EMH - Ch6 - Revised Lecture

8/13/2019 EMH - Ch6 - Revised Lecture

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A lpha, the Cap ital Markets, and

the Effic ien t Markets Hypothes is

(Chapter 6)

Adapted from Portfolio Construction, Management, & Protection , 4e, Robert A. Strong

Copyright 2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.


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No matter how many winners youve got, if you

either leverage too much or do anything that

gives you the chance of having a zero inthere, itll all turn into pumpkins and mice.

Warren Buffett


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Outline

Introduction

Alpha and Portfolio Management

Role of the Capital Markets

Efficient Market Hypothesis

Anomalies


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What is alpha?

Alpha = the amount by which the market is beaten, afteradjusting for risk

What is alpha for the market as a whole?

Alpha for market as a whole is zero

So, on average, portfolios are ON the SML

Provides conceptual value of CAPM

Regardless of whether market is efficient, it is still a zero-sumgame

Burden of active manager In order to win (i.e., beat the market), someone else has to lose

Key question = what is special about you (and aboutyour knowledge) that will allow you to be the one thatwins?


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Generating alpha

Are there ways to consistently generate

alpha?

See portfolio manager performanceexample:


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Portfolio Managers Performance:

Past Three Years

Previous Three Years: S&P 500

Fund

Manager

Compound Annual Return -4.98% -22.01%

Total Return -14.20% -52.56%


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Past Four Years

Previous Four Years: S&P 500

Fund

Manager

Compound Annual Return 0.50% -14.19%

Total Return 2.02% -45.77%


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Past Five Years

Previous Five Years: S&P 500

Fund

Manager




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Past Six Years

Previous Six Years: S&P 500

Fund

Manager

No. of Down Years 2 of 6 4 of 6




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Generating alpha

Would you have invested with this manager?

Who is this manager with this horrible record?

Warren Buffett, of course!!! Portfolio = investment in Berkshire-Hathaway, over

the period of 19701975

Note: while stock price lagged marketsubstantially, book value per share grew fasterthan market each year except 1975; this is ametric with which Buffett is more concerned


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Generating alpha

As we have seen previously in discussing the EMH, valuestocks tend to outperform growth stocks

Concomitantly, Warren Buffett has the best investment

record in history, becoming the 2nd

richest man in the worldin the process

However, as we have just now seen, although value winson average, over the long run, it does notwin perfectlyconsistently!

Instead, the markets tend to cycle, with different styles ofinvestment performing well at different times

B k M k P di f R


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Book to Market as a Predictor of Return:Value (positive a) tends to outperform Growth (negative a)

Value

0%

5%

10%

15%

20%

25%

Annualized

Rate

ofReturn

10987654321

High Book/Market Low Book/Market


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Rolling Annualized Average 5-year Difference

Between the Returns to Value and Growth Composites:The Market cycles between Value and Growth,

But Value Wins on Average

-20%

-10%

0%

10%

20%

30%

40%

50%

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

199

2

199

3

199

4

199

5

199

6

1997

Year

Relative

Difference


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Empirical Regularities:

Sources of alpha Three categories that tend to outperform over the long run:

Valuestocks vs. Growth stocks

Size: Small caps tend to outperform large caps

Momentum: stocks with momentum (earnings or price) tend to beatstocks without momentum

However, the payoffs to all of these tend to cycle!

A typical portfolio manager, being judged on a quarter-by-quarterbasis, would have been fired long before if he had the same record

as Buffett for 19701975!

(In fact, he fired himself during this period!)

None of these beats the market perfectly consistently

A typical portfolio manager would need to try to cycle along with the

market, in order to keep from ever lagging too far behind it


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Empirical Regularities:

Sources of alpha Beating the market consistently would require some sort of

rotation strategy in order to profit from the type of securitiesthat are performing well in the given type of market

But - combination of fat tails and volatility clustering

(discussed previously) can cause problems! Best performance for a given style is likely to follow closely on the

heels of its worst performance, and much of the movement for thestyle is likely to come in a relatively short burst (thus, if you miss it,its gone)

E.g.: 40% of the stock market gains for the entire decade of the1980s occurred during a mere 10 trading days !

So efforts to cycle with the market and keep from falling too farbehind it also make it much more difficult to beat the market!


