Week 3 - Economic and financial theories

Question 1

What is the efficient market hypothesis?

Answer 1

The EMH suggests that security prices reflect information (that information is absorbed into prices) - this is the concept of market efficiency.

Question 2

What is the difference between market efficiency and portfolio efficiency?

Answer 2

Market efficiency - information is reflected in the prices of stocks
Portfolio efficiency - minimum volatility for a fixed rate of return

Question 3

Why are price changes random?

Answer 3

Price changes are random because prices react to information and the flow of information is random

Question 4

What is the concept of ‘random walk’?

Answer 4

Random walk is the concept that stock prices are random, and that they are random about an expected positive trend. It is a statistically naive hypothesis

Question 5

Explain how to test random walk and the results of analysis performed on the Australian market.

Answer 5

Volatility of log returns can be calculated at different data frequencies (e.g. annual, quarterly, monthly), and if independent the ratio between them should theoretically be the same (i.e. volatility ratio of 1).

When this test is applied to the Australian market, split across the total market vs industrials vs resources. Across the whole market there is mild statistical contradiction of random walk, particularly in the industrials sector, which has been clouded by the resources sector (an ever-smaller proportion of the market).

Question 6

Define the three levels of the efficient market hypothesis.

Answer 6

Weak form - Information derived from market trading data includes past prices, volumes and interest
Semi-strong form - Publicly available information, e.g. financial reports, earnings forecasts, included in pricing
Strong form - all information, including insider information, is available

Question 7

What are the three basic patterns recognised in research into the momentum of stock prices?

Answer 7

1) Longer term reversal over multiple years (winners become losers)
2) Intermediate momentum where trailing 3-12 mth performance continues (winners continue to win)
3) Short term reversal effect where trailing returns quickly reverse because of liquidity effects

Question 8

How are price momentum strategies able to outperform the market?

Answer 8

Changes occur in a company, which are not picked up by the market. Then, the market slowly realises these changes and begins to adjust price according to the impact that these changes have, until it outperforms expectations and what really should happen. Then it reverses back to a fair estimate.

Question 9

What are some of the global conclusions about how to exploit price momentum?

Answer 9

1) Large stock momentum occurs at an industry level
2) If sector allocation is controlled, a portfolio will not be exposed to momentum effect (otherwise sectoral risk is present)
3) Small stock momentum is stock specific
4) Large cap momentum is best exploited by overweighting winners, while small stock momentum is best exploited by underweighting losers (no help in a long-only market)

Question 10

What is the relationship between high risk and low risk stocks across different market conditions?

Answer 10

1) High risk stocks outperform low risk stocks in times of high growth, e.g. after recessions
2) Low risk stocks outperform high risk stocks when prices of low risk have been discounted relative to high risk stocks (e.g. at the end of the 2000’s tech bubble). Historically this has occurred because volatile stocks underperformed, not because stable stocks outperformed (esp. prior to 1990)

Question 11

Explain the value anomaly.

Answer 11

The value anomaly occurs because investors wrongly assume past growth patterns will continue into the future. Thus stocks which are momentarily experiencing a downturn and are for the moment underpriced, will eventually revert and grow at a faster rate than the market, outperforming glamour stocks, particularly in times of distress. It continues to exist because it is difficult to arbitrage away.

Question 12

How is it possible to exploit the value anomaly?

Answer 12

It is best to buy undervalued stocks rather than selling overvalued stocks. Institutional investors are unable to take advantage of this, as it primarily occurs in sectors where it cannot be utilised and is almost always restricted to small stocks. Further, there is also a tendency of companies which have ‘boosted’ earnings to experience profit growth reversal (investors are surprised by this reversal so high accrual stocks underperform).

Question 13

Does strong form market efficiency exist? Reference three event studies.

Answer 13

No. Earnings surprises have very little leakage in the build up to the event, while dividend surprises have a substantial amount of leakage up to the day of the event (and the pattern continues afterwards also). Further, there is some anticipation of profit warnings, particularly as the downward pattern occurs before and after the drop at t=0.
Leakage occurs when the pattern is noticeable before the drop. If the pattern is not noticeable before the drop then it is likely that information is not publicly available,

Question 14

What questions should be asked in anomaly investigations?

Answer 14

1) Is the sample representative of the investment universe? Must treat unweighted analysis with caution
2) Is the anomaly asymmetric?
3) Have confounding effects been controlled, e.g. size, sector?
4) Have transaction costs been allowed for?

