FIN 533 Van Ness Exam 2

Which of the following sources of market inefficiency would be most easily exploited?

A stock price drops suddenly due to a large sale by an institution. Acute market inefficiencies are temporary in nature and are more easily exploited than chronic inefficiencies. A temporary drop in a stock price due to a large sale would be more easily exploited than the chronic inefficiencies mentioned in the other responses.

Active Management

An expensive strategy Suitable only for very large portfolios

P/E effect

Basu discovered that portfolios of low-P/E ratio stocks have provided higher returns than high P/E portfolios

prospect theory

Behavioral (as opposed to rational) model of investor utility. Investor utility depends on changes in wealth rather than levels of wealth.

Keim and Stambaugh

Bond spreads can help predict market returns

• Confidence index

Confidence index • Ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds • Ratio will always be below 1 • Higher values are bullish signal

Investors are slow to update their beliefs when given new evidence.

Conservatism Bias

definition

Even if many investors exhibit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values. Arbitrageurs who observe mispricing in the securities markets would buy underpriced securities (or possibly sell short overpriced securities) in order to profit from the anticipated subsequent changes as prices move to their intrinsic values. Consequently, securities prices would still exhibit the characteristics of an efficient market.

Even if prices follow a random walk, they still might not be informationally efficient.

Even if prices follow a random walk, the existence of irrational investors combined with the limits to arbitrage by arbitrageurs may allow persistent mispricings to be present. This implies that capital will not be allocated efficiently—capital does not immediately flow from relatively unproductive firms to relatively productive firms.

Which of the following observations would most contradict the proposition that the stock market is weakly efficient?

Every January, the stock market earns abnormal returns. This is a predictable pattern in returns which should not occur if the weak-form EMH is valid

"If all securities are fairly priced, all must offer equal expected rates of return." Comment.

Expected rates of return differ because of differential risk premiums.

Lucky Event Issue

For every big winner, there may be many big losers, but we never hear of these managers

Limits to Arbitrage

Implementation Costs • Transactions costs and restrictions on short-selling can limit arbitrage activity • Model Risk • What if you have a bad model and the market value actually is correct?

Which of the following would be a viable way to earn abnormally high trading profits if markets are semitrong-form efficient?

In a semistrong-form efficient market, it is not possible to earn abnormally high profits by trading on publicly available information. Information about P/E ratios and recent price changes is publicly known. On the other hand, an investor who has advance knowledge of management improvements could earn abnormally high trading profits (unless the market is also strong-form efficient).

A good part of a company's future prospects are predictable. Given this fact, stock prices can't possibly follow a random walk. Comment.

In an efficient market, any predictable future prospects of a company have already been priced into the current value of the stock. Thus, a stock share price can still follow a random walk.

Regret Avoidance

Individuals who make decisions that turn out badly have more regret when that decision was more unconventional

Affect and Feelings

Investors tend to choose stocks with high affect, driving up prices while simultaneously driving down returns

If EMH holds which is true?

It implies prices reflect all available info.

Suppose you find that prices of stocks before a large dividend increases show on average consistently positive abnormal returns. Is this a violation of EMH?

Market efficiency implies investors cannot earn excess risk-adjusted profits. If the stock price run-up occurs when only insiders know of the coming dividend increase, then it is a violation of strong-form efficiency. If the public also knows of the increase, then this violates semistrong-form efficiency.

Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts.

Mental Accounting

Passive Management

No attempt to outsmart the market -Accept EMH -Index Funds and ETFs -Very low costs

At a cocktail party, your coworker tells you he has consistently beaten market for last 3 years. Suppose you believe him. Does this shake your belief in efficient markets?

No, markets can be efficient even if some investors earn returns above the market average. Consider the Lucky Event issue: Ignoring transaction costs, about 50% of professional investors, by definition, will "beat" the market in any given year. The probability of beating it three years in a row, though small, is not insignificant. Beating the market in the past does not predict future success as three years of returns make up too small a sample on which to base correlation let alone causation.

A successful firm like Microsoft consistently generated large profits for years. Is this a violation of EMH?

No. Microsoft's continuing profitability does not imply that stock market investors who purchased Microsoft shares after its success was already evident would have earned an exceptionally high return on their investments

Steady growth industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

No. The value of dividend predictability would already be reflected in the stock price.

Which would appear to contradict the weak form of the efficient market hypothesis?

One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. This is a classic filter rule which should not produce superior returns in an efficient market.

