INVEST CHAP 8
explain Jaffe (1974) study
documented the tendency for stock prices to rise after insiders intensively bought shares and to fall after intensive insider sales.
what is purpose of 7 studies under Weak Form? Name 7 studies and year published.
whether over short and long term can use history of prices to generate abnormal returns or above market returns. 1. Conrad and Kaul (1988) 2. Lo and MacKinlay (1988) 3. Jegadeesh and Titman (1993) 4. Fama and French (1988) 5. Poterba and Summers (1988) 6. De Bondt and Thaler (1985) 7. Chopra, Lakonishok, and Ritter (1992)
what are 4 studies for Broad Market Return?
1. Fama and French (1988) 2. Campbell and Shiller (1988) 3. Keim and Stambaugh (1986) 4. Fama and French (1989)
name the 9 mutual fund manager studies.
1. Fama and French (2010) : factors plus momentum factor 2. Wermers (2000): Funds show positive gross alphas; negative net alphas after controlling for fees, risk 3. Carhart (1997): Minor persistence in relative performance across managers, largely due to expense/transaction costs 4. Bollen and Busse (2004): rank mutual fund performance using the four-factor model over a base quarter, assign funds into one of 10 deciles according to base-period alpha, and then look at performance in the following quarter. 5. Berk and Green (2004): Skilled managers with abnormal performance will attract new funds until additional cost, complexity drives alphas to zero 6. Del Guercio and Reuter (2014): Split mutual fund investors into those who buy funds directly for themselves versus those who purchase funds through brokers, reasoning that the direct-sold segment. Average underperformance of actively managed mutual funds is driven largely by broker-sold funds, and that this underperformance may be interpreted as an implicit cost that less informed investors pay for the advice they get from their brokers. 7. Chen, Ferson, and Peters (2010): On average, bond mutual funds outperform passive bond indexes in gross returns, underperform once fees subtracted 8. Kosowski, Timmerman, Wermers, and White (2006): Stock-pricing ability of minority of managers sufficient to cover costs; performance persists over time 9. Samuelson (1989): Records of most managers show no easy strategies for success
Are Markets Efficient? what are 3 Issues?
1. Magnitude issue: Efficiency is relative, not binary 2. Selection bias issue: • Investors who find successful investment schemes are less inclined to share findings • Observable outcomes preselected in favor of failed attempts 3. Lucky event issue: Lucky investments receive disproportionate attention
short horizons?
1. Returns over short horizons: Momentum effect: Tendency of poorly- or well- performing stocks to continue abnormal performance in following periods
long horizons?
2. Returns over long horizons Reversal effect: Tendency of poorly- or well- performing stocks to experience reversals in following periods
what is POST-EARNINGS-ANNOUNCEMENT PRICE DRIFT?
A fundamental principle of efficient markets is that any new information ought to be reflected in stock prices very rapidly. When good news is made public, for example, the stock price should jump immediately.
what is resistance level?
A price level above which it is supposedly unlikely for a stock or stock index to rise.
what is support level?
A price level below which it is supposedly unlikely for a stock or stock index to fall.
explain Ball and Brown (1968) study.
A puzzling anomaly, therefore, is the apparently sluggish response of stock prices to firms' earnings announcements, as uncovered by Ball and Brown (1968).
what is study 3?
Amihud and Mendelson (1986, 1991) on the effect of liquidity on stock returns might be related to both the small-firm and neglected-firm effects. They argue that investors will demand a rate-of-return premium to invest in less liquid stocks that entail higher trading costs. In accord with their hypothesis, Amihud and Mendelson showed that these stocks show a strong tendency to exhibit abnormally high risk-adjusted rates of return. Because small and less-analyzed stocks as a rule are less liquid, the liquidity effect might be a partial explanation of their abnormal returns. However, exploiting these effects can be more difficult than it would appear. The high trading costs on small stocks can easily wipe out any apparent abnormal profit opportunity.
what are 2 studies?
Ball and Brown (1968). Rendleman, Jones, and Latané (1982)
what is passive investment strategy?