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Capital Market Theory

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 ofmore 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 functionof 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 functionof capital

markets means prices are available moment

by moment

Continuous prices are an advantage to

investors

Investors are less confident in their ability to geta quick quotation for securities that do not trade

often


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Fair Price Function

The fai r pr ice fun ct ionof capital marketsmeans that an investor can trust thefinancial system

The function removes the fear of buying orselling at an unreasonable price

The more participants and the more formal themarketplace, the greater the likelihood that thebuyer is getting a fair price


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Efficient Market Hypothesis

Definition

Types of Efficiency

Forms 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

Under the EMH, security prices fully and fairly (i.e.,without bias) reflect all available information about the

security

Since the 1960s, the EMH has been perhaps the most

important paradigm in finance Whether markets are efficient has been extensively

researched and remains controversial


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Types of Efficiency

Operational efficiencymeasures how well

things function in terms of speed of

execution and accuracy

It is a function of the number of orders 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 (contd)

Informational efficiencyis a measure ofhow quickly and accurately the marketreacts to new information

This is the type of efficiency with which the EMHis concerned

The market is informationally very efficient Security prices adjust rapidly and fairly accurately to

new information However, as weve already seen, the market is still

not completely efficient


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Forms of Market Efficiency

Eugene Famas original formulation of the EfficientMarket Hypothesis established three forms of marketefficiency, based on the level of information reflected insecurity prices:

1. Weak form= prices reflect all past market level (priceand volume) information

2. Semi-strong form= prices alsoreflect all publiclyavailable fundamental company and economic

information3. Strong form= prices alsoreflect all privately held

information that would affect the value of the companyand its securities


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Weak Form

Definition

Charting

Runs Test


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Definition

The weak formof 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 predictingstock prices


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Definition (contd)

Example

Which stock is a better buy?

Stock A

Stock B

Current Stock Price


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Definition (contd)

Example (contd)

Solution: According to the weak form of the EMH, neither

stock is a better buy, since the current price alreadyreflects all past information.


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Charting

People who study charts are technical

analystsor chartists

Chartists look for patterns in a sequence ofstock prices

Many chartists have a behavioral element


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Runs Test

A runs testis a nonparametric statisticaltechnique to test the likelihood that a series ofprice movements occurred by chance

A runis an uninterrupted sequence of the sameobservation

A runs test calculates the number of ways an observednumber of runs could occur given the relative number of

different observations and the probability of this number

These tests have provided evidence in favor of weakform efficiency


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Conducting A Runs Test

1 2

1 2

1 2 1 2 1 2

21 2 1 2

1 2

where number of runs

21

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 formof 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 (contd)

Academic research supports the semi-strong form of the EMH by investigatingvarious corporate announcements, such as:

Stock splits Cash dividends

Stock dividends

Examined through event studies This means investors are seldom going to

beat the market by analyzing public news


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Market seems to do a relatively good job at adjusting astocks valuation for certain types of new information

Determining how much the new info. will change the stocks valueand then adjusting the price by an equivalent amount

This is what event studies examine

But it does seem to have problems developing an overallvaluation for a stock in the first place

E.g., What is the correct value for IBM as a whole is a very difficultquestion to answer, but how much IBMs value should change if it isawarded a specific new contract is much easier to determine



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Burton Malkiel points out that two-thirds ofprofessionally managed portfolios are consistentlybeaten by a low-cost index fund

Suggests that securities are accurately priced and thatin the long run returns will be consistent with the level ofsystematic risk taken

Supports semi-strong form of the EMH

Also would suggest that portfolio managers do not

possess any private information that is not alreadyreflected in security prices

Supports the strong form of the EMH


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Strong Form

The strong formof the EMH states thatsecurity prices fully reflect all relevant publicand private information

This would mean even corporate insiderscannot make abnormal profits by usinginside informationabout their company

Inside informationis information not availableto the general public


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Semi-Efficient

Market Hypothesis The semi-efficient market hypothesis (SEMH)

states that the market prices some stocks moreefficiently than others

Less well-known companies are less efficiently priced

The market may be tiered

A security pecking order may exist

Lynch prefers stocks that the analysts dont follow

and the institutions dont own

See the Small Firm and Neglected Firm Effectsdiscussed later


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Security Prices and

Random Walks

The unexpected portion of news follows a

random walk

News arrives randomly and security pricesadjust 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