• Magnitude issue

Only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort

If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average?

Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. Over longer periods, the small expected daily returns accumulate, and upward moves are more likely than downward ones.

Present Value of Growth Opportunities

Present value of growth opportunities (PVGO) is the net present value of a firm's future investments The value of the firm is the sum of the following: • Value of assets already in place (no-growth value) • Net present value of the future investments the firm will make, or PVGO

Investors are reluctant to bear losses caused by unconventional decisions.

Regret Avoidance

Investors disregard sample size when forming views about the future from the past.

Representativeness Bias

Technical Analysis

Research to identify mispriced securities that focuses on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market • Key to success is a sluggish response of stock prices to fundamental supplyand-demand factors • EMH implies technical analysis should be fruitless

Fama and French

Return on aggregate stock market tends to be higher when dividend yield is high

All the following actions are consistent with feelings of regret except

Selling losers quickly. Investors attempt to avoid regret by holding on to losers hoping the stocks will rebound. If the stock rebounds to its original purchase price, the stock can be sold with no regret. Investors also may try to avoid regret by distancing themselves from their decisions by hiring a full-service broker.

• Anomalies over time

Should self-destruct in well-functioning markets • Chordia, Subrahmanyam, and Tong find evidence that liquidity and low trading costs facilitate efficient price discovery

After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. What behavioral characteristic does Shrum have as the basis for her decision making?

Shrum refuses to follow a stock after she sells it because she does not want to experience the regret of seeing it rise. The behavioral characteristic used for the basis for her decision making is the fear of regret.

If markets are efficient, what should be the correlation coefficient between stock returns for 2 nonoverlapping time periods?

The correlation coefficient between stock returns for two non-overlapping periods should be zero. If not, one could use returns from one period to predict returns in later periods and make abnormal profits.

Semistrong Tests: Book to Market Effects

The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns

"Constantly fluctuating stock prices suggest that the market does not know how to price stocks." Comment.

Volatile stock prices could reflect volatile underlying economic conditions as large amounts of information being incorporated into the price will cause variability in stock price. The Efficient Market Hypothesis suggests that investors cannot earn excess risk-adjusted rewards. The variability of the stock price is thus reflected in the expected returns as returns and risk are positively correlated.

Behavioral Finance

What if investors don't behave rationally? arbitrageurs are limited and therefore insufficient to force prices to match intrinsic value.

Price-Earnings Ratio and Growth Opportunities

When PVGO = 0, P0 = E1 /k • The stock is valued like a nongrowing perpetuity As PVGO becomes an increasingly dominant contributor to price, the P/E ratio can rise dramatically P/E ratio reflects the market's optimism concerning a firm's growth prospects

"If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must be predictable." Respond.

While positive beta stocks respond well to favorable new information about the economy's progress through the business cycle, they should not show abnormal returns around already anticipated events. If a recovery, for example, is already anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery

If markets are efficient, you might as well select your portfolio by throwing darts at stock listings in wall street journal. Comment.

While the random nature of dart board selection seems to follow naturally from efficient markets, the role of rational portfolio management still exists. It exists to ensure a well-diversified portfolio, to assess the risk-tolerance of the investor and to take into account tax code issues.

Mental Accounting

a specific form of framing in which people segregate certain decisions

All Versions of EHM

assert prices should reflect available information

Weak-form

asserts that stock prices already reflect all information contained in the history of past prices

Semistrong-form

asserts that stock prices already reflect all publicly available information

Strong-form

asserts that stock prices reflect all relevant information, including insider information

Liquidity Effect

illiquid stocks have a strong tendency to exhibit abnormally high returns

Neglected-firm effect

investments in stock of less well-known firms have generated abnormal returns

Event Study

is a methodological approach designed to measure impact of an event of interest on stock returns

• Maurice Kendall (1953) found

no predictable pattern in stock price changes... Prices were as likely to go up as to go down on any particular day, regardless of past performance

Efficient market anomalies

patterns of returns that seem to contradict the EMH

abnormal return

t is the difference between the stock's actual return and a proxy for the stock's return in the absence of the event

• P/E increases:

• As ROE increases • As plowback, b, increases, if ROE > k • As plowback decreases, if ROE < k • As k decreases

Fundamental Analysis

• Assessment of firm value that focuses on such determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation • Seeks to find firms that are mispriced • Attempt to find firms that are better than everyone else's estimate or troubled firms that may be great bargains • EMH predicts that most fundamental analysis is doomed to failure