Buying a well-diversified portfolio without attempting to search out under or overvalued stocks. efficient market hypothesis believe that active management is largely wasted effort and unlikely to justify the expenses incurred. Therefore, they advocate a passive investment strategy that makes no attempt to outsmart the market. Passive management is usually characterized by a buy-and-hold strategy. Because the efficient market theory indicates that stock prices are at fair levels, given all available information, it makes no sense to buy and sell securities frequently, which generates large brokerage fees without increasing expected performance.
explain Campbell and Shiller (1988)
Campbell and Shiller (1988) found that the earnings yield can predict market returns.
what is last 2 of 4 long-term horizon studies?
De Bondt and Thaler (1985) Chopra, Lakonishok, and Ritter (1992) Extreme performance in particular securities also tends to reverse itself: The stocks that have performed best in the recent past seem to underperform the rest of the market in following periods, while the worst past performers tend to offer above-average future performance. find strong tendencies for poorly performing stocks in one period to experience sizable reversals over the subsequent period, while the best-performing stocks in a given period tend to follow with poor performance in the following period. For example, the De Bondt and Thaler study found that if one were to rank-order the performance of stocks over a five-year period and then group stocks into portfolios based on investment performance, the base-period "loser" portfolio (defined as the 35 stocks with the worst investment performance) outperformed the "winner" portfolio (the top 35 stocks) by an average of 25% (cumulative return) in the following three-year period. This reversal effect, in which losers rebound and winners fade back, suggests that the stock market overreacts to relevant news. After the overreaction is recognized, extreme investment performance is reversed. This phenomenon would imply that a contrarian investment strategy—investing in recent losers and avoiding recent winners—should be profitable. Moreover, these returns seem pronounced enough to be exploited profitably. Thus, it appears that there may be short-run momentum but long-run reversal patterns in price behavior both for the market as a whole and across sectors of the market. One interpretation of this pattern is that short-run overreaction (which causes momentum in prices) may lead to long-term reversals (when the market recognizes its past error).
what is ETF?
Exchange-traded funds (ETFs) are a close (and usually lower-expense) alternative to indexed mutual funds. shares in diversified portfolios that passive investment strategy can be bought or sold just like shares of individual stock. ETFs matching several broad stock market indexes such as the S&P 500 or CRSP indexes stock indexes are available to investors who want to hold a diversified sector of a market without attempting active security selection.
explain Fama and French (1988)
Fama and French (1988) showed that the return on the aggregate stock market tends to be higher when the dividend/price ratio, the dividend yield, is high. Again, the interpretation of these results is difficult. On the one hand, they may imply that abnormal stock returns can be predicted, in violation of the efficient market hypothesis. More probably, however, these variables are proxying for variation in the market risk premium. For example, given a level of dividends or earnings, stock prices will be lower and dividend and earnings yields will be higher when the risk premium (and therefore the expected market return) is higher. Thus, a high dividend or earnings yield will be associated with higher market returns. This does not indicate a violation of market efficiency. The predictability of market returns is due to predictability in the risk premium, not in risk-adjusted abnormal returns.
explain Fama and French (1989)
Fama and French (1989) showed that the yield spread between high- and low-grade bonds has greater predictive power for returns on low-grade bonds than for returns on high-grade bonds, and greater predictive power for stock returns than for bond returns. suggesting that the predictability in returns is in fact a risk premium rather than evidence of market inefficiency. Similarly, the fact that the dividend yield on stocks helps to predict bond market returns suggests that the yield captures a risk premium common to both markets rather than mispricing in the equity market.
what is book-to-market effect study?
Fama and French (1992) showed that a powerful predictor of returns across securities is the ratio of the book value of the firm's equity to the market value of equity. Fama and French stratified firms into 10 groups according to book-to-market ratios and examined the average rate of return of each of the 10 groups. The decile with the highest book-to-market ratio had an average annual return of 17.5%, while the lowest-ratio decile averaged only 11.0%. The dramatic dependence of returns on book-to-market ratio is independent of beta, suggesting either that high book-to-market ratio firms are relatively underpriced or that the book-to-market ratio is serving as a proxy for a risk factor that affects equilibrium expected returns. In fact, Fama and French found that after controlling for the size and book-to-market effects, beta seemed to have no power to explain average security returns. This finding is an important challenge to the notion of rational markets because it seems to imply that a factor that should affect returns—systematic risk—seems not to matter, while a factor that should not matter—the book-to-market ratio—seems capable of predicting future returns.
