CHAPTER 7, Lecture Notes

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CHAPTER 7, Lecture Notes
Stock Price Behavior and Market Efficiency
Chapter Sections Introduction to Market
Efficiency What Does Best the Market
Mean? Fluctuations of Market Efficiency Forms of
Market Efficiency Why Would a Market Be
Efficient? Some Implications of Market
Efficiency Informed Traders and Insider
Trading How Efficient are Markets? Market
Efficiency and the Performance of Money
Managers Anomalies Bubbles and Crashes All Stars
of Investing
A better name for this chapter might be, Can
You Beat the Market?
I can calculate the movement of the stars, but
not the madness of men. Sir Isaac Newton
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Random Walks Efficient Markets

• Random Walk Hypothesis
• The theory that stock price movements are
  unpredictable
• In the short term, yes, they appear random
• In the long term, no (We hope Failure is not an
  option!)
• Efficient Market Hypothesis
• A market in which securities reflect all possible
  information quickly and accurately
• If there are large numbers of knowledgeable
  investors who react quickly to new information,
  security prices will adjust quickly and
  accurately
• The New York Stock Exchange is an efficient market

A Random Walk Down Wall Street
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Levels of Market Efficiency

• Weak Efficiency Hypothesis
• Past data on stock prices are of no use in
  predicting future prices
• However, stock prices do tend to demonstrate
  momentum
• Stock prices tend to rise more often than they
  fall
• And they tend to move far higher than is usually
  justified (mania, bubble) or far lower than is
  usually warranted (crash)
• The market can stay irrational longer than you
  can stay solvent. -- John Maynard Keynes

If this theory is true, then technical analysis
(which we will cover in Chapter 8) is useless.
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Levels of Market Efficiency
(continued)

• Semi-strong Efficiency Hypothesis
• Abnormally large profits cannot be consistently
  earned using publicly available information
• In other words, no amount of analysis that you do
  to determine the future price of a stock will
  help you beat the market
• But there are many, many investors who have
• We will look at some of them later
• What does the theory say about those investors?
• They are just lucky!
• The more I practice, the luckier I get.

If this theory is true, then fundamental analysis
(which we covered in Chapters 6 17) is useless.
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Levels of Market Efficiency
(continued)

• Strong Efficiency Hypothesis
• No information, public or private, allow
  investors to earn abnormally large profits
  consistently
• But one insider information trade can make you
  rich
• If you do not get caught, that is

This is obviously false. If you had material
nonpublic information (the legal term for insider
information) about a company, you could make a
fortune overnight! But you could also go to
jail.
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Market Efficiency Rational

• The Random Walk and Efficient Market theorists
  are often also major proponents of index funds
• They point to the fact that many professional
  money managers simply do not Beat the Market
• Especially during bull markets
• From 1963 to 1998, the SP 500 index outperformed
  general equity mutual funds 22 out of 36 times

They reason that you are better off accepting
(close to) the markets return with low-cost
index funds since their theory tells them that no
one can consistently beat the market.
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Market Efficiency Rational
(continued)

• Why cant many pros beat the averages?
• Many mutual funds have high annual operating
  expenses and high turnover rates, and
• Many mutual fund managements have a very short
  time horizon
• Consequently, many mutual fund managers have a
  very short lifespan
• But the premises and casual observations of the
  Efficient Market theories show them to be
  patently absurd
• Many money managers have Beaten the Market
• Over long periods of time (the more I
  practice)

Plus if markets are efficient and rational, how
do you explain ?
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Manias

• Occasionally, investors get caught up in what are
  called manias (a.k.a. bubbles)
• The Internet bubble of the 1990s was the latest
  stock mania
• Before that, there was the Nifty-Fifty of the
  early 1970s
• The mania of the 1920s resulted in the Crash of
  1929
• In the 1840s, there were 400 railroad firms
• The Granddaddy of all Manias was the Dutch
  tulip bulb craze of the early 1600s
• Extraordinary Popular Delusions the Madness of
  Crowds
• The Botany of Desire
• Each time, the phrase was
• Its a New Era or
• Its Different This Time or
• The old ways of valuing stock are gone
• Each time, they were wrong!

