Are Markets Rational? Part 1 Adapted from Haugen, Ch. 15: “The Wrong 20-Yard Line”ReferencesForms Of EMTWeak Form EMHSemi-Strong Form EMHSummary on Semi-Strong Form EMHStrong Form EMHFund ManagersSlide 9Tests and Results of EMHSlide 11Haugen’s Trilogy“The New Finance”Changing Investor Opinion as to the Length of the Short RunBut …The Relative Performance of Portfolios Equally-weighted in the Cheap and Expensive QuartilesPowerPoint PresentationSlide 18What has Over-estimation of the Length of the Short Run Done to Risk and Return?How Long Have Risk and Return Been Up-side Down?Slide 21The Relationship Between the Perceived and True Growth Horizon and Average Growth RatesSlide 23Slide 24“Beast on Wall Street”Three Components of Stock VolatilityHigh-wire Act at the Financial CircusComponents of the Movements in the Balance BarsThe Types of Volatility ContrastedSynthesisContentionsMysteries of the Stock MarketSlide 34Slide 35Volatility Shifts Over 8-week Trading PeriodsRealization of Risk Premiums Following the Price-level AdjustmentsSlide 38Percentage Changes in Stock Prices on 49 Historic DaysPercentage Changes in Stock Prices on Historic Days“Events” Associated with the Five Largest One-day Percentage Changes in Stock PricesHaugen vs. Mauboussin“The Inefficient Stock Market”It’s Tough to Beat the MarketSlide 45The Wrong 20-Yard LineSlide 47Slide 48Slide 49Slide 50Slide 51The TriumphMy OpinionSlide 54Slide 55Are Markets Rational?Are Markets Rational?Part 1Part 1Adapted from Haugen, Ch. 15: Adapted from Haugen, Ch. 15: “The Wrong 20-Yard Line”“The Wrong 20-Yard Line”References References •Reilly & Brown, Ch. 7 – “Efficient Capital Markets”•Haugen, Ch. 15 – “The Wrong 20-Yard Line”•Mauboussin (www.capatcolumbia.com) – “Shift Happens”•Hagstrom, Ch. 8 – “The Market as a Complex Adaptive System”•Rubinstein (Financial Analysts Journal, 2001) – “Rational Markets: Yes or No? The Affirmative Case”•Fortune (3 Dec. 2002) – “Is the Market Rational?”Forms Of EMTForms Of EMT•Weak Form–Prices reflect all historical information–Price changes follow a random walk–“Tests of Return Predictability”–Technical Analysis•Semi-Strong Form–Prices reflect all public information–“Event Studies”–Fundamental Analysis•Strong Form–Prices reflect all public and private information–“Tests for Private Information”–Insider TradingWeak Form EMHWeak Form EMH•Supported by:–Studies on Autocorrelation–Tests of Filter Rules•Contradicted by:–Seasonality•January Effect•Day-of-the-Week Effect–Long-term overreaction/reversal patternsSemi-Strong Form EMHSemi-Strong Form EMH•Supported by: –Most Event Studies•Contradicted by:–Various Accounting Anomalies •Size Effect•M/B Effect–Neglected Firm EffectSummary on Summary on Semi-Strong Form EMHSemi-Strong Form EMH•Market seems to do a relatively good job at adjusting a stock’s valuation for certain types of new information•Determining how much the new info. will change the stock’s value and then adjusting the price by an equivalent amountThis is what event studies examine•But it seems to have problems developing an overall valuation for a stock in the first place •E.g., What is the correct value for IBM as a whole is a very difficult question to answer, but how much IBM’s value should change if it is awarded a specific new contract is much easier to determineStrong Form EMHStrong Form EMH•Supported by: –Under-performance of most fund managers •Most are beaten by the market averages•Contradicted by:–Returns following insider purchases–Value Line effect–Consistent outperformance of some fund managers •Notably, Warren Buffett and the “Superinvestors of Graham-and-Doddsville”Fund ManagersFund Managers•Trained professionals, working full time at investment management•If any investor can achieve above-average returns, it should be this group•If any non-insider can obtain inside information, it would be this group, due to the extensive management interviews that they conduct•But, Peter Lynch criticism:–“have blinders on”•Also …Fund ManagersFund Managers•Quote from “Wall Street:”–“Do you want to know why fund managers can’t beat the S&P 500? Because fund managers are sheep … and sheep get slaughtered.”•Problems Fund Managers Face:–Administrative expenses and trading costs–Agency problems that contribute to poor performance–Compensation structure that encourages “sheep-like” behaviorTests and Results of EMHTests and Results of EMH•Many results tend to support EMH–Event studies–Performance of most fund managers•But many other results tend to contradict EMH–Performance of Buffett–Numerous anomalies & long-run overreaction/reversals•So, are markets efficient (or rational) or not?–Need to examine whether markets can be beaten, after adjusting for risk–But, how should you model and measure risk? CAPM? APT?Tests and Results of EMHTests and Results of EMH•Tests face a joint hypothesis problem –Results are dependent on both of two factors: –Market efficiency •Is the stock’s price equal to its true value?–Asset pricing model used (CAPM, APT, etc.)•What is the stock’s true value?•So, are the markets efficient or rational?–Ultimately, can never answer definitively–Mauboussin’s view (“Shift Happens”): stock market as a chaotic or complex adaptive system–Haugen’s view follows …Haugen’s TrilogyHaugen’s Trilogy““The New Finance”The New Finance”““Beast on Wall Street”Beast on Wall Street”““The Inefficient Stock Market”The Inefficient Stock Market”““The New Finance”The New Finance”•Focuses on the market’s major systematic error:–Fails to appreciate the strength of competitive forces in a market economy–Over-estimates the length of the “short run”–Over-reacts to records of success and failure for individual companies–Drives the prices of successful companies too high–Drives the prices of unsuccessful companies too low•So:–Successful firms tend to experience negative earnings surprises down the road–Unsuccessful firms tend to benefit from positive earnings surprisesChanging Investor Opinion as to the Changing Investor Opinion as to the Length of the Short RunLength of the Short Run•Prior to 1924 Prior to 1924 -Stock valuation based on Stock valuation