Interpreting Anomalies - what are the 2?
Fama and French (1993): Market phenomena can be explained as manifestations of risk premiums Lakonishok, Shleifer, and Vishny (1995): Market phenomena are evidence of inefficient markets
explain Barber, Lehavy, McNichols, and Trueman (2001)
Firms with most-favorable recommendations outperform firms with least-favorable recommendations. Barber, Lehavy, McNichols, and Trueman (2001) focus on the level of consensus recommendations and show that firms with the most favorable recommendations outperform those with the least favorable recommendations. While their results seem impressive, the authors note that portfolio strategies based on analyst consensus recommendations would result in extremely heavy trading activity with associated costs that probably would wipe out the potential profits from the strategy.
what is one common strategy for passive management to create?
Index fund Mutual fund which holds shares in proportion to market index representation such as the S&P 500.
explain Competition as Source of Efficiency
Investor competition should imply stock prices reflect available information Investors exploit available profit opportunities Competitive advantage can verge on insider trading
Strong-Form Tests: Inside Information - what are 3 named studies?
Jaffe (1974) Seyhun (1986) Givoly and Palmon (1985) The ability of insiders to trade profitably in their own stock has been documented in studies by Jaffe (1974), Seyhun (1986), Givoly and Palmon (1985), and others.
explain Keim and Stambaugh (1986)
Keim and Stambaugh (1986) showed that bond market data such as the spread between yields on high and low-grade corporate bonds also help predict broad market returns.
Under weak form, what are first 2 studies associated with abnormal returns from short term trends?
Less than 3 months. Both Conrad and Kaul (1988) Lo and MacKinlay (1988) examine weekly returns of NYSE stocks and find positive serial correlation over short horizons. However, the correlation coefficients of weekly returns tend to be fairly small, at least for large stocks for which price data are the most reliably up to date. Thus, while these studies demonstrate weak price trends over short periods, the evidence does not clearly suggest the existence of trading opportunities. While broad market indexes demonstrate only weak serial correlation, there appears to be stronger momentum in performance across market sectors exhibiting the best and worst recent returns.
what is study 2?
Merton (1987) provides a rationale for the neglected firm effect. He shows that neglected firms might be expected to earn higher equilibrium returns as compensation for the risk associated with limited information. In this sense the neglected-firm premium is not strictly a market inefficiency but is a type of risk premium.
under short horizons, what is serial correlation?
One way of discerning trends in stock prices is by measuring the serial correlation of stock market returns. Serial correlation refers to the tendency for stock returns to be related to past returns. Positive serial correlation means that positive returns tend to follow positive returns (a momentum type of property). Negative serial correlation means that positive returns tend to be followed by negative returns (a reversal or "correction" property
what is anomalies?
Patterns of returns that seem to contradict the efficient market hypothesis
what is P/E effect? what is the study?
Portfolios of low P/E stocks exhibit higher average risk-adjusted returns than high P/E stocks Basu (1977, 1983) that portfolios of low price-earnings (P/E) ratio stocks have higher returns than do high P/E portfolios. The P/E effect holds up even if returns are adjusted for portfolio beta. Is this a confirmation that the market systematically misprices stocks according to P/E ratio? This would be an extremely surprising and, to us, disturbing conclusion, because analysis of P/E ratios is such a simple procedure. Although it may be possible to earn superior returns through unusual insight, it hardly seems plausible that such a simplistic technique is enough to generate abnormal returns. Another interpretation of these results is that returns are not properly adjusted for risk. If two firms have the same expected earnings, the riskier stock will sell at a lower price and lower P/E ratio. Because of its higher risk, the low P/E stock also will have higher expected returns. Therefore, unless the CAPM beta fully adjusts for risk, P/E will act as a useful additional descriptor of risk and will be associated with abnormal returns if the CAPM is used to establish benchmark performance.
