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2009 McGraw 2009 McGraw--Hill RyersonHill RyersonLimitedLimited

88--11

Chapter 8Chapter 8Stock PriceStock Price

Behavior andBehavior and

MarketMarketEfficiencyEfficiency

Prepared byPrepared by

AyAye Ye Ycece

Ryerson UniversityRyerson University

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Stock Price BehaviourStock Price Behaviour

A market is the combined behavior of thousands ofA market is the combined behavior of thousands ofpeople responding to information, misinformation,people responding to information, misinformation,and whim.and whim.

Kenneth ChangKenneth Chang

If you want to know what's happening in the market,If you want to know what's happening in the market,ask the market.ask the market.

Japanese ProverbJapanese Proverb

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Chapter eight outlineChapter eight outline

Introductions to MarketIntroductions to Market EfficiencyEfficiency

What doesWhat does it mean to Beatit mean to Beat the Marketthe Market??

Foundations of Market EfficiencyFoundations of Market Efficiency

Forms of Market EfficiencyForms of Market Efficiency

Why would be a Market be Efficient?Why would be a Market be Efficient?

Some Implications of Market EfficiencySome Implications of Market Efficiency

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Chapter eight outlineChapter eight outline

Informed Traders and Inside TradingInformed Traders and Inside Trading

How Efficient are Markets?How Efficient are Markets?

Market Efficiency and the Performance ofMarket Efficiency and the Performance of

Professional Money ManagersProfessional Money Managers

AnomaliesAnomalies

Bubbles and CrashesBubbles and Crashes

Tests of Different Types of MarketTests of Different Types of MarketEfficiencyEfficiency

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Controversy, Intrigue, and ConfusionControversy, Intrigue, and Confusion

We begin by asking a basic question: Can you, as an investor,We begin by asking a basic question: Can you, as an investor,consistently beat the market?consistently beat the market?

It may surprise you to learn that evidence strongly suggests thatIt may surprise you to learn that evidence strongly suggests that

the answer to this question is probably not.the answer to this question is probably not.

We show that even professional money managers have troubleWe show that even professional money managers have trouble

beating the market.beating the market.

At the end of the chapter, we describe some market phenomenaAt the end of the chapter, we describe some market phenomena

that sound more like carnival side shows, such as the amazingthat sound more like carnival side shows, such as the amazing

January effect.January effect.

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Market EfficiencyMarket Efficiency

TheThe Efficient market hypothesis (EMH)Efficient market hypothesis (EMH) is a theoryis a theory

that asserts: As a practical matter, the major financialthat asserts: As a practical matter, the major financial

markets reflectmarkets reflect all relevant informationall relevant information at a givenat a given

time.time.

Market efficiencyMarket efficiency researchresearch examines the relationshipexamines the relationship

between stock prices and available information.between stock prices and available information.

The important researchThe important research questionquestion:: is it possible for investors tois it possible for investors to

beat the market?beat the market? Prediction of the EMH theory: if a market is efficient, it is notPrediction of the EMH theory: if a market is efficient, it is not

possible to beat the market (except by luck).possible to beat the market (except by luck).

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What Does Beat the MarketWhat Does Beat the Market

Mean?Mean?

TheThe excess returnexcess return on an investment is theon an investment is the

return in excess of that earned by otherreturn in excess of that earned by otherinvestments that have the same risk.investments that have the same risk.

Beating the marketBeating the market means consistentlymeans consistentlyearning aearning a positive excess returnpositive excess return..

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Three Economic Forces that CanThree Economic Forces that Can

Lead to Market EfficiencyLead to Market Efficiency

Investors use their information in a rational manner.Investors use their information in a rational manner. Rational investors do not systematically overvalue orRational investors do not systematically overvalue or

undervalue financial assets.undervalue financial assets.

If every investor always makes perfectly rational investmentIf every investor always makes perfectly rational investment

decisions, it would be very difficult to earn an excess return.decisions, it would be very difficult to earn an excess return.

There are independent deviations from rationality.There are independent deviations from rationality. Suppose that many investors are irrational.Suppose that many investors are irrational.

The net effect might be that these investors cancel each otherThe net effect might be that these investors cancel each otherout.out.

So, irrationality is just noise that is diversified away.So, irrationality is just noise that is diversified away.

What is important here is that irrational investors have differentWhat is important here is that irrational investors have differentbeliefs.beliefs.

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Three Economic Forces that CanThree Economic Forces that Can

Lead to Market EfficiencyLead to Market Efficiency

Arbitrageurs exist.Arbitrageurs exist. Suppose collective irrationality does not balance out.Suppose collective irrationality does not balance out.

Suppose there are some wellSuppose there are some well--capitalized, intelligent, andcapitalized, intelligent, andrational investors.rational investors.

If rational traders dominate irrational traders, the market willIf rational traders dominate irrational traders, the market willstill be efficient.still be efficient.

These conditions are so powerful that any one of them leads to efficiency.

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Forms of Market Efficiency,Forms of Market Efficiency,

AA WeakWeak--form Efficient Marketform Efficient Market is one in which past pricesis one in which past pricesand volume figures are of no use in beating the market.and volume figures are of no use in beating the market.

