Efficiency & Nature of Business

Are Markets Efficent?

Yes the answer is always to waht degree when less, when more

Space Shuttle Challenger Case Study

The Core Event (Jan 28, 1986)

• 11:39 AM: Shuttle explodes.

• 11:47 AM: News hits the Dow Jones wire.

• The Reaction: Market immediately began selling off the 4 main shuttle contractors (Lockheed, Martin Marietta, Rockwell, Morton Thiokol).

Key Data Points (The "Why")

• Morton Thiokol (MT): Stock dropped 11.86% on day one with massive trading volume (Z-statistic of 27.57).

• The Others: Dropped significantly less (~2-3%).

• Timeline Paradox: The official Rogers Commission Report didn't name MT's "faulty seals" (O-rings) as the cause until June 1986.

Crucial Takeaway (Semi-Strong Efficiency)

• Market Insight: Investors "indicted" Morton Thiokol within minutes/hours of the crash, long before the public or the government knew the cause.

• Efficiency: Shows how the market aggregates private information and expert intuition into the stock price almost instantly.

• Note: The market "adjusted way before the actual news dropped," demonstrating that prices reflect information even without a "smoking gun."

Efficient markets

Public information (even if not universally known) is impounded into securities prices very quickly

P_t = PV of E(cash flows | available information)

Why do we expect markets to be efficient

The market is comprised of many buyers and sellers who put money on their beliefs. Mispriced securities are quickly corrected since underpriced securities attract buyers and overpriced securities attract sellers

Weak form

P_t = Pv of E(cash flows | information in past prices)

Semi-strong from

P_t = PV of E(cash flows | publicly available information)

Strong form

P_t = PV of (cash flows | all possibly available informations (impossible)

Implications of market efficency

• Random walk of stock prices, past behaviour does not predict future

• Prices unpredictable

• Very hard to outperform the market

Beating the market

Equity funds do worse compared to the market because of the fees, and if they ever outperform the market they likely got lucky

Why would you expect markets to be more efficient

• Active markets

• High volume

• Liquid markets

• Easily accessible information

• Transparent information

• Many analysts

• Developed markets

Puzzles anomalies in market efficiency

• Post-earnings announcement drift, after positive, firms outperform for a number of months

• Value vs growth, value stock (high book/market) outperform growth stocks

• Small firm effect, small firms outperform large firms

• Momentum, past winners tend to outperform

• January effect

• Dot-com bubble, market inefficient

Data Mining

If you look at enough historical data, you will find statistical relations that are completely spurious

How to distinguish spurious correlations from the real thing

1. Out of sample testing

2. Theory

3. Be careful of survivorship bias

Moral

1. Have respect for market prices

2. Be skeptical of easy predictions

3. Use past market prices to interpret information

Ease of doing business correlates with

GDP Per capita, Infant Mortality, Life Expectancy