B. Event Studies
We have included an event study for Advanced Medical Optics, Inc. (formerly,
EYE) in the text. On Friday, May 25, 2007, executives of Advanced Medical
Optics Inc. recalled a contact lens solution called Complete MoisturePlus Multi
Purpose Solution. The company took this voluntary action after the Centers for
Disease Control and Prevention (CDC) found a link between the solution and a
rare cornea infection called acanthamoeba keratitis, or AK for short.
Executives at Advanced Medical Optics chose to recall their product even though
they did not find evidence their manufacturing process introduced the parasite
that can lead to AK.
Researchers use a technique known as an event study to test the effects of news
announcements on stock prices.
It has been our experience that students really like to get a glimpse of an “actual”
technique used by finance researchers. You will note that we strove to focus our
exposition on the reaction to the news, rather than the methods of event studies.
7.1 Informed Traders and Insider Trading
Recall that if a market is strong-form efficient, no information of any kind, public
or private, is useful in beating the market. However, inside information of many
types clearly would enable you to earn essentially unlimited returns. This fact
generates an interesting question: Should any of us be able to earn returns
based on information that is not known to the public?
In the United States (and in many other countries, though not all), making profits
on nonpublic information is illegal. This ban is said to be necessary if investors
are to have trust in U.S. stock markets. The United States Securities and
Exchange Commission (SEC) is charged with enforcing laws concerning illegal
trading activities.
As a result, we present the distinctions among informed traders, illegal insider
trading, and legal insider trading.
A. Informed Trading
When an investor makes a decision to buy or sell a stock based on publicly
available information and analysis, this investor is said to be an informed trader.
The information that an informed trader possesses might come from reading The
Wall Street Journal, reading quarterly reports issued by a company, gathering
Stock Price Behavior and Market Efficiency 7-2
financial information from the Internet, talking to other traders, or a host of other
sources.
Lecture Tip. You will notice that we do not talk about noise traders here. We left
them out here because the focus of this section is on information. Talking about
noise traders (and their lack of information) could deflect the discussion away
from information and the types of information-based trades.
B. Insider Trading
Illegal Insider Trading: For the purposes of defining illegal insider trading, an
insider is someone who possesses material nonpublic information. Such
information is both not known to the public and, if it were known, would impact
the stock price. A person can be charged with insider trading when he or she acts
on such information in an attempt to make a profit.
Legal “Insider Trading”: A company’s corporate insiders can make perfectly
legal trades in the stock of their company. To do so, they must comply with the
reporting rules made by the U.S. Securities and Exchange Commission. When
they make a trade and report it to the SEC, these trades are reported to the
public. In addition, corporate insiders must declare that trades that they made
were based on public information about the company, rather than “inside”
information. Most public companies also have guidelines that must be followed.
It’s Not a Good Thing: What did Martha Do? Martha Stewart was accused,
but not convicted, of insider trading. She was accused, and convicted, of
obstructing justice and lying to investigators.
7.2 How Efficient are Markets?
A. Are Financial Markets Efficient?
There are four reasons why market efficiency is difficult to test:
The risk-adjustment problem
The relevant information problem
The dumb luck problem
The data snooping problem
There are three generalities based on research that are relevant to market
efficiency:
Short-term stock price and market movements are very difficult to predict
with accuracy.
The market reacts quickly and sharply to new information. There is little
evidence that a market under (or over) reaction can be profitably
Stock Price Behavior and Market Efficiency 7-3
exploited.
If the stock market can be beaten, it is not obvious, so this implies that the
market is not grossly inefficient.
B. Some Implications of Market Efficiency
Even if all markets are efficient, asset allocation is still important because the
risk-return tradeoff still holds.
7.3 Market Efficiency and the Performance of Professional Money
Managers
There have been a number of studies that compare the performance of mutual
fund managers with market indexes. The results of almost every study indicate
that the market indexes outperform the mutual fund managers. This is further
evidence in favor of market efficiency. Mutual fund managers should be experts
in technical and fundamental analysis, and they should be able to use these tools
to earn excess returns, if anybody can.
Lecture Tip: An interesting study by Fortin and Michelson [Journal of Financial
Planning, February 1999] compares the performance of a large sample of mutual
funds categorized by investment objective, to their respective market indexes.
For example, growth funds were compared to the S&P 500, corporate bond
funds were compared to the Lehman Brothers Corporate Bond index,
international funds were compared to the Morgan Stanley EAFE index, and small
company equity funds were compared to the Wilshire 2000. This study found
that, on average, the benchmark indexes significantly outperformed the mutual
funds for all fund categories but one. The one category in which the funds
outperformed the index was small company equity funds. Apparently the fund
managers were able to exploit enough market inefficiencies in the small firm
equity market to allow excess returns to accrue.
7.4 Anomalies
In this section, several well-known market anomalies are discussed: the Day-of-
the-week effect; the amazing January effect (and two of its extensions), and;
Bubbles and Crashes (including the Market Crashes of 1929, 1987, and 2008;
the Asian Crash; and the “Dot-Com” Bubble and Crash).
A. The Day-of-the-Week Effect
Day-of-the-week effect: This is the term for the tendency for Monday to
have a negative average return.
Stock Price Behavior and Market Efficiency 7-4
Table 7.2 shows the day-of-the-week effect, which indicates that Monday is the
only day with a negative average return. Notice that Friday has a high positive
return. This effect is statistically significant, but it is difficult to exploit it to earn a
positive excess. About all we can do is use this in our trading decisions; purchase
a stock late on Monday and sell our stocks late on Friday.
B. The Amazing January Effect
January effect: This is the term for the tendency for small stocks to have
large returns in January.
