –
Slide 14.8 Stock Price Reactions
Lecture Tip: Is the degree of market efficiency increasing? Consider the
following:
–Investors today have virtually instantaneous access to financial and
economic information at low (or no) cost. A few years ago, the
same information was available only to professional money
managers at high cost.
–The proportion of individuals owning stocks directly doubled between 1965
and 1990 and doubled again between 1990 and 1997.
–A substantial proportion of retail stock market trading is done online.
Virtually none was done online a few years ago.
What does all of this mean? An efficient market is one in which
information is quickly and costlessly disseminated to all
participants. And while we are not there yet, the advent of the
Internet has resulted in being closer to that ideal than we have
been previously. Some analysts believe that required returns have
fallen because the cost of obtaining information has dropped so
dramatically. This would lead to higher sustainable P/E ratios.
We cannot say for sure that markets are more efficient; that is an empirical
question. But, the changes in the last few years seem to be moving
us in that direction, assuming our theories of what makes a market
efficient are correct.
14.3. The Different Types of Efficiency
Slide 14.9 The Different Types of Efficiency
.A The Weak Form
Weak form efficiency – All historical market information, including prices and
volume, is included in the price. It says that you cannot
consistently earn excess returns by looking for patterns in past
price and volume information, such as is done by technical
analysts. Evidence suggests that markets are weak form efficient
based on the trading rules that we have been able to test.
Slide 14.10 Weak Form Market Efficiency
Slide 14.11 Why Technical Analysis Fails
.B The Semistrong and Strong Forms
Semistrong form efficiency – All public information is already
incorporated in the price. It says that you cannot consistently earn
excess returns using available information to do fundamental
analysis. Evidence is mixed, but suggests that it holds for widely
held firms.
Slide 14.12 Semistrong Form Market Efficiency
Strong form efficiency – All information, both public and private is
already incorporated in the price. Empirical evidence indicates that
this form of efficiency does NOT hold.
Slide 14.13 Stong Form Market Efficiency
Slide 14.14 Information Sets
Ethics Note: Insider trading is illegal, but the determination of what
constitutes insider trading is difficult. Rule 10B-5 of the Securities
Exchange Act of 1934 states: “It shall be unlawful for any person,
directly or indirectly, by use of any means or instrumentality of
interstate commerce, or of the mails, or of any facility on a
national securities exchange, (1) to employ any device, scheme, or
artifice to defraud, (2) to make any untrue statement of a material
fact or omit to state a material fact necessary in order to make the
statements made, in light of the circumstances under which they
were made, not misleading, (3) to engage in any act, practice, or
course of business which operates or would operate as a fraud or
deceit upon any person, in connection with the purchase or sale of
any security.”
Additionally, several court cases have sought to more clearly define insider
trading. For insider trading to exist, there must be a fiduciary
relationship between the parties. Actions of the inside trader do
not have to meet the legal requirements of fraud; they merely have
to have the appearance of acting as a fraud or deceit. Accidental
discovery does not constitute a fiduciary relationship.
The court decided in Chiarella v. United States that an employee of a
printing firm, who was requested to proofread proxies that
contained unannounced tender offers (and unnamed targets) was
not guilty of insider trading because the employee determined the
identity of the target through his own expertise.
Despite the passage of increasingly severe penalties for insider trading
(see the Insider Trading Sanctions Act of 1984 and the Insider
Trading and Securities Fraud Enforcement Act of 1988), the
evidence suggests that the practice persists in one form or another.
Evidence of this can be found in the high profile trial of Martha
Stewart. The gist of the case was that Martha’s friend and CEO of
Imclone told her that an important drug had not received approval
prior to the public announcement. Martha proceeded to sell her
stock in Imclone. Martha was not convicted of insider trading,
however. She was convicted of obstructing justice and received a
relatively light sentence of 5 months in prison, 5 months of house
arrest, and 2 years of probation.
.C Some Common Misconceptions about the Efficient Market
Hypothesis
Market efficiency does NOT imply that it does not make a difference how you
invest, since the risk/return trade-off still applies, but rather that
you cannot expect to consistently earn excess returns using costless
trading strategies.