Value Line Enigma

January Effect


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Anomalies (contd)

Day-of-the-Week Effect

Turn-of-the Calendar Effect

Persistence of Technical Analysis

Behavioral Finance

Joint Hypothesis Problem

Chaos Theory


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Definition

A financial anomalyrefers 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 returnsthan stocks with higher PEs

And similarly for high P/B (hence lower Book/Market)stocks

Supported by several academic studies

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

Related to both semi-strong form and weak formefficiency


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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

S ll Fi d N l t d Fi


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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 marketcapitalization 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 toextreme news

Investors may be able to predict systematicprice reversals

Results because people often rely tooheavily on recent data at the expense of the

more extensive set of prior data


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The Value Line Enigma

Value Line (VL) publishes financial information onabout 1,700 stocks

The report includes a timing rank from 1 down to 5

Firms ranked 1 substantially outperform themarket

Firms ranked 5 substantially underperform the

market

Victor Niederhoffer refers to Value Lines ratingsas the periodic table of investing


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The Value Line Enigma

Changes in rankings result in a fast priceadjustment

Some contend that the Value Line effect is merely

the unexpected earnings anomaly due to changesin rankings from unexpected earnings

Nonetheless, Value Lines successful record is

evidence in support of the existence of superioranalysts who apparently possess privateinformation


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January Effect (contd)

Possible explanations:

Tax-loss trading late in December (Branch)

The risk of small stocks is higher early in theyear (Rogalski and Tinic)


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January Returns by Type of Firm

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

adjust ing for

systematic r isk

Average January

return m inus 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, 413.


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Day-of-the-Week Effect

Mondays are historically bad days for the

stock market

Wednesday and Fridays are consistentlygood

Tuesdays and Thursdays are a mixed bag

D f th W k


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Day-of-the-Week

Effect (contd) Should not occur in an efficient market

Once a profitable trading opportunity isidentified, it should disappear

The day-of-the-week effectcontinues topersist

Howeverthere are confounding effectsbetween the levels and the volatilities ofreturns across different days


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Persistence of


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Persistence of

Technical Analysis Technical analysisrefers to any technique in

which past security prices or other publiclyavailable information are employed to

predict future prices Studies show the markets are efficient in the

weak form

Literature based on technical techniquescontinues to appear but should be useless


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Behavioral Finance

Concerned with the analysis of variouspsychological traits of individuals and how thesetraits affect the manner in which they act asinvestors, analysts, and portfolio managers

Growth companies will usually not be growthstocks due to the overconf idenceof analystsregarding future growth rates and valuations

Notion of herd m ental ity of analysts in stockrecommendations or quarterly earnings estimatesis confirmed


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Chaos Theory

Chaos theoryrefers to instances in whichapparently random behavior is systematic or evendeterministic under Mauboussins theory of the market as a complex

adaptive system, then we would expect to see chaoticdynamics

Econophys icsrefers to the application of physicsprinciples in the analysis of stock market behavior

e.g., an investment strategy based on studies ofturbulence in wind tunnels

Includes use of multifractal models


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Are Markets Rational?

This question always faces ajo in t hypo thes is

problem:

Tests of EMH are always dualtests of bothmarket

efficiency and the specific asset-pricing model assumed

Market efficiency

Is the stocks price equal to its true value?

Asset pricing model used (CAPM, APT, etc.)

What isthe stocks t ruevalue?

Never known for sure

The question of value presupposes an answer to the question,

of value to whom, and for what? Ayn Rand

E.g., the value of Apple stock would be different to Steve Jobs

than to any other investor


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Are Markets Rational?

Related issuewhat is information? Information is that which causes changes Claude

Shannon (father of information theory)

So, if something causes the markets to move, then by

definition, it must be information, and vice versa

From this perspective, the market is neither efficient nor

inefficient, it just is

So, are the markets efficient or rational?

Ultimately, difficult to answer categorically

Key question is not whether or not the markets are efficient

this is a side issuebut how investors should act, given

how the markets work

EMH - Ch6 - Revised Lecture

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