Ch. 8/9 Efficient Market Hypothesis
The Academic Celebrity Deathmatch
*Fama vs. Thaler: The punchline* *Fama:* -Mr. Thaler hasn't "really established anything" in more than 20 years of research *Thaler:* -Mr. Fama "is the only guy on earth who doesn't think there was a bubble in Nasdaq in 2000"
The Academic Celebrity Deathmatch: Round 1
*Thaler:* -If the market was efficient and impossible to beat, why would value stocks outperform growth stocks? *Fama:* -A rational explanation - Value stocks come with hidden risks and investors are rewarded for those risks with higher returns
Performance of Actively Equity Mutual Funds
SEE GRAPH
Persistence of Active Equity Mutual Funds
SEE GRAPH
Performance of Active Funds
A key reason for the popularity of passive investment is the disappointing performance of active investment -On average, actively managed US equity mutual funds underperform index funds, net of fees -On an ex ante basis, it is difficult to find a fund that can persistently outperform passive benchmarks
Definition of Market Efficiency
A market is efficient (price is right) with respect to a set of information if the stock price reflects that set of information and there is no way to (systematically) make abnormal profits by using that information.
What Does It Mean?
Economists realized that randomness of returns was a result of rationality rather than craziness. It is best summarized as follows: -Current stock prices reflect the currently known information. -Stock prices change when new information arrives. -New information, or news, by its very definition cannot be predicted. -Therefore, changes in stock price cannot be predicted.
Role of Portfolio Management in Efficient Market
If financial market is efficient, what are the roles of portfolio management? 1. You still have to optimize your portfolio: -Diversify! -Take the appropriate risk level according to the risk preference of the clients. 2. Consider other investor needs in portfolio decisions: -investors' tax status -clients' liquidity needs -diversifying away from clients' own industries, etc.
Implications of Market Efficiency on Investment Management (4)
Implications of market efficiency on investment management: -Technical analysis -Fundamental analysis -Passive vs. active investment -Role of portfolio management in an efficient market
The Beginning ...
In 1953, Maurice Kendall find -Stock prices follow random walk. -Stock returns are random numbers. The stock price series appeared to be "a 'wandering' one, almost as if once a week the Demon of Chance drew a random number... and added it to the current price to determine the next week's price".
Believers in efficient markets
*Eugene Fama* -the intellectual father of the Efficient Market Theory -Financial markets were highly efficient in reflecting the underlying value of stocks -Of course, it's impossible for the market to attain full efficiency all the time -Empirical evidence on market anomalies is mainly driven by inefficient econometric analysis *The book:* -a discussion of the efficient market hypothesis
Fundamental Analysis (2)
*Examples* Can you predict stock returns using ratio analysis, such as return on equity (profitability), sales turnover (operating efficiency)? -Not if the market is semi‐strong efficient A mutual fund manager, in order to predict the revenue of a hotel company, sends analysts to count the hotel rooms with lights on at night. Will this help predict stock returns? -This generates private information; may be profitable if market is only semi‐strong efficient; not profitable if market is strong‐form efficient
The Academic Celebrity Deathmatch: Round 4
*Fama vs. Thaler in real world* *Dimensional Fund Advisers* -$56 billion in assets -Assumes the market can't be beaten: invests in broad areas rather than picking individual stocks -*Results:* 16% over the past decade, 4 percentage points better than the S&P 500 *Fuller & Thaler Fund* -$2.4 billion assets -Try to pick stocks and outfox the market -*Results:* 6% annual returns since 1997, 3 percentage points better than the S&P 500
In the end...
*Fama* The May, 2004 U of Chicago conference -It is possible that poorly informed investors can theoretically lead the market astray -Stock prices could become "somewhat irrational" *Thaler* -Most of his retirement assets are held in index fund -"It is NOT easy to beat the market, and most people don't"
Fundamental Analysis (1)
*Fundamental analysis:* -using information about macroeconomy and corporate cash flows to predict stock returns -Taught by Ben Graham and David Dodd (their book Security Analysis first published in 1934) and practiced by Warren Buffett -Currently the most popular practice of security analysis. *Punch line:* -fundamental analysis based on public information is not profitable if the market is semi‐ strong efficient.
Strong-Form Market Efficiency
*Interpretation:* -All information (public or private) is impounded into prices. *Evidence:* -fund managers on average can't beat the market performance. *The ultimate question:* -can anyone consistently beat the market? -Ex post: sure (by sheer chance) -Ex ante: the real question!!!