Stock price fluctuations are evidence that the market is efficient since new
information is constantly arriving – prices that do not change are
evidence of inefficiency.
The EMH does not say prices are random. Rather, the influence of previously
unknown information causes randomness in price changes. As a
result, price changes cannot be predicted before they happen.
Slide 14.15 What the EMH Does and Does NOT Say
Lecture tip: Claims of superior performance in stock picking are very
common and often hard to verify. However, if markets are
semistrong form efficient, the ability to consistently earn excess
returns is unlikely. Discuss the following situation with students:
Suppose Mick Mannock runs the “High Flyers” Common Stock fund,
which is about as risky as the market. The fund has outperformed
the S&P 500 by 2 percent annually for the last four years, and as a
result, Mick has declared himself an “ace fund manager.” Is this
correct?
Assume that managers of other funds of equivalent risk have just matched
the market in terms of performance, and that the standard
deviation of excess returns has been about 6 percent over the last
four years. The t-stat for Mick’s performance is:
4/%6
%)0%2(
size sample
returns excess ofdeviation standard
return) excess average –return excess sMick’(
The t-stat is .67, which is much less than the 2.35 required at the 5 percent
level of significance. Therefore, Mick’s performance is not good
enough to be declared “superior” based on the distribution of
returns.
Ethics Note: Program trading is defined as automated trading generated by
computer algorithms designed to react rapidly to changes in
market prices. Program trading enables traders to quickly respond
to up or down market movements or to changes in price
relationships across markets, e.g., between spot prices and futures
prices. Therefore, program trading occurs more quickly than
traditional floor trading. It has been argued that it is unethical for
investment banking houses to operate automated trading programs
for their own accounts. One reason is that the bank may be trading
ahead of its customers when it uses the automated trading system.
If this trading affects prices, then the bank is not acting in the best
interest of its customers.
Program trading can affect market prices. For example, a large,
erroneously executed sell order (which was literally a clerical
error) on March 25, 1992, resulted in a 12-point loss in the DJIA
(a .31% drop in value at that time). This trade occurred during the
final minute of trading. Had the error occurred earlier in the day,
this action could have caused a much larger drop in market value.
Lecture Tip: Even the experts get confused about the meaning of capital
market efficiency. Consider the following quote from a column in
Forbes magazine: “Popular delusion three: Markets are efficient.
The efficient market [sic] hypothesis, or EMH, would do credit to
medieval alchemists and is about as scientific as their efforts to
turn base metals into gold.” The writer is definitely not a
proponent of EMH. Now consider this quote: “The truth is nobody
can consistently predict the ups and downs of the market.” This
statement is clearly consistent with the EMH. Ironically, the same
person wrote both statements in the same column with exactly nine
lines of type separating them.
14.4. The Evidence
For the most part, evidence is generally consistent with market
efficiency.
In studying efficiency, tests are typically of three types:
randomness, event studies, and the record of professional
managers.
Slide 14.16 The Evidence
.A The Weak Form
Reported serial correlation coefficients are quite small, which is
consistent with weak form efficiency.
Randomly generated prices present similar patterns to those found
using actual prices. In effect, it appears prices follow a random
walk
Slide 14.17 Are Changes in Stock Prices Random?
Slide 14.18 What Pattern Do You See?
.B The Semistrong Form
Event studies evaluate price changes around the announcement of
new information. If prices react quickly, the semistrong form
would appear to hold. For the most part, this is what we find. It
does appear, however, that news leaks early, leading to slight
changes prior to the actual announcement.
Slide 14.19 –
Slide 14.20 Event Studies
Slide 14.21 Event Studies: Dividend Omissions
Slide 14.22 Event Study Results
Another test of semistrong form efficiency involves analyzing the
performance of professional fund managers. This would be a group
of investors most likely to benefit from available information.
Evidence suggests that these fund managers, however,
underperform the broad market, which is consistent with
efficiency.
Slide 14.23 –
Slide 14.24 The Record of Mutual Funds
.C The Strong Form
The strong form suggests that insider trading would be
unprofitable; however, this is obviously untrue.
Slide 14.25 The Strong Form of the EMH
14.5. The Behavioral Challenge to Market Efficiency
Efficiency is built on investor rationality, independence, and
arbitrage; however, these may not hold in practice.
