6/1/2014 Market Efficiency 1 Market Efficiency and Information Processing in Financial Markets Andrei Simonov

04/10/23Market Efficiency1

Market Efficiency and Information Market Efficiency and Information Processing in Financial Markets Processing in Financial Markets

Andrei Simonov


OutlineOutlineEfficient Markets HypothesisPredicting future returns from the past returns

– Value strategies– Momentum Strategies

Analysts & Information dissemination


Do security prices reflect information ?Why look at market efficiency

– Implications for business and corporate financeMitigation of agency problems: market sees through

– Implications for investment Impossibility to ”beat the market”

Efficient Market Hypothesis Efficient Market Hypothesis (EMH)(EMH)


Random Walk - stock prices are random– Actually

submartingaleExpected price is

positive over timePositive trend and

random about the trend

Random Walk and the EMHRandom Walk and the EMH

Security Prices

Time


Why are price changes random?Prices react to informationFlow of information is randomTherefore, price changes are random

Random Price ChangesRandom Price Changes



Case study:Challenger DisasterCase study:Challenger Disaster

Jan 28, 1986 at 11:39 am Shuttle explodes on live TV

Four companies involved: Rockwell, Martin Marietta, Morton Thiokol and Lockheed. Trading is suspended for 90 min, companies are in ”no comments” mode.

Feb. 2nd: first mention of faulty seals Feb. 5th: First time MT is mentioned as prime

suspect March 31st: Problems with O-rings reported by

Fortune.


What happen on NYSE?What happen on NYSE?Variable MT Lockheed MM Rockwell

Ret(28.02) -11.86% -2.14 -3.25 -2.48

3mo mean 0.21% 0.07% 0.14% 0.06%

3mo StdDev 1.86% 1.36% 1.80% 1.80%

Daily Volume, Kshares

1740 668 446 563

3mo mean 100 350 200 221

3mo StdDev 60 160 137 117


Stock prices fully and accurately reflect publicly available information

Once information becomes available, market participants analyze it

Competition assures prices reflect informationGrossman-Stigliz ParadoxForms of EMH

EMH and CompetitionEMH and Competition

StrongAll

available info,Incl.

private

Semi-Strong

All publicInfo

WeakOld stock prices


Econometric tool to study EMHEconometric tool to study EMH

Event studyMeasure abnormal returnProblem: what is normal return?Problem: How to measure event date?


Example: Takeover premium before Example: Takeover premium before and after introduction of insider trading and after introduction of insider trading

laws (Bris, 2000)laws (Bris, 2000)

BP oil spill



Predicting from past returnsPredicting from past returns


Buying losers and selling winnersBuying losers and selling winners(1)(1)

• "Contrarian" strategy; the opposite is a "price-momentum" or "relative strength" strategy

de Bondt and Thaler (1986) considered all NYSE stock return data from 1926 to 1983. They measured cumulative abnormal returns over 36-month periods and identified the 35 best and worst performers which they called winners and losers. The diagram shows the performance of these stocks over the subsequent months.


Buying losers and selling winnersBuying losers and selling winners (2)(2)


Buying winners and selling loosersBuying winners and selling loosersShort-run momentum effect: Select 6mo past

winners/loosers and create 0-cost portfolio. Hold it for 3-6 mo.– Industry effect (Grinblatt/Moskowitz) – essentially

missed macroeconomic trend– Cross-sectional variability in stock returns (Caul&

Condrad, but rejected by Grundy&Martin)Money are lost in 261 out of 828 mo.Feasible only by institutions (high transaction

cost)


Earnings announcementsEarnings announcements

Bernard and Thomas (1989) and many others before them document that, subsequent to the announcement of earnings, the stock price continues to drift up for "good news" firms and down for "bad news" firms [Price/earnings momentum].

The enclosed figures are based on a sample of approximately 85,000 observations for NYSE and AMEX stocks over the 1974-1986 period.




Event driven investingEvent driven investing

Extension of the same idea to other events:– Analysts’ forecasts and revisions– Share buy backs– Dividend continuations or not– Etc..

In my opinion, most promising form of active (tactical) investing


NewslettersNewslettersfrom Graham and Harvey, from Graham and Harvey, FAJFAJ, , Nov/Dec 97Nov/Dec 97

As a group, newletters do not appear to possess any special information about the future direction of the market (see picture),

Nevertheless, investment newsletters that are on a hot streak (have correctly anticipated the direction of the market in previous recommendations) may provide valuable information about future returns.