IfIf true,true, then technical analysis is of little use.then technical analysis is of little use.

AA SemistrongSemistrong--form Efficient Marketform Efficient Market is one in whichis one in whichpublicly available information is of no use in beating thepublicly available information is of no use in beating themarket.market.

IfIf true,true, then fundamental analysis is of little use.then fundamental analysis is of little use.

AA StrongStrong--form Efficient Marketform Efficient Market is one in whichis one in whichinformation of any kind, public or private, is of no use ininformation of any kind, public or private, is of no use in

beating the market.beating the market.

IfIf true,true, then inside information is of little use.then inside information is of little use.

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Information Sets for MarketInformation Sets for Market

EfficiencyEfficiencyFigure 8.1

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Why Would a Market be Efficient?Why Would a Market be Efficient?

The driving force toward market efficiency isThe driving force toward market efficiency issimply competition and the profit motive.simply competition and the profit motive.

Even a relatively small performanceEven a relatively small performanceenhancement can be worth a tremendousenhancement can be worth a tremendousamount of money (when multiplied by theamount of money (when multiplied by thedollar amount involved).dollar amount involved).

This creates incentives to unearth relevantThis creates incentives to unearth relevantinformation and use it.information and use it.

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Does Old Information Help Predict FutureDoes Old Information Help Predict Future

Stock Prices?Stock Prices? T

his is a surprisingly difficult question to answerT

his is a surprisingly difficult question to answerclearly.clearly.

Researchers have used sophisticated techniques toResearchers have used sophisticated techniques totest whether past stock price movements help predicttest whether past stock price movements help predictfuture stock price movements.future stock price movements.

Some researchers have been able to show that future returns are partlySome researchers have been able to show that future returns are partlypredictable by past returns. BUT: there is not enough predictability topredictable by past returns. BUT: there is not enough predictability toearn an excess return.earn an excess return.

Also, trading costs swamp attempts to build a profitable trading systemAlso, trading costs swamp attempts to build a profitable trading systembuilt on past returns.built on past returns.

Result: buyResult: buy--andand--hold strategies involving broad market indexes arehold strategies involving broad market indexes areextremely difficult to outperform.extremely difficult to outperform.

Technical Analysis implication: No matter how often a particular stockprice path has related to subsequent stock price changes in the past,there is no assurance that this relationship will occur again in the future.

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Random Walks and Stock PricesRandom Walks and Stock Prices If you were to ask people you know whether stock marketIf you were to ask people you know whether stock market

prices are predictable, many of them would say yes.prices are predictable, many of them would say yes.

To their surprise, and perhaps yours, it is very difficult toTo their surprise, and perhaps yours, it is very difficult topredict stock market prices.predict stock market prices.

In fact, considerable research has shown that stock pricesIn fact, considerable research has shown that stock priceschange through time as if they are random.change through time as if they are random.

That is, stock price increases are about as likely as stock priceThat is, stock price increases are about as likely as stock price

decreases.decreases.

When there is no discernable pattern to the path that a stockWhen there is no discernable pattern to the path that a stockprice follows, then the stocks priceprice follows, then the stocks price behaviourbehaviour is largelyis largelyconsistent with the notion of aconsistent with the notion of a random walk.random walk.

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Random Walks and Stock Prices,Random Walks and Stock Prices,

Figure 8.2

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How New Information Gets into Stock PricesHow New Information Gets into Stock Prices

In its semiIn its semi--strong form, the EMH states simply that stockstrong form, the EMH states simply that stockprices fully reflect publicly available information.prices fully reflect publicly available information.

Stock prices change when traders buy and sell shares based onStock prices change when traders buy and sell shares based ontheir view of the future prospects for the stock.their view of the future prospects for the stock.

But, the future prospects for the stock are influenced byBut, the future prospects for the stock are influenced byunexpected news announcements.unexpected news announcements.

Prices could adjust to unexpected news in three basic ways:Prices could adjust to unexpected news in three basic ways: Efficient Market ReactionEfficient Market Reaction: The price instantaneously adjusts to the: The price instantaneously adjusts to the

new information.new information. Delayed ReactionDelayed Reaction: The price partially adjusts to the new information.: The price partially adjusts to the new information.

Overreaction and CorrectionOverreaction and Correction: The price over: The price over--adjusts to the newadjusts to the newinformation, but eventually falls to the appropriate price.information, but eventually falls to the appropriate price.

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How New Information Gets into Stock PricesHow New Information Gets into Stock Prices

Figure 8.3

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Event StudiesEvent Studies Researchers have examined the effects of many typesResearchers have examined the effects of many types

of news announcements on stock prices.of news announcements on stock prices.

Such researchers are interested in:Such researchers are interested in: The adjustment process itselfThe adjustment process itself

T

he size of the stock price reaction to a newsT

he size of the stock price reaction to a newsannouncement.announcement.

To test for the effects of new information on stockTo test for the effects of new information on stockprices, researchers use an approach called anprices, researchers use an approach called an eventevent

studystudy..

