Problems with the Efficient Market Hypothesis

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Problems with the Efficient Market Hypothesis

• Critics Anomalies
• Covered in Ch. 6 of Scott text

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Example Crash of 1987

• 22.7 percent devaluation of stocks
• Unreasonable to assume caused by sudden major
  shift in perceived risk or expected future
  dividends!
• Surprise to corporate insiders (Bates 1991)
• Survey most investors traded because of price
  changes rather than news about fundamentals
  (Schiller 1991)

3
Adoption of Fair Values Can Lead To Large
Write-offs

• GM to take charge of 20.8 billion
• February, 1993 page 132 in text
• No immediate cash flow impact
  

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Are Securities Markets Efficient?

• Behavioral Finance

5
Why Accountants Care

• To extent markets not efficient, the information
  perspective is less useful
• Reporting on risk ß is no longer the only
  relevant risk measure
• Much empirical research on usefulness of
  financial statement information relies on
  efficient securities markets

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Keynes EMH
              John M. Keynes

• EMH assumes investor rationality
• Keynes philosophy assumes animal spirits rule
  the casino
• Stock market as a
• Beauty contest
• Mass psychology of ignorant speculators
• Uncertainty vs. risk

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Partially Rational Behavior

• Expected utility theory fails to describe human
  behavior
• Real people
• Have limited information processing capabilities
• Exhibit systematic bias in processing information
• Are prone to making mistakes
• Tend to rely on the opinion of others
• Rely on irrelevant points of reference

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Re-evaluating Utility Function

• Fad component in stock prices?
• Herd mentality
• An alternative to the theory of the optimal
  investment decision
• Separate evaluation of gains and losses
• Overconfidence
• Weighting of probabilities
• Rare events over-weighted
• Probable events under-weighted
• Prospect theory utility function

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Prospect Theory (See Section 6.2.2 in Scott)

• Prospect theory has been used to explain a wide
  range of situations which appear inconsistent
  with standard economic rationality

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Prospect Theory

• A. Curve is steeper for losses than for gains
• Greater aversion for losses than for equivalent
  gains

• B. Both gains losses obey law of diminishing
  returns

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Is Beta Dead?

• Under CAPM, Beta is only risk
• Higher ß ? higher return, vice versa
• Fix Beta?
• Treat as nonstationary
• Acknowledge other sources of risk?
• Behavioral realities (over-reactions)
• In any case, investors must consider other types
  of risk
• Role for accounting information?

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Bubbles and Volatility

• Bubbles
• Momentum
• Herd behavior
• Evidence of excess market volatility
• Found by Shiller (1981)
• Disputed by Ackert and Smith (1993)

13
FS are Explaining LESS

• Lev Zarowin 1999 Study of 20 years between
  1977 to 1996
• Results indicate weakening of the association
  between market values and accounting information
  (earnings, cash flows and book values)
• R2 and ERC dropping over period
• Explanation?
• Changing business environment?
• Failure to account for intangibles?

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Anomalies

• Empirical Findings Inconsistent with EMH

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EMH Anomalies

• A. The January Effect
• B. The Weekend Effect (or Monday Effect)

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EMH Anomalies

• C. Other Seasonal Effects
• D. Small Firm Effect
• E. P/E Ratio Effect

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EMH Anomalies

• F. Value-Line Enigma
• G. Over/Under Reaction of Stock Prices to
  Earnings Announcements
• Post announcement drift
• Discussed page 182-183 in text
• H. Standard Poors (SP) Index effect

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EMH Anomalies

• I. Pricing of Closed-end Funds
• J. The Distressed Securities Market
• K. The Weather

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EMH Anomalies

• Financial statement ratios
• Discussed page 183-185 in text
• Prices may not reflect balance sheet information
• Ou Penman (1989)

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Paradigm Shifting?

• These anomalies cannot be explained within the
  existing paradigm of EMH
• Information alone is not moving the prices
• Researchers now questioning EMH
• Such a development is consistent with Kuhn's
  (1970) route for progress in science
• "Discovery commences with the awareness of
  anomaly, i.e., with the recognition that nature
  has somehow violated the paradigm induced
  expectations..." Kuhn, 52

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EMH Anomalies

• Possible explanations for anomalies that are
  consistent with securities market efficiency
• Risk
• Transactions costs
• The issue is the EXTENT to which markets are
  efficient
• Do we believe its close enough ???

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Text Conclusions re EMH

• Efficiency a matter of degree
• Growing theory and evidence in behavioral
  finance
• Securities market efficiency a worst case
  scenario for usefulness of financial statement
  information

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Moving Toward A Measurement Perspective

• Means greater use of fair values in the financial
  statements
• New paradigm for empirical research
• Clean surplus theory or residual income model
• Ohlson and Feltham Ohlson
• To be discussed next lecture

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Impact of A Measurement Approach

• If markets are less efficient, accounting
  information has larger role to play if relevant
• Fair value accounting results in earnings
  volatility
• Reduce through different income statement ????
• Auditor Liability (decrease/increase?)

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Measurement Perspective Applications

• Chapter 7
• Review of measurement oriented accounting
  standards

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Examples with Long History

• Accounts receivable and payable
• Cash flows fixed by contract
• LCM rule for inventory
• Pushdown accounting (for acquired subsidiaries)
• Fair value accounting for certain investments
• SFAS No. 115 (1993)

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More Recent Standards

• Recognition of liabilities related to pension and
  other post-retirement obligations
• SFAS No. 87, 88 (1985) 106 (1990)
• Impairment of creditor loans
• SFAS No. 114 (1993) as amended
• Fair value accounting for derivatives
• SFAS No. 133 (1998) as amended

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More Recent Standards, cont

• Impairment tests for goodwill intangible assets
• SFAS No. 142 (2001)
• Recognition of liability for asset retirement
  obligations
• SFAS No. 143 (2001)
• Impairment tests for capital assets
• SFAS No. 144 replaced the 1995 standard (No.
  121) in 2001