Chapter 7
Stock Price Behavior and Market
Efficiency
Slides:
7-1. Chapter 7
7-2. Stock Price Behavior and Market Efficiency
7-3. Learning Objectives
7-4. Controversy, Intrigue, and Confusion
7-5. Market Efficiency
7-6. What Does “Beat the Market” Mean?
7-7. Three Economic Forces that Can Lead to Market Efficiency
7-8. Forms of Market Efficiency, (i.e., what information is used?)
7-9. Information Sets for Market Efficiency
7-10. Why Would a Market be Efficient?
7-11. Some Implications of Market Efficiency: Does Old Information Help Predict
Future Stock Prices?
7-12. Some Implications of Market Efficiency: Random Walks and Stock Prices
7-13. Random Walks and Stock Prices, Illustrated
7-14. How New Information Gets into Stock Prices, I.
7-15. How New Information Gets into Stock Prices, II.
7-16. Event Studies, I.
7-17. Event Studies, II.
7-18. Event Studies, III.
7-19. Event Studies, IV.
7-20. Event Studies, V.
7-21. Event Studies, VI.
7-22. Event Studies, VII.
7-23. Informed Traders and Insider Trading, I.
7-24. Informed Traders and Insider Trading, II.
7-25. Informed Trading
7-26. Legal Insider Trading
7-27. Who is an “Insider”?
7-28. Illegal Insider Trading
7-29. It’s Not a Good Thing: What did Martha do? (Part 1)
7-30. It’s Not a Good Thing: What did Martha do? (Part 2)
7-31. Are Financial Markets Efficient (Part 1)?
7-32. Are Financial Markets Efficient (Part 2)?
7-33. Some Implications if Markets are Efficient
7-34. Market Efficiency and the Performance of Professional Money Managers, I.
7-35. Market Efficiency and the Performance of Professional Money Managers, II.
7-36. Market Efficiency and the Performance of Professional Money Managers, III.
7-37. Market Efficiency and the Performance of Professional Money Managers,
IV.
7-38. Market Efficiency and the Performance of Professional Money Managers, V.
7-39. Market Efficiency and the Performance of Professional Money Managers,
VI.
7-40. Market Efficiency and the Performance of Professional Money Managers,
VII.
7-41. Market Efficiency and the Performance of Professional Money Managers,
VIII.
Stock Price Behavior and Market Efficiency 7-2
7-42. Market Efficiency and the Performance of Professional Money Managers,
IX.
7-43. What is the Role for Portfolio Managers in an Efficient Market?
7-44. Anomalies
7-45. The Day-of-the-Week Effect: Mondays tend to have a Negative Average
Return
7-46. The Amazing January Effect, I.
7-47. The Amazing January Effect, II.
7-48. The Turn-of-the-Year Effect, I.
7-49. The Turn-of-the-Year Effect, II.
7-50. The Turn-of-the-Month Effect, I.
7-51. The Turn-of-the-Month Effect, II.
7-52. Bubbles and Crashes
7-53. The Crash of 1929
7-54. The Crash of 1929 — The Aftermath
7-55. The Crash of 1987
7-56. The Crash of 1987 and its Aftermath
7-57. Circuit Breakers
7-58. The Asian Crash
7-59. The Asian Crash — Aftermath
7-60. The “Dot-Com” Bubble and Crash, I.
7-61. The “Dot-Com” Bubble and Crash, II.
7-62. The Dow Jones Average, January 2008 through April 2010
7-63. The Crash of October 2008
7-64. Chapter Review, I.
7-65. Chapter Review, II.