Semi-Strong-Form Market Efficiency
*Interpretation:* -All the public information is impounded into prices immediately once released. *Implication:* -cannot profit from any news once its publicly announced, such as earnings reports
Weak-Form Market Efficiency
*Interpretation:* -all the information contained in past prices of the stock is impounded into the current price. Therefore you cannot predict future prices by observing past prices/returns. If weak-form market efficiency holds, -Technical analysis does not work -Prices follow random walk -Trading rules based on historical prices/returns (e.g. filter rules) do not work
Passive vs. Active Investment Management
*Passive investment:* -Price is right. No need to perform technical or fundamental analysis -Hold broadly diversified index funds to reap the benefit of diversification *Active investment:* -Price is not always right and security analysis is profitable -Buy undervalued stocks and sell overvalued stocks *Punch line:* -active investment becomes less profitable when the market becomes more efficient
The Academic Celebrity Deathmatch: Round 2
*Shiller vs. Fama* *Shiller:* -EMH's mistake - Just because markets are unpredictable doesn't mean they are efficient *Fama:* -Behavioral economists made the same mistake in reverse - The fact that some individuals might be irrational doesn't mean the market is inefficient
Technical Analysis
*Technical analysis:* -using past prices and trading volume information to predict future price changes -The oldest form of security analysis, dating back to the beginning of Wall Street. The first two editors of Wall Street Journal, Charles H. Dow and William P. Hamilton, were well‐known market technicians *Punch line:* -if market is weak‐form efficient, technical analysis is not profitable
Random Walk
*Test of random walk:* -relation between yesterday's price change (or return, which is standardized price change) and today's price change (or return).
The Academic Celebrity Deathmatch: Round 3
*Thaler vs. Fama* *Thaler:* -Can market add and subtract? - The Palm Inc. Carveout *Fama:* -It was just an isolated anomaly - "Is this the tip of an iceberg, or the whole iceberg?"
John Pulson
*hedge fund manager* -became famous in 2008 because his fund made 15billion during financial crisis (shorting housing market)
Filter Rules
-Buy a stock when the stock has increased by x% and sell the stock once it has dropped by y%. -If weak-form market efficiency holds, filter rules should not work. *Evidence:* -filter rules do not work once taking into account trading costs.
Outline
-Definition of market efficiency -What drives market efficiency? -Implications of market efficiency --What phenomena are consistent or inconsistent with EMH? --Implications on investment management -Behavioral finance: why market prices can be systematically irrational? -Why the market can't be either completely efficient or very inefficient?
Market Efficiency: A Summary
-Prices can't be predicted by observing old information. Only new information can move prices. -Market efficiency is driven by competition. -If market is efficient, prices are correct so that investments in financial assets are zero-NPV projects. In other words, you earn a normal rate of return.
Active Investment Management as Information Production
In an fairly efficient market, active investment management can be viewed as a production process -The product is information -Similar to other production activities such as farming, car manufacturing, etc., you make a profit by producing products at a cost lower than the price you sell -It is possible to generate superior investment performance if you can find a way to produce unique investment information in a cost‐efficient way --(keep this in mind when you become an investment manager)
Why Market Efficiency?
Market can be efficient because of competition. Many smart and diligent investors constantly monitor stock prices and search for profit opportunities -Competition among investors would make stock prices to incorporate information very quickly. -If there is a profitable pattern, everyone will try to take advantage of the pattern. The result is that the pattern will disappear very soon.
Believers in behavioral finance
From left to right: -Daniel Kahneman, -Richard Thaler, and -Alan Greenspan *Nobel Prize winner: Robert Shiller*
An Example of Market Reaction
On Jan 3rd, 2001, the Federal Reserve Bank cut the interest rate by half percent. SEE GRAPH
Three forms of market efficiency
1. *Weak-form market efficiency:* -Efficient w.r.t past price/returns 2. *Semi-strong-form market efficiency:* -Efficient w.r.t public information 3. *Strong-form market efficiency:* -Efficient w.r.t all information
Market Efficiency: The Two Sides
Competition means the market must be fairly/very efficient. Grossman and Stiglitz (1980) paradox: the market cannot be fully efficient. -If markets are 100% efficient, then no one will generate information. -But if no one generates information, then how will markets be efficient? Hence, market efficiency is a matter of degree.
Market Anomalies (6)
EMH seems to be remarkably good description of reality However, there is evidence of anomalies -Long-run reversals and short-run momentum in returns -Value stocks outperform growth stocks. -Small-cap firms outperform large-cap firms. -Post-earnings announcement drifts -Long-run under-performance of IPOs and SEOs -The Bubbles QUIZ - which form of market efficiency each anomaly violates
Trend of Passive Investing
Institutional investors increasingly practice passive investing in recent decades -e.g., Majority of UI's equity and fixed income portfolios are passively managed ICON article: "History of Index Funds"("The Devil's Invention") -SEE GRAPH
Semi-Strong-Form Market Efficiency 2
Only new information moves the prices. -Online auctioneer eBay Inc. said fourth-quarter net income rose 44%, but this narrowly missed Wall Street expectations. The rare stumble, and a lukewarm financial forecast for this year, sent its high-flying shares down 12% in after-hours trading. (WSJ 1/20/2005) The speed prices adjust to new information is a measure for market efficiency: the faster the adjustment, the more efficient the market is.
Why Markets May Be Irrational?
People had systematic biases that weren't rational -Overconfidence -Representativeness -Limited attention *Limited arbitrage* -> the influence of rational people is limited