So much for Rational Efficient Markets!
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Manias
(continued)

• Why do manias occur over and over again? Why
  havent investors learned their lesson?
• Any ideas?

market manias will happen over and over again
because the public is infinitely stupid.
Leonard Kaplan, president of commodities
brokerage firm Prospector Asset Management in
Evanston, Illinois.
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Manias
(continued)

• Benjamin Graham sez

The speculative public is incorrigible. It will
buy anything, at any price, if there seems to be
some action in progress. It will fall for any
company identified with franchising, computers,
electronics, science, technology, or what have
you, when the particular fashion is raging.
the abuses are so largely the result of the
publics own heedlessness and greed. The
Intelligent Investor, 1972 edition Replace
franchising, computers, etc. with Internet,
biotechnology, etc. and Good Ol Ben could have
been writing in 2000 instead of 1972. Today, its
social networking and China.
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Crashes

• How do most manias end?
• Yep You guessed it! They usually end with a
  crash.
• The bigger the party, the bigger the hangover
• They are not fun but the odds are you will live
  through at least one during your investing career

With this many strong years, I have the concern
that there are a vast majority of companies that
are significantly overvalued on a long-term
basis. -- Jon Lovelace, August 1999, mutual fund
manager with almost 50 years experience at the
time
Oh, by the way, the 2008/2009 market crash was
not caused by a stock market bubble. It was a
real estate bubble (and the mortgage-backed bonds
that were tied to the real estate mortgages).
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Crashes
Eleven Worst Days of the Dow Jones Industrial
Average
(continued)
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Index Funds, Market Indices, Manias, and Crashes

• Recall Index funds and ETFs rely on indices
• Instead of trying to beat the market, just buy
  the market and be happy with the market return
• But sometimes an index can become skewed
• Especially when a sector or region becomes hot

MSCI EAFE 12/31/89
SP 500 3/31/00
Info Tech, 33.3 P/E 59.2
Japan, 59.8 P/E 51.9
All else, 66.7 P/E 19.3
All else, 40.2 P/E 13.0
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Anomalies, Silly Theories, Oddities

• Timing Theories
• The Monday Effect Best day to buy (or is it
  sell?)
• The January Effect As goes January, so goes the
  year
• The Santa Claus Rally Turn-of-the-year
  effect
• Sell in May and Go Away!
• September and October Worst months of the year
• November to March Best months of the year
• Super Bowl Theory
• National League Wins bullish
• American League Wins bearish
• Hemlines of skirts
• Mini skirts bullish (1920s, 1960s)
• Long skirts bearish (1930s, 1970s)
• Politics and the Stock Markets

There are many other silly theories such as the
Lipstick Indicator, the Boston Snow Indicator
(a.k.a. the BS Indicator), the Hot Waitress
Indicator, and the Aspirin Count Theory.
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All Stars of Investing

• Peter Lynch
• Fund Manager of Fidelitys Magellan mutual fund
• Buy what you know
• Warren Buffet
• Dont buy a stock buy a company
• Puts emphasis on the value of the entire company
• Benjamin Graham
• He was Warren Buffets teacher
• Father of Value Investing
• Wrote The Intelligent Investor and Security
  Analysis
• John Templeton
• One of the first mutual fund managers to invest
  globally

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All Stars of Investing
(continued)

• Bill Miller
• Fund Manager of Legg Mason Value Trust
• For 15 years calendar years in a row, he beat the
  SP 500, an unprecedented record!
• He became (unfortunately for him, as far as I was
  concerned) the financial medias mega-star
• Luckily for him (as far as I am concerned), he
  did not beat the SP 500 in 2006
• He also lagged badly in 2007 and 2008
• But before his 15-year record setting run, he
  lagged the SP 500 two years in a row
• And then in 2009, he was up over 40!
• But again trailed the SP 500 badly in 2010

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All Stars of Investing
(continued)