Chapter Organization
7.1 Introduction to Market Efficiency
7.2 What does “Beat the Market” Mean?
7.3 Foundations of Market Efficiency
7.4 Forms of Market Efficiency
7.5 Why Would a Market Be Efficient?
7.6 Some Implications of Market Efficiency
A. Does Old Information Help Predict Future Stock Prices?
B. Random Walks and Stock Prices
C. How Does New Information Get into Stock Prices?
D. Event Studies
7.7 Informed Traders and Insider Trading
A. Informed Trading
B. Insider Trading
7.8 How Efficient are Markets?
A. Are Financial Markets Efficient?
B. Some Implications of Market Efficiency
7.9 Market Efficiency and the Performance of Professional Money
Managers
7.10 Anomalies
A. The Day-of-the-Week Effect
Stock Price Behavior and Market Efficiency 7-3
B. The Amazing January Effect
C. Turn-of-the-Year Effect
D. Turn-of-the-Month Effect
E. The Earnings Announcement Puzzle
F. The Price-Earnings (P/E) Puzzle
7.11 Bubbles and Crashes
A. The Crash of 1929
B. The Crash of October 1987
C. The Asian Crash
D. The “Dot-Com” Bubble and Crash
E. The Crash of October 2008
7.12 Summary and Conclusions
Selected Web Sites
www.e-m-h.org (for information on market efficiency)
www.zakon.org/robert/internet/timeline (documentation of the growth of the
internet)
Annotated Chapter Outline
7.1 Introduction to Market Efficiency
Market efficiency: Relation between stock prices and information
available to investors indicating whether it is possible to “beat the market;”
if a market is efficient, it is not possible except by luck.
Efficient market hypothesis (EMH): Theory asserting that, as a practical
matter, the major financial markets reflect all relevant information at a
given time.
The primary question is: Can you, or can anyone, consistently “beat the market?”
(Note that the duck on slide 7-5 is trying to “beat the market” with his hammer. In
PowerPoint 2007 and above, the duck is animated (This is the only animated
slide in the supplements). The duck attempts to beat the market, but fails. This is
intended to provide a bit of levity to the subject.)
7.2 What does “Beat the Market” Mean?
Abnormal return: A return in excess of that earned by other investments
having the same risk.
Stock Price Behavior and Market Efficiency 7-4
To judge if an investment “beat the market,” we need to know if the return was
high or low relative to the risk involved. We need to determine if the investment
has earned a positive abnormal return in order to say it “beat the market.”
7.3 Foundations of Market Efficiency
Three economic forces can lead to market efficiency. These conditions are so
powerful that any one of them can result in market efficiency.
These conditions are:
1. Investor Rationality. If every investor always made perfectly rational
investment decisions, earning an excess return would be difficult. If everyone is
fully rational, equivalent risk assets would all have the same expected returns.
Put differently, no bargains would be there to be had, because relative prices
would all be correct.
2. Independent Deviations from Rationality. Even if the investor rationality
condition does not hold, the market could still be efficient. Suppose that many
investors are irrational, and a company makes a relevant announcement about a
new product. Some investors will be overly optimistic, while some will be overly
pessimistic, but the net effect might be that these investors cancel each other
out. In a sense, the irrationality is just noise that is diversified away. As a result,
the market could still be efficient (or nearly efficient). What is important here is
that irrational investors do not have similar beliefs.
3. Arbitrage. Suppose there are many irrational traders and further suppose that
their collective irrationality does not balance out. In this case, observed market
prices can be too high or too low relative to their risk. Now suppose there are
some well-capitalized, intelligent, and rational investors. This group of traders
would see these high or low market prices as a profit opportunity and engage in
arbitrage—buying relatively inexpensive stocks and selling relatively expensive
stocks. If these rational arbitrage traders dominate irrational traders, the market
will still be efficient. We sometimes hear the expression “Market efficiency
doesn’t require that everybody be rational, just that somebody is.”
Lecture Tip. Students, like all of us, look at the world through their own
experiences. They have met some irrational people in their lives. It is easy for
them to think that these irrational people could be representative investors and
that market efficiency simply cannot hold because of investor irrationality.
Stock Price Behavior and Market Efficiency 7-5
7.4 Forms of Market Efficiency
Weak-form efficient market: A market in which past prices and volume
figures are of no use in beating the market.
Semistrong-form efficient market: A market in which publicly available
information is of no use in beating the market.
Strong-form efficient market: A market in which information of any kind,
public or private, is of no use in beating the market.
“A market is efficient with respect to some particular information if that
information is not useful in earning a positive abnormal return.” So, a market can
only be determined to be efficient with respect to specific information. The three
forms include:
Weak-form efficiency, with respect to information reflected in past price
and volume figures.
Semistrong-form efficiency, with respect to any publicly available
information.
Strong-form efficiency, with respect to any information, both public and
private.
To be clear, if the information allows an investor to earn abnormal returns on an
investment, the market is not efficient with respect to that information. Therefore,
if an investor uses past price information to earn an abnormal return, then the
market is not weak-form efficient. If an investor uses a firm’s financial statements
to earn an abnormal return, the market is not semistrong-form efficient. Finally, if
an investor uses inside information to earn an abnormal return, the market is not
strong-form efficient.