Over the past decade, I have attempted to exploit many of the seemingly most promising ”inefficiences” by actually trading significant amount of money... Many of these effects are surprisingly strong in the reported empirical work, but I have never yet found one that worked in practice.

Richard Roll


How information is reflected in How information is reflected in prices?prices?

Via trading and price discovery Via public announcements Via investment research

– Analyzing analysts’ “Task Accuracy” just how good are analysts at what they do? we’ll examine estimates and recommendations

– Evaluating their Decision Making are they better at some things than others? why do they make the errors they make?

– Debiasing and Using Analyst Information we do get their info, how best can we use it?


What do (sell-side) What do (sell-side) security analysts security analysts dodo??

Tasks?– Estimate industry & company models & EPS

– Recommend the best securities

– Sell new securities to investors Ultimate Goal?

– Find the “right” price for MSFT or Amazon.com? Not a trivial task . . .

Incentives?– “On the folly of rewarding A, while hoping for B”


Task #1: forecasting EPSTask #1: forecasting EPS

EPS: a virtual sub-industry in investing– IBES, First Call, others

– A separate II All-American category: “EPS accuracy”

How good are analysts at forecasting EPS?

– An opinion: “somewhere between mediocre and bad”

– Dreman and Berry (1995):

off by more than 10% over 55% of the time


Dreman and Berry, FAJ, ‘95Dreman and Berry, FAJ, ‘95


… … and Montier (DKW)and Montier (DKW)


Task #1: forecasting EPS Task #1: forecasting EPS (cont.)(cont.)

Why “between mediocre and bad” ?– In spite of “help” from the companies– not yet adept at “Games Firms Play”

Incentives of firms “Earnings Manipulation to Exceed Thresholds”

Why?– A discretionary component in EPS?– Listening too carefully to the firms? Or not carefully

enough?– Missing the macro-economic trends! See Chopra (FAJ,

Nov/Dec ‘98) Great article!


Task #2: recommending stocksTask #2: recommending stocks

Predicting relative stock price performance is “hard”– Recommendations: a pure test of market “skill”

– “Efficient markets” argues against success

The Catch 22 of market efficiency– The markets need information “snoopers”

– Grossman and Stiglitz: An “equilibrium level of inefficiency” is needed in markets. The inefficiency is needed to pay the “snoopers”.


Do Brokerage Analysts’ Recommendations Have Do Brokerage Analysts’ Recommendations Have Investment Value?”, Womack, JF ‘96Investment Value?”, Womack, JF ‘96

Buy Recommendations

– Lots of them

– Do move stocks, about 3% on average

– Stocks continue to go up 4-6 more weeks

Sell Recommendations

– 1 for every 15 Buys

– Taken seriously, -5%

– Stocks drift lower for 6 more months, -9%

Ç Ç Ç Ç Ç Ç Ç

ÇÇ Ç Ç Ç Ç Ç

ÇÇ

ÇÇ

ÇÇ Ç

Ç

ÜÜ Ü Ü

ÜÜ Ü

Ü Ü

ÜÜ

Ü Ü ÜÜ

ÜÜÜ Ü

ÜÜ

Ü-6 -5 -4 -3 -2 -1 0

0.8

0.85

0.9

0.95

1

1.05

1.1

1.15

1.2

Pric

e R

elat

ive

to R

ecom

men

datio

n Ev

ent D

ate

Months Relative to Recommendation Event Date

ÇBuy Recs

ÜSell Recs

Months Relative to Removal from Rec.1 2 3 4 -4 -3 -2 -1 0 1 2 3 4


ÇÇ Ç Ç Ç Ç Ç

ÇÇ

ÇÇ

ÇÇ Ç

Ç

ÜÜ Ü Ü

ÜÜ Ü

Ü Ü

ÜÜ

Ü Ü ÜÜ

ÜÜÜ Ü

ÜÜ

Ü-6 -5 -4 -3 -2 -1 0

0.8

0.85

0.9

0.95

1

1.05

1.1

1.15

1.2

Pric

e R

elat

ive

to R

ecom

men

datio

n Ev

ent D

ate


ÇBuy Recs

ÜSell Recs



Do Brokerage Analysts’ Recommendations Have Do Brokerage Analysts’ Recommendations Have Investment Value?”, Womack, JF ‘96Investment Value?”, Womack, JF ‘96