As a final note, we can also ask the question - “Is it relevant?” - as the majority of the Australian market index is accounted for by a select few stocks

Question 15

Define the following terms:

1) Prospect theory
2) Overconfidence
3) Attribution bias
4) Hindsight bias

Answer 15

1) Prospect theory assumes investors are loss averse, and that they are willing to sell their winners early but hold their losers to postpone the regret of incurring a loss
2) Overconfidence is when investors over-estimate the accuracy of their knowledge and overrate their own abilities
3) Attribution bias is the theory that investors attribute cause to the wrong event (e.g. good results are because of skill, bad ones because of uncontrollable factors)
4) Hindsight bias is the theory that investors are likely to overestimate the probability they assigned to an event that has already occurred

Question 16

Define the following terms:

1) Representative heuristic
2) Underreaction/confirmation bias
3) Overreaction

Answer 16

1) Representative heuristic occurs when investors wrongly assume small samples are highly representative of the parent population from which they are drawn
2) Confirmation bias assigns more importance to information that confirms prior views (e.g. momentum)
3) Over-reaction is when investors exaggerate optimism and pessimism over the medium term (e.g. value anomaly, where stocks that underperform eventually reverse and appreciate)

Question 17

How should we invest on the basis of anomaly research?

Answer 17

1) Avoid small stocks with negative momentum
2) Overweight sectors with positive momentum (large cap) but beware of associated risks (sectors)
3) If you expect a market crash avoid volatile stocks, if you expect a market run, favour volatile stocks
4) Buy cheap small stocks, not with negative momentum, but with strong cash backing of earnings
5) There are very few anomalies for large stocks - no real opportunities for a typical manager

Question 18

What is the major issue with superannuation funds and equity managers?

Answer 18

Super funds typically imagine that managers’ past performance is an indicator of future performance. This is not true, particularly when performance is assessed pre-tax/transaction costs. As such, the selection decision of managers has a large impact. Managers are typically fired after a bad performance but hired after a good performance, but managers perform in a cycle which means that they are often hired when their performance is about to worsen and fired when performance is likely to improve.

Question 19

What are some of the benefits of passive management?

Answer 19

Passive management involves simply matching the index, and is not just about whether some managers can reliably outperform the index portfolio but whether it is consistent. Typical survey results indicate that super funds would be better off if they avoided active management (due to selection issue).

Question 20

What are the 3 hurdles for active management?

Answer 20

1) Are there anomalies to efficient markets
2) If so, can they be effectively exploited
3) Can funds identify and employ effective active managers without spoiling by ill-timed hiring and firing

Even if 1) and 2) are answered with yes, it is unlikely that super funds are able to do 3) effectively, despite managers often outperforming the market (esp. in Australia, not so much US)

Question 21

What is the Black-Litterman model used for?

Answer 21

The Black-Litterman model is one which uses risk estimation as a basis for estimating returns. It is particularly useful as it provides a framework to blend investor views with implied market consensus.

Question 22

What are the BL model formulas for:

1) Covariance matrix
2) Unscaled risk premia
3) Scaled risk premia/implied returns

Answer 22

1) Covariance matrix is defined as the correlation matrix pre and post multiplied by a diagonal matrix of volatilities (all size n x n)
2) Unscaled risk premia is given by covariance matrix * weight vectors (n x 1 outcome)
3) Scaled risk premia/Implied returns is the unscaled risk premia * scaling factor (n x 1 outcome). The formula in Greek letters is delta (risk aversion coefficient) * sigma (covariance matrix) * w (weights of stocks). Delta can be found by making an assumption on one return and scaling everything to be in line with that

Question 23

What is the information ratio? What components does it have?

Answer 23

InfRatio = alpha/omega, where alpha is the excess return over benchmark and omega is the standard deviation of active return.

Alternatively it can be defined as root(M)*c where M is the breadth of the strategy and c is the skill involved.

Question 24

Which level of information ratio is preferred - higher or lower? Why?

Answer 24

Higher - indicates more return and/or less volatility. This has implications for concentrated portfolios, thematic investment (less breadth) and unskilled managers (less skill)

Question 25

What is the transfer coefficient? How does it modify the information ratio?

Answer 25

The transfer coefficient is an indicator of the level of impediments to the construction of the ideal portfolio (e.g. long only constraint/active weighting lower than 5%) - i.e. can the manager get the return into the portfolio?

Information ratio is then root(M) * c * TC

Question 26

What is a bubble?

Answer 26

A bubble is a social epidemic where there is social feedback from price increase to price increase. In other words, it is an environment where there is a rapid price increase in certain stocks as a result of other price increases.

Question 27

What worsens and assists in controlling bubbles?

Answer 27

In the past, MP has permitted strong credit growth, which has relegated financial stability. Another further contributor is cross-border capital flows, which correlate asset prices with curency movements.

Post-GFC, we have seen a contemporary focus on macro-prudential policies designed to promote financial sustainability, e.g. capital requirements and credit growth restrictions.

Question 28

Should valuation be used as a timing tool? Why/why not.

Answer 28

Valuation is a poor timing tool - being at a high price doesn’t mean you should sell as the stock may go up and being at a low price doesn’t mean you should buy as the stock may go down further! Selling assets at perceived bubble prices risks significant opportunity cost if prices continue to climb. Further, weak investment governance plays an important factor in whether valuation should be used - often if a stock price continues to rise after it has been sold, an investor can be tempted to buy in again but at a higher asset price!

Question 29

What is the link between credit and bubbles?