7.5 Why Would a Market Be Efficient?
The driving force toward market efficiency is simply competition and the profit
motive.
Consider a large mutual fund such as the Fidelity Magellan Fund (one of the
largest equity funds in the United States, with about $15 billion under
management). Suppose Fidelity was able, through its research, to improve the
performance of this fund by 20 basis points for one year only. How much would
this one-time 20-basis point improvement be worth?
Stock Price Behavior and Market Efficiency 7-6
The answer is 0.0020 times $15 billion, or $30 million. Thus, Fidelity would be
willing to spend up to $30 million to boost the performance of this one fund by as
little as one-fifth of 1 percent for a single year only.
This example shows that even relatively small performance enhancements are
worth tremendous amounts of money and thereby create the incentive to unearth
relevant information and use it.
7.6 Some Implications of Market Efficiency
If markets are efficient:
Security selection is less important; investors may as well hold index funds
to minimize their costs.
There is little need for professional money managers.
Investors should not try to time the market. (In fact, successful market
timing is very difficult to achieve, even ignoring market efficiency.)
Lecture Tip: It may be helpful to restate the implications of market efficiency with
respect to the forms of market efficiency, as follows:
Weak-form efficiency: If weak-form efficiency holds, then technical
analysis is of no use, and the efforts of technical analysts are of no benefit
to investors.
Semistrong-form efficiency: If semistrong-form efficiency holds, then
fundamental analysis using publicly available information is of no benefit,
and most of the financial analysts and mutual fund managers are not
providing any value.
Strong-form efficiency: If strong-form efficiency holds, then inside
information is of no value, suggesting that there should be no restrictions
on insider trading.
A. Does Old Information Help Predict Future Stock Prices?
In its weakest form, the efficient market hypothesis is the simple statement that
stock prices fully reflect all past information. If this is true, this means that
studying past price movements in the hopes of predicting future stock price
movements is really a waste of time.
Stock Price Behavior and Market Efficiency 7-7
There is also a very subtle prediction at work here. That is, no matter how often a
particular stock price path has related to subsequent stock price changes in the
past, there is no assurance that this relationship will occur again in the future.
Researchers have used sophisticated statistical techniques to test whether past
stock price movements are of any value in predicting future stock price
movements. This turns out to be a surprisingly difficult question to answer clearly
and without qualification. In short, although some researchers have been able to
show that future returns are partly predictable by past returns, the predicted
returns are not economically important, which means that predictability is not
sufficient to earn an abnormal return.
In addition, trading costs generally swamp attempts to build a profitable trading
system on the basis of past returns. Researchers have been unable to provide
evidence of a superior trading strategy that uses only past returns. That is,
trading costs matter, and buy-and-hold strategies involving broad market indexes
are extremely difficult to outperform.
B. Random Walks and Stock Prices
Ask your students whether stock market prices are predictable: many of them will
say yes. To their surprise, it is very difficult to predict stock market prices. In fact,
considerable research has shown that stock prices change through time as if
they are random. That is, stock price increases and decreases are equally likely.
When the path that a stock’s return follows shows no discernible pattern, then the
stock’s price behavior is largely consistent with the notion of a random walk. A
random walk is related to the weak-form version of the efficient market
hypothesis because past knowledge of the stock price is not useful in predicting
future stock prices.
We illustrate daily price changes for Intel stock in the text. These daily price
changes are not truly a random walk. To qualify as a true random walk, Intel
stock price changes would have to be independent and identically distributed.
Still, the graph of daily price changes for Intel stock is essentially what a random
walk looks like. It is certainly hard to see any pattern in these daily price changes.
C. How Does New Information Get into Stock Prices?
In its semistrong form, the efficient market hypothesis is the simple statement
that stock prices fully reflect publicly available information. Stock prices change
when traders buy and sell shares based on their view of the future prospects for
the stock. The future prospects for the stock are influenced by unexpected news
announcements. Prices can adjust to news announcements in three ways:
Stock Price Behavior and Market Efficiency 7-8
Efficient market reaction: The price instantaneously adjusts to, and
fully reflects, new information. There is no tendency for subsequent
increases or decreases to occur.
Delayed reaction: The price partially adjusts to the new information,
but days elapse before the price completely reflects new information.
Overreaction and correction: The price over-adjusts to the new
information; it overshoots the appropriate new price but eventually falls to the
new price.