Let us look at how researchers use this method.WeLet us look at how researchers use this method.Wewill use a dramatic example.will use a dramatic example.

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Event StudiesEvent Studies On Friday, February 25, 2005, executives of Elan CorporationOn Friday, February 25, 2005, executives of Elan Corporation

announced that the company was voluntarily halting theannounced that the company was voluntarily halting thesupply and marketing of a drug used to treat multiple sclerosis.supply and marketing of a drug used to treat multiple sclerosis.

In addition, the company advised doctors to stop prescribingIn addition, the company advised doctors to stop prescribing

the drug.the drug.

Even though the drug had approval from the U.S. Food andEven though the drug had approval from the U.S. Food and

Drug Administration, executives of Elan Corporation felt thatDrug Administration, executives of Elan Corporation felt that

potentially serious side effects of the drug meant that sales ofpotentially serious side effects of the drug meant that sales of

the drug should be suspended.the drug should be suspended.

On Monday, February 28, 2005, Elan shares plummetedOn Monday, February 28, 2005, Elan shares plummeted

$18.10, or more than 69 percent, to $8.00.$18.10, or more than 69 percent, to $8.00.

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Event StudiesEvent Studies

Figure 8.4

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Researchers then align the abnormal return on a stockResearchers then align the abnormal return on a stock

to the days relative to the news announcement.to the days relative to the news announcement.

Researchers usually assign the value of zero to the day aResearchers usually assign the value of zero to the day a

news announcement is made.news announcement is made. One day after the news announcement is assigned a valueOne day after the news announcement is assigned a value

of +1.of +1.

Two days after the news announcement is assigned a valueTwo days after the news announcement is assigned a value

of +2, and so on.of +2, and so on. Similarly, one day before the news announcement isSimilarly, one day before the news announcement is

assigned the value ofassigned the value of --1.1.

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Event StudiesEvent Studies According to the EMH, the abnormal return today should onlyAccording to the EMH, the abnormal return today should only

relate to information released on that day.relate to information released on that day.

To evaluate abnormal returns, researchers usually accumulateTo evaluate abnormal returns, researchers usually accumulate

them over a 60 or 80them over a 60 or 80--day period.day period.

Figure 7.5 contains a plot of cumulative abnormal returns forFigure 7.5 contains a plot of cumulative abnormal returns for

Elan beginning 40 days before the announcement.Elan beginning 40 days before the announcement.

The first cumulative abnormal return, or CAR, is just equal to theThe first cumulative abnormal return, or CAR, is just equal to the

abnormal return on dayabnormal return on day --40.40.

The CAR on dayThe CAR on day --39 is the sum of the first two abnormal returns.39 is the sum of the first two abnormal returns.

The CAR on dayThe CAR on day --38 is the sum of the first three, and so on.38 is the sum of the first three, and so on.

By examining CARs, we can see if there was overBy examining CARs, we can see if there was over-- or underor under--reaction toreaction to

an announcement.an announcement.

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Event StudiesEvent StudiesFigure 8.5

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As you can see in Figure 7.5, Elans cumulative abnormalAs you can see in Figure 7.5, Elans cumulative abnormalreturn hovered around zero before the announcement.return hovered around zero before the announcement.

After the news was released, there was a large, sharpAfter the news was released, there was a large, sharp

downward movement in the CAR.downward movement in the CAR.

The overall pattern of cumulative abnormal returns isThe overall pattern of cumulative abnormal returns is

essentially what the EMH would predict.essentially what the EMH would predict.

That is:That is: There is a flat area of cumulative abnormal returnsThere is a flat area of cumulative abnormal returns

A sharp break in cumulative abnormal returns, andA sharp break in cumulative abnormal returns, and

Another flat area of cumulative abnormal returns.Another flat area of cumulative abnormal returns.

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Informed Traders and InsiderInformed Traders and Insider

TradingTrading If a market is strongIf a market is strong--form efficient, no informationform efficient, no information

of any kind, public or private, is useful in beating theof any kind, public or private, is useful in beating the

market.market.

But, it is clear that significant inside informationBut, it is clear that significant inside information

would enable you to earn substantial excess returns.would enable you to earn substantial excess returns.

This fact generates an interesting question:This fact generates an interesting question: ShouldShould

any of us be able to earn returns based onany of us be able to earn returns based on

information that is not known to the public?information that is not known to the public?

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Informed Traders and Insider TradingInformed Traders and Insider Trading

It is illegal to make profits onIt is illegal to make profits on material nonmaterial non--publicpublic

information.information.

It is argued that this ban is necessary if investors are toIt is argued that this ban is necessary if investors are to

have trust in stock markets.have trust in stock markets. Securities exchange commissions enforce laws concerningSecurities exchange commissions enforce laws concerning

illegal trading activities.illegal trading activities.