Answer 29

If there is too much credit available, then it becomes too easy to borrow and too easy to pay higher prices for items. As this has continued to grow, the price of goods also continues to grow until it pops. In the example of the housing market, the prices drop because there is a limit on income growth and ability to pay back the loan

Question 30

What are the three types of economic indicators? Give one example of each type.

Answer 30

1) Leading indicators - factors that change before the market moves, e.g. stock prices
2) Coincident indicators - factors that change as the market moves, e.g. consumption, fixed investment
3) Lagging indicators - factors that change after the market moves, e.g. interest rates, inflation

Question 31

Can stock prices be used as an indicator of how the equity market will perform?

Answer 31

Not really - the stock market has seen the inherent market expectations and accounted for them in their price. It is not worth forming a view on the equity market based on this result (as the price has already accounted for it in the view)

Question 32

Which type of indicator is unemployment?

Answer 32

Unemployment is a countercyclical indicator.
It lags at a trough, as firms are likely to use up all their excess capacity before hiring new workers (e.g. part-time to full-time to over-time). As growth continues unemployment will also continue.
It leads at the peak, as firms see that future consumption is limited and choose to refrain from hiring workers as they expect demand to decrease

Question 33

What is the relationship between the market cycle and business cycle?

Answer 33

The market cycle leads the business cycle. At a trough, the market cycle is ahead of the business cycle as it jumps greatly in expectation of future earnings (high P/E at this point). It then plateaus for a while before dropping drastically as it anticipates a downturn. This is often less foreseen than the growth after a trough, which means the market leads more at a trough than a peak.

Question 34

What are the four phases of the market cycle?

Answer 34

1) Despair (16 mths average) - market expects deterioration in economy, increased volatility and risk premiums. Defensive outperform cyclical, bonds outperform equities
2) Hope (9 mths) - Growth anticipated, volatility normalises, tail risks down, cyclical outperform defensive, equities outperform bonds
3) Growth (34 mths) - earnings growth in this phase, as good returns occured during hope
4) Optimism (24 mths) - earnings continue and investors are less cautious, growth outperform value

Question 35

What suggests that we are in a current market of secular stagnation? List three factors.

Answer 35

1) Liquidity trap - We have seen a reduction in short-term nominal interest rates, which have historically been subject to a zero lower bound (ZLB) and are now, in some countries, below 0 (e.g. Japan). This was reliant on the fact that inflation was reasonable. As inflation has dropped, the real interest rate has also dropped and is causing this phenomenon known as the liquidity trap
2) Neutral rate - The neutral rate is the rate that would restrict the capacity of the economy. This rate has been steadily falling in the last 30 years, particularly because of lowering inflation reducing the impact that a rate change will have on the economy. 10 years ago 3% was considered to be contractionary MP, now 3% is expansionary.
3) Reliant on unsustainable credit growth - The global economy has been heavily dependent on high levels of credit growth for the last 20 years. As interest rates are driven to extreme levels, stability deteriorates, bubble prices occur and bad debt is more easily accessible. This brings the consumption of the future into today. Eventually future consumption will be depleted and growth will stall and deteriorate.

Question 36

How has the global economic vulnerability of low rates developed? List four reasons.

Answer 36

1) Slower population growth and cheaper technology requires lower investment levels
2) Developed economies are beyond the heavy investment phase (e.g. China is still undergoing heavy investment and will have greater overall investment and growth)
3) Rising inequality directs income to those with a higher propensity to save, meaning the impact of rate cuts on the nation will be reduced
4) Australia is a small open economy and is strongly influenced by global trends

Question 37

What can monetary policy do beyond short rates?

Answer 37

MP is nearly exhausted, the prospect of quantitative easing is an attractive prospect, but it had little to no impact during the GFC, suggesting that the impact of QE has since passed. Adding to liquidity can only help so far. Fiscal stimulus or structural changes to the economic environment are potential solutions to assist with boosting growth and inflation.

Question 38

What are Bob Farrell’s 10 Market Rules to remember?

Answer 38

1) Markets tend to revert to the mean over time
2) Excesses in one direction will lead to an opposite excess in the other direction
3) There are no new eras - excesses are never permanent
4) Rapidly rising/falling markets usually go further than you think, but they never correct by going sideways, they always rise/fall to correct
5) The public buys most at the top, least at the bottom
6) Fear and greed ares stronger than long-term resolve
7) Markets are strongest when they are broad, weakest when narrow
8) Bear markets (falling ones) have three stages - sharp down, reflexive rebound and drawn-out fundamental downtrend
9) When forecasts and experts all agree, something else will happen
10) Bull markets are more fun than bear markets

Question 39

What is an inverted yield curve?

Answer 39

An inverted yield occurs when long-term bond yields (10 yrs) drop below short term bond yields (2 yrs). It happens rarely but when it does, it indicates a recession is near. This causes banks’ operational model to be thrown into disarray as they stand to lose money if they continue to borrow short and lend long.