CH 7: Stock Price Behavior and Market Efficiency

Informed traders and insider trading

Strong form efficient - no information of any kind is useful in beating the market.

Each province’s Securities Commission (OSC) enforces laws concerning illegal trading activities.

Illegal to make profits on non-public information.

An insider is someone who has material non-public information.

Informed trading is when an investor makes a decision to buy or sell a stock based on publicly available information and analysis. Investor is said to be an informed trader.

Illegal Insider Trading includes a tipper ( the person who has purposely divulged material non-public information) and a tippee (the person who has knowingly used such information in an attempt to profit).

Legal Insider Trading occurs when company insiders make legal trades in their own stock. They must comply with the reporting rules of the Securities Commission. Must declare it was based on public information, rather than “inside” information.

• BCSC = British Columbia Securities Commision

• SEC= U.S Securities Exchange Commission

Financial Markets

3 Generalities about Market Efficiency:

• Short-term stock price and market movements appear to be difficult to predict with any accuracy

• Markets react quickly and sharply to new information, various studies find little or no evidence that such reactions can be profitably exploited

• If the stock market can be beaten, the way to do so is not obvious.

Effects if markets are efficient

• Security selection becomes less important, because securities will become fairly priced.

• little use for professional money managers

• no sense to time the market

In an efficient market, portfolio managers’ jobs are to build diversified portfolios to meet the specific needs of individual investors.

• Some employers may offer employee stock options, must be taken into consideration when building an investment portfolio.

If markets are inefficient

Then, professional money managers should be able to consistently beat the market.

If markets are inefficient and tools like fundamental analysis are valuable, why can’t mutual fund managers beat a broad market index? Equity markets must be efficient.

Anomalies

3 facts about market anomalies:

• Anomalies generally do not involve many dollars relative to the overall size of the stock market

• Many anomalies are fleeting and tend to disappear when discovered

• Not easily used as the basis for a trading strategy because transaction costs render many of them unprofitable.

The day-of-the-week effect refers to the tendency for Monday to have a negative average return, which is economically significant.

The January effect refers to the tendency for small-cap stocks to have large returns in January.

Two possible explanations for the January Effect:

• Tax-loss selling

  Investors have a strong tax incentive to sell stocks that have gone down in value before the end of the year to realize the loss for tax purposes

  After selling, investors tend to buy other investments after the turn of the year.

• Investment strategy by portfolio managers

Portfolio managers buy lots of small-cap stocks at the beginning of the year for their growth potential.

Over the year, they will sell poorly performing small-cap stocks for large-cap stocks.

The turn of the year effect:

Researchers look at returns over a specific 3-week period and compare these returns to the rest of the world.

Turn of the year Days - the last week of daily returns in a calendar year and the first two weeks of daily returns in the next calendar year.

Rest of the days - Any daily return that does not fall into these 3 weeks.

Seperated daily stock market returns into two categories:

Turn of the month days - daily returns from the last day of any month OR the following 3 days of the following month.

Rest of the days - Any other daily returns.

Bubbles and Crashes

Bubble: Occurs when market prices soar far more than what normal and rational analysis would suggest.

• investment bubbles eventually pop

• Bubble can form over weels, months, or even years

Crash: A Significant and sudden drop in market values

• Generally associated with a bubble

• Sudden, generally lasting less than a week

• The financial aftermath of a crash can last for years

One contributing factor to the crash of 1987 was that the stock exchanges were not equipped to handle such large volumes, which resulted in the delay in posting of prices.

Circuit Breakers

After the crash, one of the most interesting changes was the introduction of NYSE circuit breakers.

Level 1: 7%<

Level 2: 13%<

Trading halts in all stocks for 15 minutes when the decline triggers a level 1 or 2.

Failure of the Chinese Circuit Breaker:

If an index rose or fell 5%, trading was halted for 15 minutes. If it rose or dropped by 7%, trading would stop for the rest of the day. The circuit breaker was suspended after only 3 days of implementation.

Investor euphoria led to a surge in Internet IPOs, which were commonly referred to as Dotcoms because so many names ended in .com. Lack of solid business models doomed many, with many of them suffering huge losses.

The major cause of the crash of 2008 was the sub-prime mortgage crisis in the U.S.