It is important to be able to distinguish between:It is important to be able to distinguish between: Informed tradingInformed trading

Legal insider tradingLegal insider trading

Illegal insider tradingIllegal insider trading

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Mosaic TheoryMosaic Theory

TheThe information that an informed trader possessesinformation that an informed trader possessesmight come from:might come from:

Reading journalsReading journals

Reading quarterly reports issued by a companyReading quarterly reports issued by a company

Gathering financial information from the InternetGathering financial information from the Internet

Talking to otherTalking to other investorsinvestors

Talking to customersTalking to customers

Visiting plantsVisiting plants

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Legal Insider TradingLegal Insider Trading

Some informed traders are alsoSome informed traders are also insider tradersinsider traders..

When you hear the termWhen you hear the term insiderinsider tradingtrading,, you mostyou most

likely think that such activity is illegal.likely think that such activity is illegal.

But, not all insider trading is illegal.But, not all insider trading is illegal.

CCompany insiders can make perfectly legal trades in the stock of theirompany insiders can make perfectly legal trades in the stock of theircompany.company.

They must comply with the reporting rules made by the SEC.They must comply with the reporting rules made by the SEC. When company insiders make a trade and report it to the SEC, these trades areWhen company insiders make a trade and report it to the SEC, these trades are

reported to the public by the SEC.reported to the public by the SEC.

In addition, corporate insiders must declare that trades that they made wereIn addition, corporate insiders must declare that trades that they made were

based on public information about the company, rather than insidebased on public information about the company, rather than inside

information.information.

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Who is an Insider?Who is an Insider?

For the purposes of definingFor the purposes of defining illegal insider tradingillegal insider trading, an, aninsider is someone who hasinsider is someone who has materialmaterial nonnon--publicpublic

informationinformation..

Such information is both not known to the public and,Such information is both not known to the public and,

if it were known, would impact the stock price.if it were known, would impact the stock price.

A person can be charged with insider trading when heA person can be charged with insider trading when heor she acts on such information in an attempt to makeor she acts on such information in an attempt to make

a profit.a profit.

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Illegal Insider TradingIllegal Insider Trading

When an illegal insider trade occurs, there is aWhen an illegal insider trade occurs, there is a tippertipperand aand a tippeetippee.. The tipper is the person who has purposely divulged material nonThe tipper is the person who has purposely divulged material non--public information.public information.

The tippee is the person who has knowingly used such information in an attempt to profit.The tippee is the person who has knowingly used such information in an attempt to profit.

It is difficult to prove that a trader is truly a tippee.It is difficult to prove that a trader is truly a tippee.

It is difficult to keep track of insider information flows and subsequentIt is difficult to keep track of insider information flows and subsequenttrades.trades. Suppose a person makes a trade based on the advice of a stockbroker.Suppose a person makes a trade based on the advice of a stockbroker.

Even if the broker based this advice on material nonEven if the broker based this advice on material non--public information, the trader mightpublic information, the trader mightnot have been aware of the brokers knowledge.not have been aware of the brokers knowledge.

It must be proved that the trader was, in fact, aware that the brokers information wasIt must be proved that the trader was, in fact, aware that the brokers information wasbased on material nonbased on material non--public information.public information.

Sometimes, people accused of insider trading claim that they justSometimes, people accused of insider trading claim that they justoverheard someone talking.overheard someone talking.

Be aware:When you take possession of material nonBe aware:When you take possession of material non--public information,public information,you become an insider, and are bound to obey insider trading laws.you become an insider, and are bound to obey insider trading laws.

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Its Not a Good Thing: What did Martha do?Its Not a Good Thing: What did Martha do?

The SEC believed that Ms. Stewart was told by her friend, Sam Waksal,The SEC believed that Ms. Stewart was told by her friend, Sam Waksal,who founded a company called ImClone, that a cancer drug beingwho founded a company called ImClone, that a cancer drug beingdeveloped by ImClone had been rejected by the Food and Drugdeveloped by ImClone had been rejected by the Food and DrugAdministration.Administration.

This development would be bad news for ImClone shares.This development would be bad news for ImClone shares.

Martha Stewart sold her 3,928 shares in ImClone onMartha Stewart sold her 3,928 shares in ImClone on December 27, 2001December 27, 2001.. On that day, ImClone traded below $60 per share, a level that Ms. StewartOn that day, ImClone traded below $60 per share, a level that Ms. Stewart

claimed triggered an existing stopclaimed triggered an existing stop--loss order.loss order.

However, the SEC believed that Ms. Stewart illegally sold her shares becauseHowever, the SEC believed that Ms. Stewart illegally sold her shares becauseshe had information concerning FDA rejection before it became public.she had information concerning FDA rejection before it became public.

The FDA rejection was announced after the market closed on Friday,The FDA rejection was announced after the market closed on Friday,December 28, 2001December 28, 2001..

This news was a huge blow to ImClone shares, which closed at about $46This news was a huge blow to ImClone shares, which closed at about $46per share on the following Monday (the first trading day after theper share on the following Monday (the first trading day after theinformation became public).information became public).

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Its Not a Good Thing: What did Martha do?Its Not a Good Thing: What did Martha do? In June 2003, Ms. Stewart and her stock broker, Peter Bacanovic, wereIn June 2003, Ms. Stewart and her stock broker, Peter Bacanovic, were

indicted on nine federal counts. They both plead not guilty.indicted on nine federal counts. They both plead not guilty.