explain Rendleman, Jones, and Latané (1982) study
Rendleman, Jones, and Latané (1982) provide an influential study of sluggish price response to earnings announcements. They calculate earnings surprises for a large sample of firms, rank the magnitude of the surprise, divide firms into 10 deciles based on the size of the surprise, and calculate abnormal returns for each decile. The abnormal return of each portfolio is the return adjusting for both the market return in that period and the portfolio beta. It measures return over and above what would be expected given market conditions in that period. Their results are dramatic. The correlation between ranking by earnings surprise and abnormal returns across deciles is as predicted. There is a large abnormal return (a jump in cumulative abnormal return) on the earnings announcement day (time 0). The abnormal return is positive for positive-surprise firms and negative for negative-surprise firms. The more remarkable, and interesting, result of the study concerns stock price movement after the announcement date. The cumulative abnormal returns of positive-surprise stocks continue to rise—in other words, exhibit momentum—even after the earnings information becomes public, while the negative-surprise firms continue to suffer negative abnormal returns. The market appears to adjust to the earnings information only gradually, resulting in a sustained period of abnormal returns.
what is Technical Analysis?
Research on recurrent/predictable price patterns and on proxies for buy/sell pressure in market technicians believe that such information is not necessary for a successful trading strategy because whatever the fundamental reason for a change in stock price, if the stock price responds slowly enough, the analyst will be able to identify a trend that can be exploited during the adjustment period. The key to successful technical analysis is a sluggish response of stock prices to fundamental supply-and-demand factors. This prerequisite, of course, is diametrically opposed to the notion of an efficient market.
what is the Small-Firm effect? what is the study?
Stocks of small firms have earned abnormal returns, primarily in the month of January. Banz (1981) It shows the historical performance of portfolios formed by dividing the NYSE stocks into 10 portfolios each year according to firm size (i.e., the total value of outstanding equity). Average annual returns between 1926 and 2013 are consistently higher on the small-firm portfolios. The difference in average annual return between portfolio 10 (with the largest firms) and portfolio 1 (with the smallest firms) is 8.0%. Of course, the smaller-firm portfolios tend to be riskier. But even when returns are adjusted for risk using the CAPM, there is still a consistent premium for the smaller-sized portfolios.
what is the THE LUCKY EVENT ISSUE?
The analogy to efficient markets is clear. Under the hypothesis that any stock is fairly priced given all available information, any bet on a stock is simply a coin toss. There is equal likelihood of winning or losing the bet. However, if many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets. For every big winner, there may be many big losers, but we never hear of these managers. Our point is that after the fact there will have been at least one successful investment scheme. A doubter will call the results luck; the successful investor will call it skill. The proper test would be to see whether the successful investors can repeat their performance in another period, yet this approach is rarely taken.
why does the efficient market hypothesis implies that technical analysis is without merit?
The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past prices has already been reflected in stock prices. As investors compete to exploit their common knowledge of a stock's price history, they necessarily drive stock prices to levels where expected rates of return are exactly commensurate with risk. At those levels one cannot expect abnormal returns.
what is book-to-market effect?
The tendency for investments in shares of firms with high ratios of book value to market value to generate abnormal returns.
what is momentum effect?
The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
what is the reversal effect?
The tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in the following period.
what is weak-form tests? what are the 2 types?
Weak-Form Tests: Patterns in Stock Returns Returns over short horizons: Momentum effect Returns over long horizons: Reversal effect
what the 3 analysts are overly positive about firm prospects?
Womack (1996) Jegadeesh, Kim, Kristie, and Lee (2004) Barber, Lehavy, McNichols, and Trueman (2001)
explain Womack (1996)
Womack (1996) focuses on changes in analysts' recommendations and finds that positive changes are associated with increased stock prices of about 5% and negative changes result in average price decreases of 11%. One might wonder whether these price changes reflect the market's recognition of analysts' superior information or insight about firms or, instead, simply result from new buy or sell pressure brought on by the recommendations themselves. Womack argues that price impact seems to be permanent and, therefore, consistent with the hypothesis that analysts do in fact reveal new information.
what is THE MAGNITUDE ISSUE?
an investment manager overseeing a $5 billion portfolio who can improve performance by only .1% per year will increase investment earnings by .001 × $5 billion = $5 million annually. All might agree that stock prices are very close to fair values and that only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort. According to this view, the actions of intelligent investment managers are the driving force behind the constant evolution of market prices to fair levels. Rather than ask the qualitative question, "Are markets efficient?" we should instead ask a more quantitative question: "How efficient are markets?
what size portfolio benefit from passive strategy?
are economically feasible only for managers of large portfolios. The billion-dollar manager reaps extra income of $10 million annually from a 1% increment. Small investors reap too little to make worthwhile.
explain Seyhun (1986)
carefully tracked the public release dates of the Official Summary, found that following insider transactions would be to no avail. Although there is some tendency for stock prices to increase even after the Official Summary reports insider buying, the abnormal returns are not of sufficient magnitude to overcome transaction costs.
