Lecture 8-Stock market & Efficiency Flashcards
Big 3 stock markets in the world are
New York, London, Tokyo
How can the the size of stock markets be measured
- Number or value of trades
- Number or value of listed companies
The overall performance of a stock market is measured by what?
index of leading companies
E.g. Dax, Nasdaq, Hang Seng, Cac
What is the FTSE100?
Index of the 100 largest UK companies by market capitalisation
Launched at 1000 on 3/1/1984
Represents ~ 80% of the UK market value
How often is the FTSE100 updated?
- Updated quarterly
- Included if ranked 90th or better
- Deleted if ranked 111th or worse
What happens to deleted companies in the FTSE100?
drop into next index which is the FTSE250
What are index calculations?
All indices aim to reflect market performance but can be calculated in many ways
- Number of compaines
- Calculation i.e arithmetic average or weighted average
- Inclusion of companies i.e. fixed or changing
- Starting point i.e 100, 1000
What is the value of efficient markets?
Encourages share buying
Investors will only invest if they can be sure they will get a fair price when they come to sell their shares
This increases market liquidity and reduces investor risk
-Signals management
Lets management know if they are making the right decisions to maximise the wealth of their shareholders
-Allocates resources
Pricing inefficiency could mean funds fail to flow to where they can best be utilised
What are the 3 types of efficiency?
- Operational efficiency: e.g. cheap transaction costs
- Allocational efficiency: resources flow to where they are required
- Pricing efficiency: Prices instantaneous adjust to reflect relevant information
What are perfect capital markets?
Markets are frictionless
No transaction costs, no taxes
All assets are perfectly divisible
- Perfect competition: participants are price takers
- Informationally efficient: information is costless and received simultaneously by all
- Individuals are rational
What is the efficient market hypothesis?
Relates to pricing efficiency
Efficient capital markets don’t have to be perfect capital markets
The EMH says that “prices instantaneously reflect all available relevant information”
Traders cannot “beat” the market
What is security analysis (SA)?
-Predicting share prices
What are the two types of security analysis?
- Fundamental analysis
- Technical analysis
What is fundamental analysis?
-Looks at news and information
Company specific information
Earnings, dividends, debt, production techniques, personnel, etc
Economic information
Unemployment rates, government policies, etc
Financial information
Changes in interest rates or exchange rates, etc
General information
The weather forecast, sports results, etc
What is technical analysis?
-Look at patterns in past prices
Ignores all fundamental information
Establishes trading rules based solely on the pattern of past share prices (and volumes) volumes)
Technical analysts (also known as chartists) believe past performance is a good indicator of future performance
What is the dow theory?
-Dow theory argues three forces simultaneously affect stock prices
Three forces that affect stock prices in dows theory
-Primary trend:the long-term movement of prices, lasting from several months to several years.
-Secondary trends or intermediate trends: caused by short-term deviations of prices from the underlying trend line
These deviations are eliminated via corrections when prices revert back to trend values.
-Tertiary or minor trends: daily fluctuations which are of little importance
What are the three levels of efficiency?
Weak Form Efficient Markets
Semi-Strong Form Efficient Markets
Strong Form Efficient Markets
What is weak form efficiency?
The current share price reflects all information contained in past prices only
Past share prices or patterns in prices cannot predict future share prices
Mechanical/computer trading rules will not yield abnormal profits
Technical analysts/Chartists will not yield abnormal profits
What is the only way that chartists can make money?
-markets need to be weak form inefficient
What are random walks in relation to market efficiency?
-Random walks imply there is no relationship between the share price movement today and the movement yesterday
What is semi-strong form efficiency?
Prices reflect all PUBLICLY available information
i.e. all company announcements, earnings and dividend news, technological breakthroughs (as well as all past share prices) are already incorporated in the current price
Trading rules based on publicly available information will not yield abnormal profits
Fundamental analysts will not achieve abnormal profits
What are examples of all publicly available information in semi-strong efficiency?
