BMF5332 Foundation of Investments

Lecture 4: Are Financial Markets Efficient?

AY 2023/2024 Semester 2
Karsten Müller
Do you think financial markets are efficient?
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Overview
• What is market efficiency?

• The efficient market hypothesis

• Evidence on behavioural factors in financial markets

• Market valuations and forward excess market returns

The 1986 challenger explosion
January 28, 1986
▪ 11:39am: Challenger explodes
▪ 11:47am: “Space Shuttle Explodes”
▪ 12:17pm: “Lockheed Has No
Immediate Comment”
▪ 12:52pm: “Rockwell Intl Has No
Comment”
President Reagan establishes commission to investigate
Conclusion 4 ½ months later
• Booster rocket exploded due to faulty “O-ring” produced by Morton-Thiokol

O-ring
An academic paper studies the stock market’s reaction
Stock prices of space shuttle manufacturers

Stock market had

identified the culprit
in a few minutes
What is market efficiency?
In economist lingo:
“A market is efficient with respect to information set 𝜃𝑡 if it is impossible to make
economic profits by trading on the basis of information set 𝜃𝑡 .” (Jensen, 1978)

A simpler definition:
An efficient market is one in which no single investor can, beyond luck, consistently
outperform the market’s risk-adjusted rate of return net of transaction costs.

Many questions:
• What is the information set 𝜃𝑡 , and who observes it?
• What are “economic profits”?
o Need to adjust returns for risk using an asset pricing model (e.g., CAPM)
o Many tests of efficiency are joint tests of efficiency and the asset pricing model
Understanding investing in four Nobel Prizes
1990 1990 2013 2013
Understanding investing in four Nobel Prizes
1990 1990 2013 2013

Eugene Efficient Market Hypothesis

Fama Financial markets tend to price in
relevant information.
The efficient market hypothesis (EMH)
It is impossible to make economic profits if the information set 𝜃𝑡 contains…

Weak form
• …past price data (e.g., knowing what the stock return was over the past week)

Semi-strong form
• …all publicly available information (e.g., CAPE)

Strong form
• …all public and private information (e.g., O-ring as source of Challenger failure)

Source: Fama (1970), “Efficient Capital Markets: A Review of Theory and Empirical Work”, Journal of Finance
Market efficiency has important implications
“Even a dart-throwing chimpanzee can select a
portfolio that performs as well as one carefully
selected by the experts. This, in essence, is the
practical application of the theory of efficient
markets…

The theory holds that the market appears to

adjust so quickly to information about individual
stocks and the economy as a whole that no
technique – neither technical nor fundamental
analysis – can consistently outperform a strategy
of simply buying and holding a diversified group
of securities such as those that make up the
popular market averages.”

Source: Burton G. Malkiel (1973), “A Random Walk Down Wall Street”

Market efficiency has important implications
Conceptual questions
• What is the value of producing information on specific firms?
• Are all stocks and markets equally efficiently priced?
• Can stock prices deviate from equilibrium?

Practical questions
• Should you invest all money in market indices, and if yes, which ones?
• Are there “magical formulas” or signals that generate superior returns?
• How does the “smart money” (institutional investors and hedge funds) invest?
• If “active” management does not add value, why does it exist?
Common misperceptions
Positive returns of an investment strategy do not necessarily reject EMH
• EMH does not predict investors cannot earn a positive return
• It predicts you cannot consistently earn risk-adjusted returns after transaction costs

Main challenge: how to adjust for risk

• No consensus theory on which types of risks should attract premia
• No consensus on right empirical asset pricing model to correct for risk (e.g. CAPM)
• Consequence: EMH proponents can claim trading profits are reward for risk-taking
• This problem is called the joint hypothesis issue
How rational are markets, really?
Thousands of studies show fundamentals aren’t all

Empirical evidence in three broad categories:

1 Observing stock returns around corporate events

2 Predicting aggregate stock market (index) returns

3 Sorting stocks based on characteristics

We will discuss this in detail next lecture

A quick survey on cancer risks
Vote: PollEv.com/bmf5332
You were just part of a scientific experiment…
• In many settings, statistics on absolute numbers are uninformative or even irrelevant
• Instead, what matters are proportions
• Examples: Mortality rates, fuel usage, returns on financial assets
You were just part of a scientific experiment…
• In many settings, statistics on absolute numbers are uninformative or even irrelevant
• Instead, what matters are proportions
• Examples: Mortality rates, fuel usage, returns on financial assets
Can markets do simple math?