Ms. Stewarts trial began in January 2004.Ms. Stewarts trial began in January 2004.

Just days before the jury began to deliberate, however, Judge MiriamJust days before the jury began to deliberate, however, Judge MiriamCedarbaum dismissed the most serious charge of securities fraud.Cedarbaum dismissed the most serious charge of securities fraud.

Ms. Stewart, however, was convicted on all four counts of obstructingMs. Stewart, however, was convicted on all four counts of obstructingjustice.justice. Judge Cedarbaum fined Ms. Stewart $30,000 and sentenced her to five monthsJudge Cedarbaum fined Ms. Stewart $30,000 and sentenced her to five months

in prison, two years of probation, and five months of home confinement.in prison, two years of probation, and five months of home confinement.

The fine was the maximum allowed under federal rules while the sentence wasThe fine was the maximum allowed under federal rules while the sentence wasthe minimum the judge could impose.the minimum the judge could impose.

Peter Bacanovic, Ms. Stewart's broker, was fined $4,000 and was sentenced toPeter Bacanovic, Ms. Stewart's broker, was fined $4,000 and was sentenced tofive months in prison and two years of probation.five months in prison and two years of probation.

So, to summarize:

Martha Stewart was accused, but not convicted, of insider trading.

Martha Stewart was accused, and convicted, of obstructing justice.

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Are Financial Markets Efficient?Are Financial Markets Efficient? Financial markets are the most extensively documented of allFinancial markets are the most extensively documented of all

human endeavors.human endeavors.

Colossal amounts of financial market data are collected andColossal amounts of financial market data are collected andreported every day.reported every day.

These data, particularly stock market data, have beenThese data, particularly stock market data, have beenexhaustively analyzed to test market efficiency.exhaustively analyzed to test market efficiency.

But, market efficiency is difficult to test for these four basicBut, market efficiency is difficult to test for these four basic

reasons:reasons: The riskThe risk--adjustment problemadjustment problem

The relevant information problemThe relevant information problem

The dumb luck problemThe dumb luck problem

The data snooping problemThe data snooping problem

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Are Financial Markets Efficient?Are Financial Markets Efficient?

Nevertheless, three generalities about marketNevertheless, three generalities about marketefficiency can be made:efficiency can be made:

ShortShort--term stock price and market movements appear to beterm stock price and market movements appear to be

difficult to predict with any accuracy.difficult to predict with any accuracy.

The market reacts quickly and sharply to new information,The market reacts quickly and sharply to new information,

and various studies find little or no evidence that suchand various studies find little or no evidence that such

reactions can be profitably exploited.reactions can be profitably exploited.

If the stock market can be beaten, the way to do so is notIf the stock market can be beaten, the way to do so is not

obvious.obvious.

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Some Implications if Markets areSome Implications if Markets are

EfficientEfficient

Security selection becomes less important,Security selection becomes less important,

because securities will be fairly priced.because securities will be fairly priced.

There will be a small role for professionalThere will be a small role for professional

money managers.money managers.

It makes little sense to time the market.It makes little sense to time the market.

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The Performance of Professional Money ManagersThe Performance of Professional Money Managers

Lets have a stock market investment contest in which you areLets have a stock market investment contest in which you are

going to take on professional money managers.going to take on professional money managers.

The professional money managers have at their disposal theirThe professional money managers have at their disposal theirskill, banks of computers, and scores of analysts to help pickskill, banks of computers, and scores of analysts to help picktheir stocks.their stocks.

Does this sound like an unfair match?Does this sound like an unfair match?

You have a terrific advantage if you follow this investmentYou have a terrific advantage if you follow this investmentstrategy: Hold a broadstrategy: Hold a broad--based market index.based market index. One such index that you can easily buy is a mutual fund called theOne such index that you can easily buy is a mutual fund called the

Vanguard 500 Index Fund (there are other market index mutual funds)Vanguard 500 Index Fund (there are other market index mutual funds)

The fund tracks the performance of the S&P 500 Index by investing itsThe fund tracks the performance of the S&P 500 Index by investing itsassets in the stocks that make up the S&P 500 Index.assets in the stocks that make up the S&P 500 Index.

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Figure 8.6

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The previous slide shows the number of these funds that beatThe previous slide shows the number of these funds that beat

the performance of the Vanguard 500 Index Fund.the performance of the Vanguard 500 Index Fund.

You can see that there is much more variation in the dashedYou can see that there is much more variation in the dashed

blue line than in the dashed red line.blue line than in the dashed red line.

What this means is that in any given year, it is hard to predictWhat this means is that in any given year, it is hard to predict

how many professional money managers will beat thehow many professional money managers will beat the

Vanguard 500 Index Fund.Vanguard 500 Index Fund.

But, the low level and variation of the dashed red line meansBut, the low level and variation of the dashed red line means

that the percentage of professional money managers who canthat the percentage of professional money managers who can

beat the Vanguard 500 Index Fund over a 10beat the Vanguard 500 Index Fund over a 10--year investmentyear investment

period is low and stable.period is low and stable.