Limits to Arbitrage

• Behavioral biases would not matter if rational arbitrageurs could fully exploit the mistakes of behavioral investors • Fundamental risk • "Markets can remain irrational longer than you can remain solvent" • -- Keynes • Intrinsic value and market value may take too long to converge

• Consistency

• Carhart — finds minor persistence in relative performance across managers, but much of that persistence seems due to expenses and transaction costs • Bollen and Busse — support for performance persistence over short horizons • Berk and Green — skilled managers will attract new funds until the costs of managing those extra funds drive alphas down to zero

Mutual Fund Performance

• Casual evidence does not support the claim that professionally managed portfolios can consistently beat the market • Conventional performance benchmark today is a four-factor model • Three Fama-French factors • Momentum factor

Framing

• Decisions affected by how choices are described, such as whether uncertainty is posed as potential gains from a low baseline levels, or as losses from a higher baseline value

So, Are Markets Efficient?

• Enough anomalies exist in the empirical evidence to justify the search for underpriced securities that clearly takes place • However, the market is competitive enough that only differentially superior information or insight will earn money • Margin of superiority that any professional manager can add is so slight that the statistician will not easily be able to detect it

Portfolio Management in an Efficient Market

• Even if the market is efficient, a role exists for portfolio management: • Diversification • Tax considerations • Risk profile of investor • For example, investors of different ages

Interpreting the Anomalies

• Feature that small firms, low market-to-book firms, and recent "losers" seem to have in common is a stock price that has fallen considerably in recent months/years • Fama and French argue that these effects can be explained by risk premiums • Lakonishok, Shleifer, and Vishny argue that these effects are evidence of inefficient markets

Resource Allocation

• Inefficient markets result in systematic resource misallocation • Overvalued securities can raise capital too cheaply • Corporations with undervalued securities may pass up profitable opportunities because the cost of raising capital is too high • Efficient market ≠ perfect foresight market

Technical Analysis: A Warning

• It is possible to perceive patterns that really don't exist

Information Processing

• Limited attention, underreaction, and overreaction • Reliance on heuristics due to limited time/attention • Overconfidence • People tend to overestimate the precision of their beliefs or forecasts, and they tend to overestimate their abilities • Extrapolation and pattern recognition • Representativeness bias • Individuals are adept at discerning patterns, even perceiving patterns that may be illusory • Overly prone to believe these patterns are likely to persist

Breadth

• Measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market • Most common measure is the spread between the number of stocks that advance and decline in price

Liquidation Value and Tobin's Q

• Net amount that could be realized by selling the assets of a firm after paying the debt is liquidation value • Good representation of a "floor" for the stock's price • Replacement cost is the cost to replace a firm's assets • Tobin's q is the ratio of market value of the firm to replacement cost • Trends towards 1

• Selection bias issue

• Only unsuccessful (or partially successful) investment schemes are made public; good schemes remain private

Semistrong Tests: Post-Earnings-Announcement Price Drift

• Price Drift • Ball and Brown find a sluggish response of stock prices to firms' earnings announcements • Market appears to adjust to the earnings information only gradually, resulting in a sustained period of abnormal returns

Conventional Finance

• Prices are correct and equal to intrinsic value • Resources are allocated efficiently • Consistent with EMH

Efficient market hypothesis (EMH)

• Prices of securities fully reflect available information • Investors buying securities in an efficient market should expect to obtain an equilibrium rate of return

Valuation by Comparables

• Purpose of fundamental analysis is to identify stocks that are mispriced relative to some measure of "true" value that can be derived from observable financial data • Valuation ratios are commonly used to assess the valuation of one firm compared to others in the same industry

• Put/call ratio

• Ratio of outstanding put options to outstanding call options • Rising ratio is taken as a sign of broad investor pessimism and a coming market decline

Trin statistic

• Ratios above 1.0 are bearish • Rising volume in a rising market should not necessarily indicate a larger imbalance of buyers versus sellers

Technical Analysis: Relative Strength

• Relative strength • Measures the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry • Calculated as the ratio of the price of the security to a price index for the industry • Strength of industry relative to the whole market • Computed by tracking the ratio of the industry price index to the market price inde

Limitations of Book Value

• Shareholders are sometimes called "residual claimants" • Book values are based on historical cost, while market values measure the current values of assets and liabilities • Market values generally will not match historical values

Random Walks

• Stock prices should follow a random walk • Stock price changes are random and unpredictable • Necessary consequence of intelligent investors competing to discover relevant information on which stocks to buy or sell before the rest of the market becomes aware of that information