Technical analysts are sometimes called what?
chartists because they study records or charts of past stock prices, hoping to find patterns they can exploit to make a profit.
explain Jegadeesh, Kim, Kristie, and Lee (2004)
find that changes in consensus recommendations are associated with price changes, but that the level of consensus recommendations is an inconsistent predictor of future stock performance.
what is THE SELECTION BIAS ISSUE?
keep your technique secret and use it to earn millions of dollars. which presents us with a conundrum. Only investors who find that an investment scheme cannot generate abnormal returns will be willing to report their findings to the whole world. This is a problem in selection bias; the outcomes we are able to observe have been preselected in favor of failed attempts. Therefore, we cannot fairly evaluate the true ability of portfolio managers to generate winning stock market strategies.
what are THE NEGLECTED-FIRM AND LIQUIDITY EFFECTS? what is study 1?
neglected-firm: The tendency of investments in stock of less well-known firms to generate abnormal returns. Arbel and Strebel (1983) gave another interpretation of the small-firm effect. Because they tend to be neglected by large institutional traders, information about smaller firms is less available. This information deficiency makes smaller firms riskier investments that command higher returns. "Brand-name" firms, after all, are subject to considerable monitoring from institutional investors, which promises high-quality information, and presumably investors do not purchase "generic" stocks without the prospect of greater returns.
Under weak form, what are the first 2 of 4 long-term horizon studies?
returns over multiyear periods. longer than 12 months. Fama and French (1988) Poterba and Summers (1988) indicate pronounced negative long-term serial correlation in the performance of the aggregate market. The latter result has given rise to a "fads hypothesis," which asserts that the stock market might overreact to relevant news. Such overreaction leads to positive serial correlation (momentum) over short time horizons. Subsequent correction of the overreaction leads to poor performance following good performance and vice versa. The corrections mean that a run of positive returns eventually will tend to be followed by negative returns, leading to negative serial correlation over longer horizons. These episodes of apparent overshooting followed by correction give the stock market the appearance of fluctuating around its fair value. These long-horizon results are dramatic but still not conclusive. First, the study results need not be interpreted as evidence for stock market fads. An alternative interpretation of these results holds that they indicate only that the market risk premium varies over time. For example, when the risk premium and the required return on the market rise, stock prices will fall. When the market then rises (on average) at this higher rate of return, the data convey the impression of a stock price recovery. In this view, the apparent overshooting and correction are in fact no more than a rational response of market prices to changes in discount rates.
what is semistrong-form EMH?
same as weak but with: all publicly available information reflected in the stock price. Includes fundamental data on the firm's product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. If investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices.
what is weak-form EMH?
stock prices reflect all information contained in the history of past trading such as the history of past prices, trading volume, or short interest. Trend analysis is fruitless. If such data ever conveyed reliable signals about future performance, all investors already would have learned to exploit the signals. Signals lose their value as they become widely known because a buy signal, for instance, would result in an immediate price increase.
what is strong-form EMH?
stock prices reflect all relevant information, including inside information only to company insiders corporate officers have access to pertinent information long enough before public release to enable them to profit from trading on that information. Rule 10b-5 of the Security Exchange Act of 1934 sets limits on trading by corporate officers, directors, and substantial owners, requiring them to report trades to the SEC.
Under weak form, what is intermediate-horizon stock price behavior study?
using 3- to 12-month holding periods Jegadeesh and Titman (1993) found a momentum effect in which good or bad recent performance of particular stocks continues over time. They conclude that while the performance of individual stocks is highly unpredictable, portfolios of the best-performing stocks in the recent past appear to outperform other stocks with enough reliability to offer profit opportunities. Thus, it appears that there is evidence of short- to intermediate-horizon price momentum in both the aggregate market and cross-sectionally (i.e., across particular stocks).
what is Role of Portfolio Management in Efficient Market?
• Active management assumes market inefficiency • Passive management consistent with semistrong efficiency • Inefficient market pricing leads to inefficient resource allocation
