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Chapter 8

The Capital Markets and Market Efficiency

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all

turn into pumpkins and mice.

Warren Buffett

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Outline Introduction Role of the Capital Markets Efficient Market Hypothesis Anomalies

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Introduction Capital market theory springs from the

notion that:• People like return

• People do not like risk

• Dispersion around expected return is a reasonable measure of risk

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Role of the Capital Markets Definition Economic Function Continuous Pricing Function Fair Price Function

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Definition Capital markets trade securities with lives

of more than one year

Examples of capital markets• New York Stock Exchange (NYSE)• American Stock Exchange (AMEX)• Chicago Board of Trade• Chicago Board Options Exchange (CBOE)

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Economic Function The economic function of capital markets

facilitates the transfer of money from savers to borrowers• e.g., mortgages, Treasury bonds, corporate

stocks and bonds

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Continuous Pricing Function The continuous pricing function of capital

markets means prices are available moment by moment• Continuous prices are an advantage to investors

• Investors are less confident in their ability to get a quick quotation for securities that do not trade often

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Fair Price Function The fair price function of capital markets

means that an investor can trust the financial system• The function removes the fear of buying or

selling at an unreasonable price

• The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

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Efficient Market Hypothesis Definition Types of Efficiency Weak Form Semi-Strong Form Strong Form Semi-Efficient Market Hypothesis Security Prices and Random Walks

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Definition The efficient market hypothesis (EMH) is

the theory supporting the notion that market prices are in fact fair• The EMH is perhaps the most important

paradigm in finance

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Types of Efficiency Operational efficiency measures how well

things function in terms of speed of execution and accuracy• It is a function of the number of order that are

lost or filled incorrectly

• It is a function of the elapsed time between the receipt of an order and its execution

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Types of Efficiency (cont’d) Informational efficiency is a measure of

how quickly and accurately the market reacts to new information• It relates directly to the EMH

• The market is informationally very efficient– Security prices adjust rapidly and accurately to new

information– The market is still not completely efficient

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Weak Form Definition Charting Runs Test

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Definition The weak form of the EMH states that it is

impossible to predict future stock prices by analyzing prices from the past• The current price is a fair one that considers

any information contained in the past price data

• Charting techniques are of no use in predicting stock prices

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Definition (cont’d)Example

Which stock is a better buy?

Stock A

Stock B

Current Stock Price

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Definition (cont’d)Example (cont’d)

Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

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Charting People who study charts are technical

analysts or chartists• Chartists look for patterns in a sequence of

stock prices

• Many chartists have a behavioral element

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Runs Test A runs test is a nonparametric statistical

technique to test the likelihood that a series of price movements occurred by chance• A run is an uninterrupted sequence of the same

observation• A runs test calculates the number of ways an

observed number of runs could occur given the relative number of different observations and the probability of this number

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Conducting A Runs Test

1 2

1 2

1 2 1 2 1 22

1 2 1 2

1 2

where number of runs

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2 (2 )

( 1)

, number of observations in each category

standard normal variable

R xZ

R

n nx

n n

n n n n n n

n n n n

n n

Z

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Semi-Strong Form The semi-strong form of the EMH states

that security prices fully reflect all publicly available information• e.g., past stock prices, economic reports,

brokerage firm recommendations, investment advisory letters, etc.

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Semi-Strong Form (cont’d) Academic research supports the semi-strong

form of the EMH by investigating various corporate announcements, such as:• Stock splits• Cash dividends• Stock dividends

This means investors are seldom going to beat the market by analyzing public news

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Semi-Strong Form (cont’d) Burton Malkiel points out that two-thirds of

professionally managed portfolios are consistently beaten by a low-cost index fund• Suggests that securities are accurately priced

and that in the long run returns will be consistent with the level of systematic risk taken

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Strong Form The strong form of the EMH states that

security prices fully reflect all relevant public and private information

This means even corporate insiders cannot make abnormal profits by using inside information about their company• Inside information is information not

available to the general public

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Semi-Efficient Market Hypothesis

The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others• Less well-known companies are less efficiently

priced• The market may be tiered• A security pecking order may exist

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Security Prices and Random Walks

The unexpected portion of news follows a random walk• News arrives randomly and security prices

adjust to the arrival of the news– We cannot forecast specifics of the news very

accurately

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Anomalies Definition Low PE Effect Low-Priced Stocks Small Firm and Neglected Firm Effect Market Overreaction January Effect

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Anomalies (cont’d) Day-of-the-Week Effect Turn-of-the Calendar Effect Persistence of Technical Analysis Chaos Theory

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Definition A financial anomaly refers to unexplained

results that deviate from those expected under finance theory• Especially those related to the efficient market

hypothesis

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Low PE Effect Stocks with low PE ratios provide higher

returns than stocks with higher PEs

Supported by several academic studies

Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)

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Low-Priced Stocks Stocks with a “low” stock price earn higher

returns than stocks with a “high” stock price

There is an optimum trading range

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Small Firm and Neglected Firm Effects

Small Firm Effect Neglected Firm Effect

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Small Firm Effect Investing in firms with low market

capitalization will provide superior risk-adjusted returns

Supported by academic studies

Implies that portfolio managers should give small firms particular attention

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Neglected Firm Effect Security analysts do not pay as much

attention to firms that are unlikely portfolio candidates

Implies that neglected firms may offer superior risk-adjusted returns

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Market Overreaction The tendency for the market to overreact to

extreme news• Investors may be able to predict systematic

price reversals

Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

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January Effect Stock returns are inexplicably high in

January

Small firms do better than large firms early in the year

Especially pronounced for the first five trading days in January

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January Effect (cont’d) Possible explanations:

• Tax-loss trading late in December (Branch)

• The risk of small stocks is higher early in the year (Rogalski and Tinic)

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Types of Firms in January

7.71%10.72%11.32%Neglected

Non-S&P 500 Companies

5.03%6.87%7.62%Neglected

1.69%4.19%4.95%Moderately Researched

-1.44%1.63%2.48%Highly Researched

S&P 500 Companies

Average January return after adjusting

for systematic risk

Average January return minus average monthly

return in rest of year

Average January return

Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.

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Day-of-the-Week Effect Mondays are historically bad days for the

stock market

Wednesday and Fridays are consistently good

Tuesdays and Thursdays are a mixed bag

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Day-of-the-Week Effect (cont’d)

Should not occur in an efficient market• Once a profitable trading opportunity is

identified, it should disappear

The day-of-the-week effect continues to persist

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Turn-of-the-Calendar Effect The bulk of the return comes from the last

trading day of the month and the first few days of the following month

For the rest of the month, the ups and downs approximately cancel out

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Persistence of Technical Analysis

Technical analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices

Studies show the markets are efficient in the weak form

Literature based on technical techniques continues to appear but should be useless

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Chaos Theory Chaos theory refers to instances in which

apparently random behavior is systematic or even deterministic

Econophysics refers to the application of physics principles in the analysis of stock market behavior• e.g., an investment strategy based on studies of

turbulence in wind tunnels