Figures 7.9A and 7.9B show the results of the January effect. Small stocks tend
to have much higher returns in January, whereas larger stocks (S&P 500) do not
show this result. The bulk of the return occurs in the first few days of January.
The effect is more pronounced for stocks that have significant declines. This
effect exists in most major markets around the world. Two factors are important in
explaining the January effect: tax-loss selling and institutional investors
rebalancing their portfolios.
C. Turn-of-the-Year Effect
Researchers have delved deeply into the January effect to see whether the effect
is due to returns during the whole month of January or to returns bracketing the
end of the year. Table 7.4 shows our calculations concerning this effect. The
returns in the “Turn-of-the-Year Days” category are higher than returns in the
“Rest-of-the-Days” category. Further, the difference is apparent in the 1986-2012
period. However, the difference was more than twice as large in the 1962-1985
period.
D. Turn-of-the-Month Effect
Financial market researchers have also investigated whether a turn-of-the-month
effect exists. Table 7.5 shows the results of our calculations.
E. The Earnings Announcement Puzzle
Researchers have found that it takes days (or even longer) for a market price to
adjust fully to information about earnings surprises. In addition, some
researchers have found that buying stocks after positive earnings surprises is a
profitable investment strategy.
F. The Price-Earnings (P/E) Puzzle
The P/E ratio is widely followed by investors and is used in stock valuation.
Researchers have found that, on average, stocks with relatively low P/E ratios
outperform stocks with relatively high P/E ratios, even after adjusting for other
Stock Price Behavior and Market Efficiency 7-5
factors, like risk. Because a P/E ratio is publicly available information, it should
already be reflected by stock prices. However, purchasing stocks with relatively
low P/E ratios appears to be a potentially profitable investment strategy.
7.5 Bubbles and Crashes
A bubble occurs when market prices soar far in excess of what normal and
rational analysis would suggest. Investment bubbles eventually pop because
they are not based on fundamental values. When a bubble does pop, investors
find themselves holding assets with plummeting values.
A crash is a significant and sudden drop in market wide values. Crashes are
generally associated with a bubble. Typically, a bubble lasts much longer than a
crash. A bubble can form over weeks, months, or even years. Crashes, on the
other hand, are sudden, generally lasting less than a week. However, the
disastrous financial aftermath of a crash can last for years.
A. The Crash of 1929
Although the Crash of 1929 was a large decline, it pales with respect to the
ensuing bear market. As shown in Figure 7.11, the DJIA rebounded about 20
percent following the October 1929 crash. However, the DJIA then began a
protracted fall, reaching the bottom at 40.56 on July 8, 1932. This level
represents about a 90 percent decline from the record high level of 386.10 on
September 3, 1929. By the way, the DJIA did not surpass its previous high level
until November 24, 1954, more than 25 years later.
B. The Crash of October 1987
NYSE circuit breakers: This is the name for rules that kick in to slow
trading when the S&P declines by more than a preset amount in a trading
session. In fact, if the S&P declines far enough, trading will halt.
On October 19, 1987 (Black Monday) the Dow plummeted 500 points to 1,700,
with about $500 billion in losses that day. There are several explanations for what
happened:
Irrational investors bid up stock prices and the bubble popped.
Markets were volatile, the economy was shaky, and Congress was in
session considering anti-takeover legislation.
Program trading quickly created very large sell orders.
Stock Price Behavior and Market Efficiency 7-6
Interestingly, the market recovered very quickly. The market was up in 1987 and
the bull market continued for many years after the crash. As a result of the crash,
NYSE circuit breakers were introduced. These circuit breakers required trading
halts based upon 7, 13, and 20 percent declines in the DJIA. Recall we discuss
the “flash crash” in chapter 5, as well as the individual stock circuit breakers that
were instituted in response. The text in this chapter provides an article on Apple
triggering this constraint.
C. The Asian Crash
The crash of the Nikkei Index, which began in 1990, lengthened into a
particularly long bear market. It is quite like the Crash of 1929 in that respect. In
three years from December 1986 to the peak in December 1989, the Nikkei 225
Index rose 115 percent. Over the next three years, the index lost 57 percent of its
value. In April 2003, the Nikkei Index stood at a level that was 80 percent
off its peak in December 1989.
D. The “Dot-Com” Bubble and Crash
By the mid-1990s, the rise in Internet use and its international growth potential
fueled widespread excitement over the “new economy.” Investors did not seem to
care about solid business plans—only big ideas. Investor euphoria led to a surge
in Internet IPOs, which were commonly referred to as “dot-coms” because so
many of their names ended in “.com.” Of course, the lack of solid business
models doomed many of the newly formed companies. Many of them suffered
huge losses and some folded relatively shortly after their IPOs.
The Amex Internet Index soared from a level of 114.60 on October 1, 1998, to its
peak of 688.52 in late March 2000, an increase of about 500 percent. The Amex
Internet Index then fell to a level of 58.59 in early October 2002, a drop of about
91 percent. By contrast, the S&P 500 Index rallied about 31 percent in the same
1998–2000 time period and fell 40 percent during the 2000–2002 time period.
E. The Crash of October 2008
Although still under debate, many agree that one of the underlying causes of the
crash of 2008 was excess liquidity, which allowed unworthy borrowers to obtain
financing, primarily for mortgages. Moreover, much of this was done at low
“teaser rates.” When these rates reset, required payments increased, resulting in
bankruptcies for these so-called subprime loans. If house prices had continued to
climb, borrowers could have refinanced, avoiding trouble. However, this did not
happen.
7.6 Summary and Conclusions