• What do all these people have in common?
• Courage to not follow the crowd
• The conventional wisdom is usually not very
  wise!
• A eye for unrecognized value
• Almost a sixth sense
• Gary Kasparov was once asked why he and Anatoly
  Karpov were the two best chess players in the
  world
• His answer was astonishingly simple and direct
• We attack better than anybody else and we defend
  better than anybody else
• These people bought the best companies and they
  avoided the worst companies

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All Stars of Investing
(continued)

• Speaking of avoidance
• As a mutual fund investor, I am not looking to
  find the next Peter Lynch or Bill Miller or
  Warren Buffet
• I am looking to avoid the next Charles Steadman
• Charles Steadman ran his own mutual fund, the
  Steadman American Industry Fund, from December
  1959 until his death in late 1997
• His cumulative total return was -42.9
• He would have done much better simply placing his
  investors funds into a savings account at a bank
• He would have done better putting it in a
  mattress!
• Maybe he came from the life insurance industry

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Warren Buffet sez

• Be fearful when others are greedy. Be greedy
  when others are fearful.

His mentor, Benjamin Graham said it this way,
Buy when most people including experts are
overly pessimistic, and sell when they are
actively optimistic.
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John Templeton sez

• Bear markets are born of pessimism, grow on
  skepticism, mature on optimism and die on
  euphoria. The time of maximum pessimism is the
  best time to buy.

On a similar note, he also said, To buy when
others are despondently selling and sell when
others are avidly buying requires the greatest
fortitude and pays the greatest reward.
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Famous Myths Stupid Sayings

• It cant go any lower
• Oh, yes it can! It can go to zero!
• It cant go any higher
• Oh, yes it can! If the earnings are continuing
  to grow, there is no limit to how high the price
  can go
• It is only 3 a share What can I lose?
• It does not matter how low the price is, the
  price can go to zero and you can lose all your
  money
• Remember Price is irrelevant valuation is the
  key
• It has to come back
• Have any of you ever heard of Penn Central?

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Famous Myths Stupid Sayings
(continued)

• It is always darkest before the dawn
• Sometimes its always darkest before its pitch
  black
• When it rebounds to 10, I will sell
• A stock has no idea you bought it at 10
• If you would not buy it now at this price, sell
  it now!
• If it goes down 10, sell
• Stock prices fluctuate greatly, even blue chips
• If you sold each stock that lost 10, you would
  almost always sell your winners along with your
  losers
• It is taking too long
• Patience is an investors most important trait
• Besides, it gives you a chance to buy more!

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Famous Myths Stupid Sayings
(continued)

• Look at all the money Ive lost I didnt buy
  it
• Coulda, Woulda, Shoulda
• You did not lose a cent by not buying a stock
  that did well Do not fret over it!
• I missed that one, I will catch the next one
• The next one rarely makes it
• Why wait for the next Microsoft? Buy Microsoft!
• The stock has gone up, I must be a genius
• Never mistake a bull market for brains
• Old Wall Street saying
• The stock has gone down, I must be an idiot
• Ditto (but in reverse)

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Famous Myths Stupid Sayings
(continued)

• Its Different This Time
• Well, technically, yes. It is different every
  time.
• But that does not mean you should pay an
  astronomical price for a company that probably
  will never make a dollar of profit (Hint
  Internet stocks)
• Its a New Era
• Ditto (When you hear this one, it is time to
  sell)
• Its a Permanent Trend
• Aint No Such Thing! Markets move in cycles.
• Stocks are too risky
• Even with all the shenanigans and stupidity, they
  are still the best long-term investment

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CHAPTER 7 REVIEW
Stock Price Behavior and Market Efficiency
Chapter Sections Introduction to Market
Efficiency What Does Best the Market
Mean? Fluctuations of Market Efficiency Forms of
Market Efficiency Why Would a Market Be
Efficient? Some Implications of Market
Efficiency Informed Traders and Insider
Trading How Efficient are Markets? Market
Efficiency and the Performance of Money
Managers Anomalies Bubbles and Crashes All Stars
of Investing
Next week Chapter 8, Behavioral Finance and the
Psychology of Investing