Technical Analysis and Behavioral Finance

• Technical analysis attempts to exploit recurring and predictable patterns in stock prices to generate superior investment performance • Prices adjust gradually to a new equilibrium • Market values and intrinsic values converge slowly • Disposition effect • Demand for shares depends on price history • Can lead to momentum in stock prices

• Some analysts may add value, but:

• Tend to be overwhelmingly positive in the assessment of the prospects of firms • Difficult to separate effects of new information from changes in investor demand • Recommendations may lead to investing strategies that are too expensive to exploit

Strong-Form Tests: Inside Information

• The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon • SEC requires all insiders to register their trading activity • Trades become public information

DDM Implications

• The constant-growth rate DDM implies that a stock's value will be greater: 1. The larger its expected dividend per share 2. The lower the market capitalization rate, k 3. The higher the expected growth rate of dividends • The stock price is expected to grow at the same rate as dividends

Intrinsic Value and Market Price

• The intrinsic value (V0 ) is the "true" value, according to a model • If intrinsic value > market value, the stock is considered undervalued and a good investment • Trading signal • IV > MV Buy • IV < MV Sell • IV = MV Hold

• Information

• The most precious financial commodity • Strong competition assures prices reflect information • Higher investment returns motivates information-gathering • Diminutive marginal returns on research activity suggest only managers of the largest portfolios will find it useful pursuing

• Momentum and moving averages

• The moving average is the average price over a given time interval, where the interval updates as time passes • Bullish signal signifies a shift from a falling trend to a rising trend • Bearish signal signifies price series crossing from above the moving average to below it, representative of the beginning of a downward trend in stock prices

Price-Earnings Ratio and Growth Opportunities

• The ratio of PVGO to E/k is equivalent to the component of firm value due to growth opportunities to the value reflecting assets already in place

• Short interest

• Total number of shares of stock current sold short • Increased short interest reflects negative sentiment and is a warning sign concerning the stock's prospects

P/E and Growth Rate

• Wall Street rule of thumb suggests the growth rate ought to be roughly equal to the P/E ratio • "If the P/E ratio of Coca Cola is 15, you'd expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain."

Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just holds on to them a little longer, they will recover, at which time she will sell them. What behavioral characteristic does Davis have as the basis for her decision making?

. Davis uses loss aversion as the basis for her decision making. She holds on to stocks that are down from the purchase price in the hopes that they will recover. She is reluctant to accept a loss.

The Behavioral Critique • Two broad categories of irrationalities

1. Investors do not always process information correctly and therefore infer incorrect probability distributions of future returns 2. Even when given a probability distribution of returns, investors may make inconsistent or suboptimal decisions

• EMH makes two important predictions

1. Security prices properly reflect whatever information is available to investors 2. Active traders will find it difficult to outperform passive strategies such as holding market indexes

What is data mining and why must technical analysts be careful not to engage in it?

Data mining is the process by which patterns are pulled from data. Technical analysts must be careful not to engage in data mining as great is the human capacity to discern patterns where no patterns exist. Technical analysts must avoid mining data to support a theory, rather than using data to test a theory.

Investors are reluctant to sell stocks with "paper" losses.

Disposition effect

Campbell and Shiller

Earnings yield can predict market returns

Explain how some of the behavioral biases discussed in the chapter might contribute to the success of technical trading rules.

Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or gradual adjustments to 'correct' prices, or, alternatively, reversals of trends. A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information into account, resulting in gradual adjustment of prices towards their fundamental values. Another example derives from the concept of representativeness, which leads investors to inappropriately conclude, on the basis of a small sample of data, that a pattern has been established that will continue well into the future. When investors subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend.

Semistrong Tests: Small-Firm Effect

That investments in stocks of small firms appear to have earned abnormal returns.

If stock prices follow random walk, then capital markets are little different from a casino. Comment.

Though stock prices follow a random walk and intraday price changes do appear to be a random walk, over the long run there is compensation for bearing market risk and for the time value of money. Investing differs from a casino in that in the long-run, an investor is compensated for these risks, while a player at a casino faces less than fair-game odds.

What do we mean by fundamental risk, and why may such risk allow behavioral biases to persist for long periods of time?

Underlying risks still exist even during a mispricing event. The market mispricing could get worse before it gets better. Other adverse effects could occur before the price corrects itself (e.g. loss of clients with no understanding or appetite for mispricing opportunities).