Removals of Buy Recs– Analysts pick stocks that

have recently outperformed by 5%ish

– Stocks have negative abnormal returns for 3-4 months after removal

– Total underperformance of stocks after a “buy” removal: - 7%


ÇÇ Ç Ç Ç Ç Ç

ÇÇ

ÇÇ

ÇÇ Ç

Ç

ÜÜ Ü Ü

ÜÜ Ü

Ü Ü

ÜÜ

Ü Ü ÜÜ

ÜÜÜ Ü

ÜÜ

Ü-6 -5 -4 -3 -2 -1 0

0.8

0.85

0.9

0.95

1

1.05

1.1

1.15

1.2

Pric

e R

elat

ive

to R

ecom

men

datio

n Ev

ent D

ate


ÇBuy Recs

ÜSell Recs



ÇÇ Ç Ç Ç Ç Ç

ÇÇ

ÇÇ

ÇÇ Ç

Ç

ÜÜ Ü Ü

ÜÜ Ü

Ü Ü

ÜÜ

Ü Ü ÜÜ

ÜÜÜ Ü

ÜÜ

Ü-6 -5 -4 -3 -2 -1 0

0.8

0.85

0.9

0.95

1

1.05

1.1

1.15

1.2

Pric

e R

elat

ive

to R

ecom

men

datio

n Ev

ent D

ate


ÇBuy Recs

ÜSell Recs



Brokerage Analysts’ Recommendations, Brokerage Analysts’ Recommendations, Womack, JF ‘96Womack, JF ‘96

Other conclusions– Smaller stocks respond more, and drift more after

recommendations, too– Are the abnormal returns from “stock picking” or

“market timing”?

– Very substantial asymmetry between the value of 1) (the large amount of) positive new and 2) the small amount of negative news

When they say “sell” or “remove from buy”, watch out!


What are analysts good at?What are analysts good at?

A study of Womack:– Reasons analysts give for their

recommendations– Then, categorizing them into four or five

broad categories, then sub-categories– Two very common categories of reasons

“its really cheap” by relative or historical valuation standards

“something new is or will happen”, new news


““Can Investors Prophet from the Prophets?”Can Investors Prophet from the Prophets?” by by Barber, Lehavy, McNichols & Trueman ‘99Barber, Lehavy, McNichols & Trueman ‘99

In a non-event study context, they find that the consensus recommendation “average” has value

– Uses top and bottom quintiles of “averages”

– But, not if you wait 30 days to act on the “revisions”

– Therefore, the important finding of both studies: value of buy recs is gone in a month, but, value of negative recs lasts longer


Task #3: Selling new securitiesTask #3: Selling new securities

Underwriting transactions are highly profitable for firm and analyst– The changing role of security analysts in last

decade: they’re now the main “pitch” people

– Compensation to analyst for this is very big (double or triple the salary)

2nd year analyst at M.S offered $500K vs. corporate finance at $250K


““Why do firms switch underwriters?”Why do firms switch underwriters?”Krigman, Shaw, and Womack ‘99Krigman, Shaw, and Womack ‘99

Examined issuers switching to a new lead underwriter for second offering (30% of second-time issuers)– Conducted a survey of switching CFOs– Analyzed other empirical data for switchers vs.

non-switchers “Research coverage” and “influential analyst”

were top reasons to switch– Along with “trade up” to higher reputation


““Conflicts of Interest and the Credibility of Conflicts of Interest and the Credibility of Underwriter Analyst Recommendations”, Michaely Underwriter Analyst Recommendations”, Michaely and Womack, RFS ‘99and Womack, RFS ‘99

Are analysts “truth telling” or “rent seeking”?– MW examine recommendations by the lead

underwriter vs. all other analysts during the first year after the IPO

Their behavior is quite “suspicious”– underwriters’ recommendations are often called

“booster shots” are more likely to be made by underwriter when stock

is doing poorly; not so for non-underwriters!