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Figure 8.7

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Figure 8.8

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Two previous slides show the percentage of managedTwo previous slides show the percentage of managedequity funds that beat the Vanguard 500 Index Fund.equity funds that beat the Vanguard 500 Index Fund.

In only six of the 18 years (1986In only six of the 18 years (19862003) did more than half2003) did more than half

beat the Vanguard 500 Index Fund.beat the Vanguard 500 Index Fund.

The performance is worse when it comes to a 10The performance is worse when it comes to a 10--yearyear

investment periods (1977investment periods (1977--1986 through 19941986 through 1994--2003).2003).

In two of these 18 investment periods, did more than halfIn two of these 18 investment periods, did more than half

the professional money managers beat the Vanguard 500the professional money managers beat the Vanguard 500

Index Fund.Index Fund.


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Table 8.1

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The previous slide presents more evidence concerning theThe previous slide presents more evidence concerning the

performance of professional money managers.performance of professional money managers.

Using data from 1977 through 2003, we divide this timeUsing data from 1977 through 2003, we divide this time

period into:period into:

11--year investment periodsyear investment periods Rolling 3Rolling 3--year investment periodsyear investment periods

Rolling 5Rolling 5--year investment periodsyear investment periods

Rolling 10Rolling 10--year investment periodsyear investment periods

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Then, after we calculate the number of investment periods, weThen, after we calculate the number of investment periods, weask two questions:ask two questions: what percent of the time did half the professionally managed funds beatwhat percent of the time did half the professionally managed funds beat

the Vanguard 500 Index Fund?the Vanguard 500 Index Fund?

what percent of the time did threewhat percent of the time did three--fourths of them beat the Vanguardfourths of them beat the Vanguard500 Index Fund?500 Index Fund?

The previous slides raise some potentially difficult andThe previous slides raise some potentially difficult anduncomfortable questions for security analysts and otheruncomfortable questions for security analysts and other

investment professionals.investment professionals.

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If markets are inefficient, and tools like fundamental analysisIf markets are inefficient, and tools like fundamental analysisare valuable, why cant mutual fund managers beat a broadare valuable, why cant mutual fund managers beat a broadmarket index?market index?

The performance of professional money managers isThe performance of professional money managers isespecially troublesome when we consider the enormousespecially troublesome when we consider the enormousresources at their disposal and the substantial survivorship biasresources at their disposal and the substantial survivorship biasthat exists.that exists.

Managers and funds that do especially poorly disappear.Managers and funds that do especially poorly disappear.

If it were possible to beat the market, then the process of eliminationIf it were possible to beat the market, then the process of elimination

should lead to a situation in which the survivors can beat the market.should lead to a situation in which the survivors can beat the market. The fact that professional money managers seem to lack the ability toThe fact that professional money managers seem to lack the ability to

outperform a broad market index is consistent with the notion that theoutperform a broad market index is consistent with the notion that theequity market is efficient.equity market is efficient.

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What is the Role for PortfolioWhat is the Role for Portfolio

Managers in an Efficient Market?Managers in an Efficient Market?

The role of a portfolio manager in an efficient market is toThe role of a portfolio manager in an efficient market is tobuild a portfolio to the specific needs of individual investors.build a portfolio to the specific needs of individual investors.

A basic principle of investing is to hold a wellA basic principle of investing is to hold a well--diversifieddiversifiedportfolio.portfolio.

However, exactly which diversified portfolio is optimal variesHowever, exactly which diversified portfolio is optimal variesby investor.by investor.

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What is the Role for PortfolioWhat is the Role for Portfolio

Managers in an Efficient Market?Managers in an Efficient Market? Some factors that influence portfolio choice include theSome factors that influence portfolio choice include the

investors age, tax bracket, risk aversion, and even employer.investors age, tax bracket, risk aversion, and even employer.Employer?Employer? Suppose you work for Starbucks and part of your compensation isSuppose you work for Starbucks and part of your compensation is

stock options.stock options. Like many companies, Starbucks offers its employees the opportunityLike many companies, Starbucks offers its employees the opportunity

to purchase company stock at less than market value.to purchase company stock at less than market value.

You can imagine that you could wind up with a lot of Starbucks stockYou can imagine that you could wind up with a lot of Starbucks stockin your portfolio, which means you are not holding a diversifiedin your portfolio, which means you are not holding a diversifiedportfolio.portfolio.

The role of your portfolio manager would be to help you add otherThe role of your portfolio manager would be to help you add otherassets to your portfolio so that it is once again diversified.assets to your portfolio so that it is once again diversified.

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AnomaliesAnomalies

We will now present some aspects of stock price behavior thatWe will now present some aspects of stock price behavior thatare both baffling and potentially hard to reconcile with marketare both baffling and potentially hard to reconcile with market

efficiency.efficiency.

Researchers call theseResearchers call these market anomalies.market anomalies.

Three facts to keep in mind about market anomalies.Three facts to keep in mind about market anomalies.

First, anomalies generally do not involve many dollars relative to theFirst, anomalies generally do not involve many dollars relative to the

overall size of the stock market.overall size of the stock market.