Slide 14.26 The Behavioral Challenge
.A Rationality
Behavioral finance suggests that investors deviate from rationality
in predictable ways. For example:
Overconfidence: for example, 80% of people consider
themselves an above average driver. In investing,
overconfidence generally leads to increased trading, which
often reduces performance.
Regret/Pride: the disposition effect denotes the impact of
pride and regret, as investors often sell winners too soon
(seeking pride) and keep losers too long (avoiding regret)
Familiarity: we tend to overestimate the value of things we
are familiar with (i.e., home bias)
Representativeness: we tend to draw conclusions from too
little data (overreaction)
Conservatism: we may be too slow to adjust beliefs to new
information (underreaction)
Risk taking following gains or losses: this is illustrated by
the house money effect (increase risk following gains) and
the snakebite effect (reducing risk following losses)
As such, efficiency may not hold. A primary example is
speculative bubbles.
Slide 14.27 Examples of Behavioral Biases
.B Independent Deviations from Rationality
For example, representativeness (overreaction) may lead to
bubbles in security prices, while conservatiism (underreaction)
may cause security prices to respond slowly to earnings surprises.
Slide 14.28 Independent Deviations from Rationality
.C Arbitrage
The process of arbitrage is straightforward: identify a mispricing
and trade to take advantage of it. The problem is that there is no
guarantee that markets correct themselves in a timely fashion.
There is a famous quote by legendary economist John Maynard
Keynes: “Markets can stay irrational longer than you can stay
solvent.”
Slide 14.29 Arbitrage
14.6. Empirical Challenges to Market Efficiency
Studies have found evidence inconsistent with efficiency. For
example, small stocks tend to outperform large stocks, and value
stocks tend to outperform growth stocks. Also, investors appear to
react slowly to earnings announcements. In addition, arbitrage has
transactional limits. Lastly, the existence of bubbles and crashes is
inconsistent with efficiency.
Slide 14.30 –
Slide 14.31 Empirical Challenges
14.7. Reviewing the Differences
It appears unlikely that the debate regarding the efficiency of
markets will be resolved any time soon.
Slide 14.32 Reviewing the Differences
14.8. Implications for Corporate Finance
Efficiency implies that investors should expect to receive a normal
return on their investments. As such, firms should expect to receive
the fair value (i.e., present value) for securities they issue.
Thus, it is unlikely that firms can fool investors or time the markets
when issuing securities.
Lecture Tip: It is also important to point out that in efficient
markets, positive NPV projects will be “few and far–between.”
Thus, if a project manager suggests a new product is value
creating, it must come from identifiable advantages.
Slide 14.33 –
Slide 14.34 Implications for Corporate Finance
.A 1. Accounting Choices, Financial Choices, and Market Efficiency
Early studies find that stock prices do not react to changes in
accounting methods, such as LIFO versus FIFO. These findings
are consistent with the semistrong form EMH and suggest that
“Gilding the lily” by restating financial performance in a
deceptively favorable light is unlikely to increase value unless it
can also decrease taxes, bankruptcy costs or agency costs.
However, a study by Sloan (1996) suggests that investors react
slowly to changes in accounting accruals.
.B 2. The Timing Decision
Studies find that firms that issue new equity have negative
abnormal returns in following years, and firms that repurchase
equity have positive abnormal returns in following years,
suggesting that managers “time” equity sales (repurchases)
correctly. If managers use information not publicly available to
time security sales, the evidence is consistent with the strong form.
.C 3. Speculation and Efficient Markets
Debt issuance, stock repurchases, and acquisition decisions are
often based on speculation surrounding the market value of such
securities. Evidence suggests that managers are poor market timers
and that they should stick to running their own firms and not trying
to time financial markets.
.D 4. Information in Market Prices
Markets are more objective participants than firm managers. As
such, managers should pay attention to market reactions associated
with corporate announcements.
Slide 14.35 Why Doesn’t Everybody Believe?
If information exists that suggests the market is efficient, why
don’t people believe:
-there is enough evidence to the contrary
-the truth is not as interesting
-there are enough apparent patterns to suggest otherwise
Slide 14.36 Quick Quiz