Information from past share prices
Company annual report and accounts
Press and TV coverage
Earnings, dividends and trading announcements
Directors share holdings and
dealings
Restructuring proposals
New debt or equity issues
Can an investment analyst out perform the market?
- Not in a semi-strong efficient market
- As all public information is incorporated into the prices
What is strong-form efficiency?
- Price reflect all relevant information i.e. any information, public or not, is incorporated in the share price
- Even traders using “inside” information cannot make abnormal profits
What is the overlap between different market efficiencies?
If a market is strong form efficient
- It must be semi-strong form efficient as well
- It must be weak form efficient as well
If a market is semi strong form efficient
- We don’t know if it is strong form efficient
- It must be weak form efficient
If a market is NOT weak form efficient
- It cannot be strong form efficient
- It cannot be semi-strong form efficient
What if someone makes abnormal gains in the markets?
- they are inefficient - they do not fully reflect all relevant information
- By acting quickly you can make a profit while the market “catches up”
Tests to see if a market is efficient
- If money can be made
- Weak-form tests: Can you make money from studying charts - the chartist
Semi-Strong form tests: Can you make money by studying public information – the investment analyst
Strong form test: Can you make money from knowing everything – the director
Tests and results of weak form efficiency
Purchase a diversified portfolio of stocks
Purchase a second portfolio based on chartist trading rules
-Returns are the same
Chartists don’t make abnormal returns
This implies the market is weak form efficient
Evidence to contradict anticipating patterns
DeBondt & Thaler (1985)
Buy the worst performing shares based on last 3 years trading, hold for the next 3 years 3 years
Portfolio outperformed the market by 20%
Buy the best performing shares based on the last 3 years trading, hold for the next 3 years
Portfolio underperformed the market by 5%
Support for DeBondt & Thaler (1985)
Arnold & Baker (2005) looked at UK data from 1960 to 1998
They present strong evidence that buying a portfolio of shares that have recently done very badly, will significantly outperform a similar portfolio of shares that recently has done very well
Reaction time for markets in relation to Arnold & Baker (2005)
The above suggests in the long term (3years) markets over-react
i.e. A long-term reversal pattern
However, similar studies where performance measured over 3 months give opposite results!
i.e. A short-term momentum pattern
Testing semi-strong efficiency
Researchers can check for abnormal returns
-Researchers use an “event study” methodology to test for efficiency here.
The event can be any release of new information
Define a “window” after the event to check returns
Evidence of semi strong form efficiency.
Comparing actual returns after the “event” to what you would have expected to happen
Evidence indicates:
Returns are generally the same
Investment analysts don’t make abnormal returns
This suggests the market is Semi Strong Form efficient
Do fund managers generally make a profit?
No
Allowing for administrative costs “Actively” managed funds do not out-perform the market
Semi-strong conclusions
A tendency for the market to “overreact”
Shares fall too far on bad news e.g. 11/09/01
Shares rise too far on good news e.g. dot coms
The best we can say is that the markets are almost semi-strong efficient, most of the time
Where does efficiency come from?
- competition between investors
- A “Catch-22” situation
Market inefficiencies lead to abnormal gains
Which leads to more investors seeking out new information hoping to make gains
Which leads to more efficiency
Which leads to fewer gains
-In equilibrium – must be just enough inefficiency to reward effort of analysts
Strong form and insider trading
We know a share price will jump if a company announces really good news
Mining company strikes oil or gold
Drugs company finds new cure
We know insiders can purchase shares before this news is released and make abnormal returns
Thus the markets are not strong form efficient
Insider dealing damages confidence in the market and is outlawed in most countries
EMH and Irrational investors
Efficient markets don’t necessarily require all investors to be rational
One irrational investor will not influence the market
If irrational investor trades are random, they will cancel each other out
A sufficient number of rational investors will take advantage of irrational inspired price movements
