ChapterMcGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Stock Price Behavior and Market Efficiency7-2“A market is the combined behavior of thousands of people responding to information, misinformation, and whim.”“If you want to know what's happening in the market, ask the market.”— Kenneth Chang— Japanese Proverb7-3Controversy, Intrigue, and Confusion• We begin by asking a basic question: Can you, as an investor, consistently “beat the market?”• It may surprise you to learn that evidence strongly suggests that the answer to this question is “probably not.”• We show that even professional money managers have trouble beating the market. • At the end of the chapter, we describe some market phenomena that sound more like carnival side shows, such as “the amazing January effect.”7-4Market Efficiency•The Efficient market hypothesis (EMH) is a theory that asserts: As a practical matter, the major financial markets reflect all relevant information at a given time.• Market efficiency research examines the relationship between stock prices and available information.– The important research question: is it possible for investors to “beat the market?”– Prediction of the EMH theory: if a market is efficient, it is not possible to “beat the market” (except by luck).7-5What Does “Beat the Market” Mean?• The excess return on an investment is the return in excess of that earned by other investments that have the same risk. • “Beating the market” means consistently earning a positive excess return.7-6Three Economic Forces that Can Lead to Market Efficiency• Investors use their information in a rational manner.– Rational investors do not systematically overvalue or undervalue financial assets.– If every investor always makes perfectly rational investment decisions, it would be very difficult to earn an excess return. • There are independent deviations from rationality.– Suppose that many investors are irrational.– The net effect might be that these investors cancel each other out.– So, irrationality is just noise that is diversified away.– What is important here is that irrational investors have different beliefs.• Arbitrageurs exist.– Suppose collective irrationality does not balance out.– Suppose there are some well-capitalized, intelligent, and rational investors.– If rational traders dominate irrational traders, the market will still be efficient.These conditions are so powerful that any one of them leads to efficiency.7-7Forms of Market Efficiency,(i.e., what information is used?)•A Weak-form Efficient Market is one in which past prices and volume figures are of no use in beating the market. – If so, then technical analysis is of little use.•A Semistrong-form Efficient Market is one in which publicly available information is of no use in beating the market.– If so, then fundamental analysis is of little use.•AStrong-form Efficient Market is one in which information of any kind, public or private, is of no use in beating the market.– If so, then “inside information” is of little use.7-8Information Sets for Market Efficiency7-9Why Would a Market be Efficient?• The driving force toward market efficiency is simply competition and the profit motive.• Even a relatively small performance enhancement can be worth a tremendous amount of money (when multiplied by the dollar amount involved).• This creates incentives to unearth relevant information and use it.7-10Some Implications of Market Efficiency, I.Does Old Information Help Predict Future Stock Prices?• This is a surprisingly difficult question to answer clearly.• Researchers have used sophisticated techniques to test whether past stock price movements help predict future stock price movements. – Some researchers have been able to show that future returns are partly predictable by past returns. BUT: there is not enough predictability to earn an excess return. – Also, trading costs swamp attempts to build a profitable trading system built on past returns. – Result: buy-and-hold strategies involving broad market indexes are extremely difficult to outperform.Technical Analysis implication: No matter how often a particular stock price path has related to subsequent stock price changes in the past, there is no assurance that this relationship will occur again in the future.7-11Some Implications of Market Efficiency, II. Random Walks and Stock Prices• If you were to ask people you know whether stock market prices are predictable, many of them would say yes. • To their surprise, and perhaps yours, it is very difficult to predict stock market prices. • In fact, considerable research has shown that stock prices change through time as if they are random. • That is, stock price increases are about as likely as stock price decreases. • When there is no discernable pattern to the path that a stock price follows, then the stock’s price behavior is largely consistent with the notion of a random walk.7-12Random Walks and Stock Prices, Illustrated.7-13How New Information Gets into Stock Prices, I.• In its semi-strong form, the EMH states simply that stock prices fully reflect publicly available information. • Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock.• But, the future prospects for the stock are influenced by unexpected news announcements.• Prices could adjust to unexpected news in three basic ways: – Efficient Market Reaction: The price instantaneously adjusts to the new information.– Delayed Reaction: The price partially adjusts to the new information. – Overreaction and Correction: The price over-adjusts to the new information, but eventually falls to the appropriate price.7-14How New Information Gets into Stock Prices, II.7-15Event Studies, I.• Researchers have examined the effects of many types of news announcements on stock prices.• Such researchers are interested in:– The adjustment process itself– The size of the stock price reaction to a news announcement. • To test for the effects of new information on stock prices, researchers use an approach called an event study.• Let us look at how researchers use this method.• We will use a dramatic example.7-16Event Studies, II.• On Friday, February 25, 2005, executives of Elan Corporation announced that the company was voluntarily halting the supply