Second, many anomalies are fleeting and tend to disappear whenSecond, many anomalies are fleeting and tend to disappear whendiscovered.discovered.

Finally, anomalies are not easily used as the basis for a trading strategy,Finally, anomalies are not easily used as the basis for a trading strategy,

because transaction costs render many of them unprofitable.because transaction costs render many of them unprofitable.

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The DayThe Day--ofof--thethe--Week Effect:Week Effect:

TheThe dayday--ofof--thethe--week effectweek effectrefers to the tendency forrefers to the tendency forMonday to have a negative average returnMonday to have a negative average returnwhich iswhich iseconomically significant.economically significant.

Interestingly, the effect is much stronger in the 1950Interestingly, the effect is much stronger in the 1950--1979 time period than in the 19801979 time period than in the 1980--2004 time period.2004 time period.

Insert Table 8.2 Here

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The Amazing January EffectThe Amazing January Effect

But, what do we see when we look at returns onBut, what do we see when we look at returns on smallsmall--capcap

stocks?stocks?

Figure 8.9B

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The TurnThe Turn--ofof--thethe--Year EffectYear Effect Researchers have deeply explored the January effect to seeResearchers have deeply explored the January effect to see

whether:whether: the effect is due to returns during the whole month of January, orthe effect is due to returns during the whole month of January, or

due to returns bracketing the end of the year.due to returns bracketing the end of the year.

Researchers look at returns over a specific threeResearchers look at returns over a specific three--week periodweek period

and compare these returns to the returns for the rest of theand compare these returns to the returns for the rest of the

year.year.

As shown on the next slide, we have calculated daily marketAs shown on the next slide, we have calculated daily market

returns from 1962 through 2004.returns from 1962 through 2004. Turn of the Year Days: the last week of daily returns in a calendarTurn of the Year Days: the last week of daily returns in a calendar

year and the first two weeks of daily returns in the next calendar year.year and the first two weeks of daily returns in the next calendar year.

Rest of the Days: Any daily return that does not fall into this threeRest of the Days: Any daily return that does not fall into this three--

week period.week period.

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The TurnThe Turn--ofof--thethe--Month EffectMonth Effect

Researchers have also investigated whether a TurnResearchers have also investigated whether a Turn--ofof--thethe--

Month effect exists.Month effect exists.

On the next slide, we have separated daily stock market returnsOn the next slide, we have separated daily stock market returns

into two categories.into two categories.

Turn of the Month Days:Turn of the Month Days: Daily returns from the last day of anyDaily returns from the last day of any

month or the following three days of the following monthmonth or the following three days of the following month

Rest of the Days: Any other daily returnsRest of the Days: Any other daily returns

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The TurnThe Turn--ofof--thethe--Month EffectMonth Effect

Table 8.5Table 8.5

Turn of the Month returns exceed Rest of the DaysTurn of the Month returns exceed Rest of the Daysreturns.returns.

The turnThe turn--ofof--thethe--month effect is apparent in all three timemonth effect is apparent in all three time

periods.periods.

Interestingly, the effect appears to be stronger in the 1984Interestingly, the effect appears to be stronger in the 1984--2004 period than in the 19622004 period than in the 1962--1983 period.1983 period.

The fact that this effect exists puzzles EMH proponents.The fact that this effect exists puzzles EMH proponents.

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Bubbles and CrashesBubbles and Crashes

BubbleBubble: occurs when market prices soar far in excess: occurs when market prices soar far in excess

of what normal and rational analysis would suggest.of what normal and rational analysis would suggest.

Investment bubbles eventually pop.Investment bubbles eventually pop.

When a bubble does pop, investors find themselves holdingWhen a bubble does pop, investors find themselves holding

assets with plummeting values.assets with plummeting values.

A bubble can form over weeks, months, or even years.A bubble can form over weeks, months, or even years.

CrashCrash:: significant and sudden drop in market values.significant and sudden drop in market values.

Crashes are generally associated with a bubble.Crashes are generally associated with a bubble. Crashes are sudden, generally lasting less than a week.Crashes are sudden, generally lasting less than a week.

However, the financial aftermath of a crash can last forHowever, the financial aftermath of a crash can last for

years.years.

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The Crash of 1929The Crash of 1929

Figure 8.10

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The Cash of 1929The Cash of 1929TheThe

AftermathAftermathFigure 8.11

Th C h f 1987Th C h f 1987

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The Crash of 1987The Crash of 1987 Once, when we spoke ofOnce, when we spoke ofthethe CrashCrash,, we meant October 29,we meant October 29,

1929. That was until October 1987.1929. That was until October 1987.

The Crash of 1987 began on Friday, October 16th.The Crash of 1987 began on Friday, October 16th.

The DJIA fell 108 points to close at 2,246.73.The DJIA fell 108 points to close at 2,246.73.

First time in history that the DJIA fell by more than 100 points in oneFirst time in history that the DJIA fell by more than 100 points in one

day.day.

