efficient markets

technical analysis

• provides the tools to navigate the gap between intrinsic value and market prices

  • research to identify misprices securities that focuses on recurrent and predictable patterns 

  • key to success: sluggish response of stock prices to fundamental factors 

• weak form

  • implies this should be fruitless

sentiment

• price = (fundamentals * valuation)^ sentiment

  • S = 1 = rational

  • S > 1 = bull

  • S < 1 = bear

market efficiency

• informational efficiency

• security prices quickly and fully reflect available information

efficient capital market

• market that reflects all available news and information

  • new info is quickly absorbed

  • superior returns are not achievable 

  • a large number of investor analyze and value for profit 

  • new info comes to the market independent of other news in a random fashion

passive management

• preferred strategy in an efficient market

• buying and holding a broad market portfolio

market value

• price at which an asset can currently be bought or sold

intrinsic value

• value that would be placed on an asset by investors if they had a complete understanding of its investment characteristics

  • equal to market prices in an efficient market

market participant

• large number of investors follow the major financial markets closely daily

  • if mispricing exists, investors act so it disappears quickly

informational availability and financial disclosure

• the more info market participants have, the more accurate the market’s estimates of intrinsic value 

limits to trading

• restrictions to short selling limit arbitrage trading

  • impedes market efficiency

transaction and information acquisition costs

• traders incur these costs when trying to detect and exploit market inefficiencies

random walk

• stock price changes are random and unpredictable

effective market hypothesis

• prices of securities fully reflect available information about securities

information

• most important commodity

• strong comp ensures prices reflect info

• higher inv returns motivate information-gathering

• diminutive marginal returns on research activity suggest that only managers of the largest portfolios will find it useful to pursue

versions of emh

• weak form

• semi strong

• strong form

weak form

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

  • technical analysis - no

    • those trading on historical trading info should not earn abnormal returns

  • fundamental analysis - yes

  • insider trading - yes

  • active mgmt - yes

semi strong form

• asserts that stock prices already reflect all publicly available information

  • technical analysis - no

  • fundamental analysis - no

    • analyzing any public financial disclosures should be futile

  • insider trading - yes

  • active mgmt - no

strong form

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

  • technical analysis - no

  • fundamental analysis - no

  • insider trading - no

  • active mgmt - no

fundamental analysis

• assessment of firm value that focuses on earnings, dividends, interest rates, risk eval.

• stock price = discounted value of future cash flows

• semi strong

  • predicts most analysis should be fruitless

active management

• attempts to beat the market by timing it

• superior security selection

• expensive + very large

passive management

• no attempt to outsmart the market - accept EMH

• index funds, etfs

  • low cost

active management in an efficient market

• can still be used for

  • diversification

  • tax considerations 

  • risk profile of the investor

magnitude issue

• efficiency is relative, not binary

selection bias issue

• investors who find successful investment schemes are less inclined to share findings

• observable outcomes preselected in favor of failed attempts

lucky event issue

• lucky investments receive disproportionate attention

momentum effect

• tendency of poorly or well performing stocks to continue abnormal performance in following periods

  • returns over short horizons

  • weak form test (patterns 

reversal effect

• tendency or poorly or well performing stocks to experience reversals in following periods

  • returns over long horizons

  • weak form test (patterns)

predictors of broad market performance

• fama and french

• campbell and shiller

• keim and stambaugh

fama and french

• 1988

• return on aggregate stock market tends to be higher when dividend yield is low

campbell and shiller

• earnings yield can predict market returns

keim stambaugh

• bond market data (spread between yields) can predict market returns

market anomalies

• occur when a change in the price of an asset or security cannot directly be linked to current relevant information known in the market, or the release of new information

  • only valid if they are consistent over a long period of time

  • not the result of data mining / examining data w the intent of developing a hypothesis

anomalies

• observed market inefficiencies - evidence of predictable risk adjusted returns

  • may be a result of data mining

semi strong tests - market anomalies

• p/e  effect

• small firm effect

• neglected firm effect

• book to market effect

• post earnings announcement price drift

p/e effect

• portfolios of low p/e stocks exhibit higher average risk adjusted returns than high p/e stocks

small firm effect

• stocks of small firms can earn abnormal returns, primarily in january

neglected firm effect

• stocks of little known firms can generate abnormal returns

book to market effect

• shares of high book to market firms can generate abnormal returns

post earnings announcement price drift

• sluggish response of stock price to earnings announcement

• abnormal return on announcement day, momentum past market price

bubbles

• can raise price above intrinsic value

• even if prices are inaccurate, it can be difficult to take advantage of them

anomaly evidence

• most evidence appears to result from methodology used

• many anomalies are not profitable when transaction costs are considered

• some strategies only work in some periods or ceased to work over time

behavioral finance

• assumes investors suffer from cognitive bias that may lead to irrational decision making

  • may over or under react to new information

• contrary to traditional finance

  • assumes rational behavior

loss aversion bias

• tendency of investors to be more risk averse when faced with potential losses than potential gains

• dislike loss more than they like a gain of an equal amount

overconfidence bias

• investors tend to overestimate their ability to accurately determine intrinsic values

  • may not process information appropriately

  • leads to mispricing, especially in higher growth companies whose prices react slowly to new information

information cascades

• uninformed investors mimic actions of informed investors

• transmission of info from those who act first and whose decisions influence the decisions of others

  • can lead to overreaction anomalies

• greater for companies w poor quality information

herding bias

• market participants tend to trade along with other investors

  • may ignore their own private analysis

gamblers fallacy

• recent results affect estimates of future probabilities

efficiency and irrational behavior

• markets can still be efficient even if investors exhibit irrational behavior

  • irrationality does not mean that rational investors can beat the market

are markets efficient

• there are some inefficiencies (anomalies) in the market

  • sometimes prices aren’t perfectly accurate

  • investors keep looking for undervalued stocks

• only people with truly better information or insight can consistently make money