-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12

Months (Before) / After Buy Recommendation

Buy Recommendations by Non-Underwriters N=102

All Buy Recommendations N=214

Buy Recommendations byUnderwriters N=112

3-Day Event Return: +2.7% (Underwriters) vs. +4.4% (Non-Underwriters)

Michaely and Womack (1999) "Conficts of Interest . . . ", forthcoming, RFS

Figure 1: Cumulative Mean Size-Adjusted Event Return for Firms Receiving New Buy Recommendations within One Year of their IPO, Conditional Upon the Source of Recommendation


Underwriters’ Conflicts of Interest: Underwriters’ Conflicts of Interest: Does the market “Does the market “understand understand ”?”?

Investors do discount the initial info in the underwriter’s buy recommendation– But, stock still goes up +2.7% (vs. +4.4%)

On average, stocks recommended by non-underwriters increase 13% in next six months, market adjusted– But, for underwriters’, stocks decrease 5%!

Interestingly, most brokerage firms’ analysts do better on “other people’s stocks”– For 12 of the 14 large firms, their recs on their own

underwritings do worse than their recs on others’ !


-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0 3 6 9 12 15 18 21 24 27 30

Months after IPO

Firms withRecommendations by Non-Underwriters Only N=44

Firms withRecommendations by bothUnderwriters and Non-Underwriters N=41

All Firms conducting IPOs(overall average) N=391

Firms with NoRecommendations N=191

Firms withRecommendations byUnderwriters Only N=63

IPO First Day Return

Michaely and Womack (1999) "Conficts of Interest . . . ", forthcoming, RFS

Figure 2 : Cumulative Mean Buy-and-Hold Size-Adjusted Return for Companies Conducting Initial Public Offerings in 1990-1991 Conditional Upon Source of Brokerage Recommendations. Cumulative Return begins at the IPO Price.


Scandals:Scandals:

Spinning: Allocating hot IPOs to the personal brokerage accounts of top executives in return for company business Global settlement bans spinning by major underwriters

Laddering: Requiring the purchase of additional shares in the aftermarket in return for IPOs

Analyst conflicts of interest: Giving “buy” recommendations in return for underwriting and M&A business

Commission business in return for IPOs: Underwriters allocated IPOs primarily to investors that generated a lot of commissions on other trades



Conflicts of Interest Case: Lehman Conflicts of Interest Case: Lehman Brothers and RealNetworksBrothers and RealNetworks

07/11/2000

Stock drops from $52 to $38 in 10 days. Analyst issues report calming investors and reiterating the strong buy

07/18/2000

Stock bounces back. Analyst sends a message to one investor saying “RNWK has to be a short big time”. He explains its inconsistency regarding public reports: “We bank these guys”

07/19/2000

One day later, analyst issues report describing quarter results as “stellar” and reiterating strong buy

Lehman co-managed SEO for RealNetworks in June 1999 and kept a strong buy on the stock until June 2001

Source: Global Settlement Letter of AWC for Lehman Brothersdays (Jun/2000-Jun/2001)

Jan/2001

Stock is already at $9. Analyst explains privately to an investor that RNWK “is a short”, but does not changeits strong buy rating

9


Where were regulators?Where were regulators?


Survey of IPO InvestorsSurvey of IPO Investors

“Do you think that investors expect reputable underwriters to take some account of true investment value in deciding the offering price in an IPO, rather than just the price the market will bear on the day of the offering?”

84% agree


Survey of IPO InvestorsSurvey of IPO Investors

Have you done any calculations of what the true fundamental value of a share in the company was, and compared the price of a share with this value?– 80% no.


Is underwriter bias intentional?Is underwriter bias intentional?

Analysts are conflicted between two goals: their long-term reputation (“truth telling”) and profit generation for their firm– Survey results suggest “intentional”

Kahneman and Lovallo, MS, ‘93– The “inside view” vs. “the outside view”

a very important behavioral concept The most important issue w.r.t. analysts


Other possible conflicts & Other possible conflicts & problemsproblemsBetween sell-side and proprietary trading

sideAnalysts invests their own moneyOther pressure from the managementHerding

– Follow the crowd– Career concern


Using analyst information: conclusionsUsing analyst information: conclusions

The “on average” value of analysts’ info is short-lived and only modestly positive– especially for the positive news

My rules-of-thumb:– When hearing a new recommendation:

“Is the analyst’s firm the investment banker? “What in this is out of consensus?” “Is is a “news” or “valuation” story?

– When hearing a negative report:“It’s probably true.”

Documents

6/1/2014 Market Efficiency 1 Market Efficiency and Information Processing in Financial Markets Andrei Simonov