On October 19, 1987, the DJIA lost about 22.6% of its valueOn October 19, 1987, the DJIA lost about 22.6% of its value

on a new record volume (about 600 million shares)on a new record volume (about 600 million shares)

The DJIA plummeted 508.32 points to close at 1,738.74.The DJIA plummeted 508.32 points to close at 1,738.74.

During the day on Tuesday, October 20th, the DJIA continued toDuring the day on Tuesday, October 20th, the DJIA continued to

plunge in value, reaching an intraday low of 1,616.21.plunge in value, reaching an intraday low of 1,616.21.

But, the market rallied and closed at 1,841.01, up 102 points.But, the market rallied and closed at 1,841.01, up 102 points.

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The Crash of 1987The Crash of 1987AftermathAftermath

Figure 8.12

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Circuit BreakersCircuit Breakers As a result of the Crash of 1987, there have beenAs a result of the Crash of 1987, there have been

some significant market changes.some significant market changes.

One of the most interesting changes was theOne of the most interesting changes was the

introduction of theintroduction of the NYSE circuit breakersNYSE circuit breakers..

Different circuit breakers are triggered if the DJIADifferent circuit breakers are triggered if the DJIA

drops by 10, 20, or 30 percent.drops by 10, 20, or 30 percent.

A 10 percent drop will halt trading for at most one hourA 10 percent drop will halt trading for at most one hour A 20 percent drop will halt trading for at most two hoursA 20 percent drop will halt trading for at most two hours

A 30 percent drop will halt trading for the remainder of theA 30 percent drop will halt trading for the remainder of the

dayday

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The Asian CrashThe Asian Crash

The crash of the Nikkei Index, which began in 1990,The crash of the Nikkei Index, which began in 1990,lengthened into a particularly long bear market.lengthened into a particularly long bear market.

It is quite like the Crash of 1929 in that respect.It is quite like the Crash of 1929 in that respect.

The Asian Crash started with a booming bull market in theThe Asian Crash started with a booming bull market in the

1980s.1980s.

Japan and emerging Asian economies seemed to be forming aJapan and emerging Asian economies seemed to be forming apowerful economic force. The Asian economy became anpowerful economic force. The Asian economy became an

investor outlet for those wary of the U.S. market after theinvestor outlet for those wary of the U.S. market after the

Crash of 1987.Crash of 1987.

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The Asian CrashThe Asian CrashAftermathAftermath

Figure 8.13

Th D tTh D t C B bbl d C hC B bbl d C h

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The DotThe Dot--Com Bubble and CrashCom Bubble and Crash

By the midBy the mid--1990s, the rise in Internet usage and its global1990s, the rise in Internet usage and its global

growth potential fueled widespread excitement over the newgrowth potential fueled widespread excitement over the neweconomy.economy.

Investors seemed to care only about big ideas.Investors seemed to care only about big ideas.

Investor euphoria led to a surge in Internet IPOs, which wereInvestor euphoria led to a surge in Internet IPOs, which were

commonly referred to as DotComs because so many of theircommonly referred to as DotComs because so many of their

names ended in .com.names ended in .com.

The lack of solid business models doomed many DotComs.The lack of solid business models doomed many DotComs.

Many of them suffered huge losses.Many of them suffered huge losses.

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Figure 8.14

C iC i

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Chapter ReviewChapter Review

Introduction to Market EfficiencyIntroduction to Market Efficiency

What Does Beat the Market Mean?What Does Beat the Market Mean?

Foundations and Forms of Market EfficiencyFoundations and Forms of Market Efficiency

Forms of Market EfficiencyForms of Market Efficiency

Why Would be a Market be Efficient?Why Would be a Market be Efficient? Some Implications of Market EfficiencySome Implications of Market Efficiency

Does Old Information Help Predict Future StockDoes Old Information Help Predict Future StockPrices?Prices?

Random Walks and Stock PricesRandom Walks and Stock Prices How does New Information get into Stock Prices?How does New Information get into Stock Prices?


Ch R iCh R i

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Informed Traders and Inside TradingInformed Traders and Inside Trading Informed TradingInformed Trading

Insider TradingInsider Trading

How Efficient are Markets?How Efficient are Markets? Are Financial Markets Efficient?Are Financial Markets Efficient?

Consequences of Market EfficiencyConsequences of Market Efficiency

Market Efficiency and The Performance ofMarket Efficiency and The Performance of

Professional Money ManagersProfessional Money Managers

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AnomaliesAnomalies The DayThe Day--ofof--thethe--Week EffectWeek Effect

The Amazing January EffectThe Amazing January Effect

TurnTurn--ofof--thethe--Year EffectYear Effect

TurnTurn--ofof--thethe--Month EffectMonth Effect

The Earnings Announcement PuzzleThe Earnings Announcement Puzzle

The Price/Earnings (P/E) PuzzleThe Price/Earnings (P/E) Puzzle

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Bubbles and CrashesBubbles and Crashes The Crash of 1929The Crash of 1929

The Crash of October 1987The Crash of October 1987

The Asian CrashThe Asian Crash


Tests of Different Types of MarketTests of Different Types of Market

EfficiencyEfficiency

Documents

BBUS 315 - Chapter 8