Efficient Markets

What is ‘efficient’ about market efficiency?

available information is built into stock prices with nothing being ignored

• you cant find overpriced/underprices stocks with public information

• prices aren’t always “correct” you just cant predict which way they will move

What is the expected return in an efficient market and why?  

• expected return = discount rate

• because stock prices reflect the PV of expected future cash flows

• actual return may differ because of unexpected events

If the market is in equilibrium at a given price, when you buy you add to the total demand for the stock and now there are more buyers than sellers.  You push the price up, to crowd out other buyers and induce more sellers. Conversely, when you sell you add to the total supply for the stock and now there are more sellers than buyers.  You push the price down, to crowd out other sellers and induce more buyers. When does the price stop changing, and we return to equilibrium?

• when everyone gets the expected return they require

• when buyers = sellers again

Suppose that the firm (ABC) announces one day later that they are actually going to have $12M for two consecutive years, not just one year.  If the market is efficient, what return do you expect if you buy at the end of that next day? What price do you think you would pay?

• stock price will adjust to reflect higher value, the new price is now priced in

• still getting expected return required

What is a random walk?

• value change occurs in a completely unpredictable way

• change is random - has no pattern

What is a random walk with a drift?

• price moves unpredictably - but tends to move in one direction over time

• “drift” represents discount rate

Which one is a better description of a stock returns?  Why

• Random walk with drift

• stock prices are unpredictable (short-term), but over time they tend to grow (drift)

What is it about the history of Meme stocks that calls into question market efficiency?

• meme stocks rose due to “hype”

• price changes weren’t related to forecast of cash flows which doesn’t happen in an efficient market

• meme stocks delivered realized (abnormal) returns instead of the discount rate investors required

Momentum refers to a historical fact that the past one-year abnormal return on a stock tends to predict its future abnormal return (over horizons of about 1 to 3 months).  Does this violate market efficiency?

• Yes, if past returns don’t affect discount rate

• efficient markets shouldn’t be able to predict abnormal returns

The small-cap premium refers to a historical fact that the return on small-capitalization stocks tends to be higher than what we would otherwise expect (i.e.., the average return on other stocks).  ‘Small-cap’ means that the stock’s total market capitalization (= price times shares) ranks low relative to all other stocks.  Does this violate market efficiency?

• Yes, if market capitalization doesn’t affect discount rate

• efficient market shouldn’t be predictable based on firm size

The value premium refers to a historical fact that the return on stocks with a low ratio of book value to market value (the ‘book to market’ or BTM ratio) tends to be higher than what we would otherwise expect (i.e.., the average return on other stocks).  ‘Value’ stocks are those with a low book to market ratio (‘growth’ stocks are the opposite, high BTM).  Does this violate market efficiency?

• Yes, if market capitalization doesn’t affect discount rate

• efficient market returns should not be based on value vs. growth

Suppose that the value of the surviving firm following a merger of two previously independent firms is on average 10% higher than the sum of the values prior to any knowledge of the merger.  At 2:00 PM on Tuesday afternoon, two firms ‘X’ and ‘Y’ announce that they will merge.  What do you expect to happen to their stock prices at the time of the announcement?  

• value of 2 stocks go up by 10%

• gain should happen immediately since the merger is public

Why is PEAD considered a violation of market efficiency?  What ‘should’ happen?

• PEAD prices drift after news and don’t fully adjust right away → violation

• realized returns should adjust immediately so future returns match discount rate → should happen

Suppose that during the past week, 50 firms announced their earnings.  25 stocks had earnings that were much better than expected, and 25 worse.  Given the PEAD phenomenon, what would be the suggested trade, assuming

1. All stocks have a discount rate of 10% and 

2. you can sell short whatever you want.

• buy stocks with greater unexpected return bc return is >10%

• sell stocks with negative unexpected return bc return is <10%

• This is a well diversified basket, so most randomness of individual stocks will cancel out

Is a five-year investment in stocks risky?  What range of outcomes can you expect?  Use the figure below [excess market returns over the past 100 years] to frame your answer.

• 5 yr stocks are risky bc they show a wide range of outcomes

• however, risk overtime balances out - avg. excess return is 7.9%

• the long run has been strongly positive

The expected return on stocks is the mean of the distribution of possible returns. On what basis do we assert that there is a fairly clear expected return on the market?  What is that value?

• the market has consistently been around 7.5%-8% per yr over the past century

• the stability over many 5 yr periods suggest reliable expected return

Comment on the reliability of the return on a 

10yr diversified investment in equities;

20yr diversified investment in equities;

30yr diversified investment in equities.

10 yr - returns vary widely, sometimes flat, negative or above average

20 yr - variation shrinks, with fewer high and lows, there are exceptions still

30 yr - returns are reliable, shows long-term investing historically delivers stable and positive returns

We looked at several extreme periods in U.S. market history – e.g., the financial crisis; the dot-com bubble; the oil crises; etc.  What are two sharp messages to take from these experiences?

• stock prices can swing from trend line especially on the negative side due to a factor (financial crisis)

• overtime, about 10-20 yrs markets revert back to the trend

We also looked at the returns following these special cases. In the extreme case of bottom 2%, what is the average return in the next year?  What about the return over the next five years?

• bottom 2% = 22% return

• avg. 5 year return = 14%

• suggest higher returns after very bad years

Comment on why we might want to look at a longer horizon when it comes to assessing expected returns.

• valuation of stocks involves computing expected future CF over a long horizon and presumes to grow

• entire series of expected CF is discounted at appropriate rate

Another comment.  Why do you think we might want to look at the return in years t + 2 to t + 5, where t is the point in time that we are looking.  in other words, why skip the 1st year in the figures on the bottom right?

• skipping the 1st year helps avoid short term noise

• this helps get a clear view whether the discount rate has shifted by isolating the long-term effect

If instead of selecting bad years, we instead select extreme good years (i.e., top 2% or 10%), do we then see the opposite effect? Is it as strong as the case where we select years?

• returns tend to be slower than average

• not as strong when we select years

What does pattern of returns suggest to you, big picture?

bad years → followed by stronger than average returns

• because investors demand higher return after losses

What is a Sharpe ratio?  Why might we want to look at the sharp ratio instead of just the expected return?

• sharpe ration accounts for risk

If stock returns are random with a drift, and you look at the return on  250 stocks over a given period (say, 10 years), what would the resulting picture look like?

• we cant identify which will do better or worst before the fact

This picture does not necessarily prove an efficient market.  It could be that some information is out there that indicates (before the fact) which of stock will go up more and which will go up less.  There are two other bullets we can fire at the matter to defend the efficient market hypothesis.

1. Announcements

2. Professional investment managers

Explain how each helps defend the efficient market hypothesis.

Announcements

• if markets are efficient, public information should lead to immediate adjustment

• supporting the idea that markets quickly adjust to new information

Professionals

• in efficient markets, professionals fail to beat benchmarks overtime

• suggest available information is already reflected in prices and there is little room for out performance