Efficient Market Hypothesis vs. Behavioral Finance

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Efficient Market Hypothesis vs. Behavioral Finance

• Market Efficiency
• Random walk versus market efficiency
• Versions of market efficiency
• Technical analysis vs. fundamental analysis
• Predictors of future returns and market anomalies
• Behavioral finance

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Cumulative Abnormal Returns Around Takeover
Attempts Target Companies
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Stock Price Reaction to CNBC Reports
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EMH and Competition

• Stock prices fully and accurately reflect
  publicly available information.
• Once information becomes available, market
  participants analyze it.
• Competition assures prices reflect information.
• What does competition mean here? -- page 351
• Is there a role for active portfolio management
  in an efficient market?

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Forms of the EMH

• Weak
• Semi-strong
• Strong
• See page 347-348.

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Types of Stock Analysis

• Technical Analysis - using prices and volume
  information to predict future prices.
• Weak form efficiency technical analysis
• Chartist
• Relative strength versus resistance levels
• Fundamental Analysis - using economic and
  accounting information to predict stock prices.
• Semi strong form efficiency fundamental analysis

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Technical Analysis

• Relative strength page 348
• Resistance levels upper bound or
• Support levels lower bound
• Whether a workable technical trading rule will
  continue to work in the future once it becomes
  publicly known?

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Fundamental Analysis

• Uses earnings and dividend prospects of the firm,
  expectations of future interest rates, and risk
  evaluation of the firm to determine proper stock
  prices.
• Fundamental analysis is much beyond identifying
  well-run firms with good prospects. It is to
  identify companies better than every elses
  estimate.

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Active or Passive Management

• Active Management
• Security analysis
• Timing
• Passive Management
• Buy and Hold
• Index Funds

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Market Efficiency Portfolio Management

• Even if the market is efficient a role exists for
  portfolio management
• Appropriate risk level
• Tax considerations
• Other considerations

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Empirical Tests of Market Efficiency

• Event studies
• Assessing performance of professional managers
• Testing some trading rule

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Issues in Examining the Results

• Magnitude Issue
• Selection Bias Issue investing in small stocks
• Lucky Event Issue

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Weak-Form Tests

• Serial Correlation
• Momentum
• Returns over Long Horizons

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Experience with 911

• Anticipating market chaos, panic selling and a
  disastrous loss of value in the wake of the
  attacks, the NYSE and the Nasdaq remained closed
  until September 17, the longest shutdown since
  1933. Moreover, many trading, brokerage and other
  financial firms had offices in the World Trade
  Center and were unable to function in the wake of
  the tragic loss of life and collapse of both
  towers.
• On the first day of NYSE trading after 9/11, the
  market fell 684 points, a 7.1 decline, setting a
  record for the biggest loss in exchange history
  for one trading day. At the close of trading that
  Friday, ending a week that saw the biggest losses
  in NYSE history, the Dow Jones was down almost
  1,370 points, representing a loss of over 14.
• Major stock sell-offs hit the airline and
  insurance sectors as anticipated when trading
  resumed. Hardest hit were American Airlines and
  United Airlines, carriers whose planes were
  hijacked for the terrorist attacks.
• American Airlines (NYSEAMR) stock dropped from a
  29.70 per share close of September 11 to 18.00
  per share close on September 17, a 39
  decline. United Airlines (NYSEUAL) stock dropped
  from 30.82 per share close to 17.50 per share
  on the close on September 17, a 42 decline.

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Also Program trading algorithmic trading and
high-frequency trading According to the New York
Stock Exchange, in 2006 program trading accounts
for about 30 and as high as 46.4 of the trading
volume on that exchange every day. http//www.prog
ramtrading.com/ The greatest point loss of the
Dow Jones Industrial Average was 777.68 points on
September 29, 2008.
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Predictors of Broad Market Returns

• Fama and French
• Aggregate returns are higher with higher dividend
  ratios
• Campbell and Shiller
• Earnings yield can predict market returns
• Keim and Stambaugh
• Bond spreads can predict market returns

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Anomalies

• P/E Effect
• Small Firm Effect (January Effect)
• Neglected Firm
• Book-to-Market Effects
• Post-Earnings Announcement Drift
• http//biz.yahoo.com/research/earncal/today.html

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Returns in Excess of Risk-Free Rate and in excess
of the Security Market Line for 10 Size-Based
Portfolios, 1926 2005
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Average Monthly Returns as a Function of the
Book-To Market Ratio, 1963 2004
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Cumulative Abnormal Returns in Response to
Earnings Announcements
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Mutual Fund Performance

• Some evidence of persistent positive and negative
  performance.
• Potential measurement error for benchmark
  returns.
• Style changes
• May be risk premiums

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Persistence of Mutual Fund Performance
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Behavioral Finance

• The premise of behavioral finance is that
  conventional financial theory ignores how real
  people make decisions and that people make a
  difference.
• Investors Do Not Always Process Information
  Correctly
• Investors Often Make Inconsistent or
  Systematically Suboptimal Decisions

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Behavioral Biases

• Framing
• Decisions seem to be affected by how choices are
  framed page 387
• example
• Mental Accounting
• A special form of framing in which people
  segregate certain decisions
• example
• Regret Avoidance
• Individuals would have more regrets when their
  decisions are more unconventional
• example
• Prospect Theory
• Traders become risk seeking after they lose money

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Prospect Theory Graphs
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Prospect theory (2)

• Loss aversion utility depends not on the level
  of wealth from current levels.
• The convex curvature to the left of the origin
  will induce investors to be risk seeking rather
  risk averse when it comes to losses
• Traders in T-bond futures often take
  significantly greater risk in afternoon sessions
  following morning sessions in which they have
  lost money

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Limits to Arbitrage

• Fundamental Risk
• Implementation Costs
• Model Risk

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Limits to Arbitrage and the Law of One Price

• Violations
• Siamese Twin Companies
• Equity Carve-outs
• Closed-End Funds

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Bubbles and Market Efficiency

• The bust of dot-com bubble
• Financial crisis housing price bubble
• Hard to be justified by the position that
  security prices represent rational, unbiased
  assessments of intrinsic value.
• Dynamic risk taking excessive risk taking in
  bubble period

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Technical Analysis and Behavioral Finance

• Trends and corrections
• momentum (page 393)
• Dow theory primary trend, secondary trend, and
  tertiary trend
• see Figure 12-4
• Moving averages
• Breadth the spread between the number of stocks
  that advance and decline in price.

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Technical Analysis and Behavioral Finance

• Trin statistic
• Confidence index
• Put/call ratio

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Investment-based CAPM

• Cochrane (1991, 1996)
• Low costs of capital imply high NPV of new
  projects and high investment
• High costs of capital imply low NPV of new
  project and low investment
• Inverse relationship between expected return and
  investments