Source: Shue and Townsend (2021), “Can the Market Multiply and Divide?”, Journal of Finance
Can markets do simple math?
Trading platforms and media often report absolute price changes (not %)
• These numbers are meaningless! They depend on the number of shares (arbitrary).
• Thought experiment: two stocks, one is $20, one is $30.
• If investors think in $1 changes, this will affect the stocks differently (1/20 vs. 1/30)

Source: Shue and Townsend (2021), “Can the Market Multiply and Divide?”, Journal of Finance
Can markets do simple math?
Trading platforms and media often report absolute price changes (not %)
• These numbers are meaningless! They depend on the number of shares (arbitrary).
• Thought experiment: two stocks, one is $20, one is $30.
• If investors think in $1 changes, this will affect the stocks differently (1/20 vs. 1/30)

Source: Shue and Townsend (2021), “Can the Market Multiply and Divide?”, Journal of Finance
Can markets do simple math?
In the data, stocks with lower prices are more volatile, controlling for firm size

Source: Shue and Townsend (2021), “Can the Market Multiply and Divide?”, Journal of Finance
Can markets do simple math?
Clever test: stock splits only change absolute stock price, not market cap!
On exact day of stock splits, retail investors buy these stocks, thinking they’re “cheap”

Source: Shue and Townsend (2021), “Can the Market Multiply and Divide?”, Journal of Finance
Can markets do simple math?
Stock splits have a long-term effect: they increase stock volatility
Suggests institutional investors react to news as if they are thinking in $1 changes

Source: Shue and Townsend (2021), “Can the Market Multiply and Divide?”, Journal of Finance
Understanding investing in four Nobel Prizes
1990 1990 2013 2013

Robert Predictable Returns

Shiller Returns can be predicted with past data.
The Cyclically-Adjusted Price-Earnings Ratio (CAPE)
50 18

45 1981 2000 16
40 14
Price-Earnings Ratio (CAPE, P/E10)

Long-Term Interest Rates

35
1929 12
30 30.8
10
1901 1966
25
8
20
6
15
CAPE
10 4

5 Long-Term 2
Interest Rates
0 1921 0
1860 1880 1900 1920 1940 1960 1980 2000 2020 2040
Note: Data from Robert Shiller’s website (http://www.econ.yale.edu/~shiller/data.htm)
Your turn

What is the correlation between the CAPE and future

excess stock market returns?

Use CAPE_Data_Shiller.xls (‘Data’ sheet) on Canvas,

columns U and V.

Make a scatter plot (look under the “Insert” tab).

What does the relationship look like?

Scatter plot: CAPE and 10-year forward stock returns
CAPE and 10-year forward excess returns
25%

20%

15%
10-year forward excess returns

10%

5%

0%
0 5 10 15 20 25 30 35 40 45 50

-5%

-10%

-15%
CAPE

Note: Data from Robert Shiller’s website (http://www.econ.yale.edu/~shiller/data.htm), 1871-01 to 2023-01

What’s surprising: stock prices should be forward-looking

Source: Datastream, monthly data, 12/31/2019 - 09/30/2020.

So are financial markets efficient or not?
My takeaway: markets are efficient enough so it’s hard to beat the market

Weak form (next time: “momentum anomaly”)

• …past price data (e.g., knowing what the stock return was over the past week)

Semi-strong form (well, stock splits are public)

• …all publicly available information (e.g., CAPE)

Strong form (limited to some situations?)

• …all public and private information (e.g., O-ring as source of Challenger failure)
Overview
• What is market efficiency? Information set 𝜃𝑡 is priced

• The efficient market hypothesis: Weak, semi-strong, strong

• Evidence on behavioural factors suggest some non-rationality in financial markets

• Market valuations predict forward excess market returns