An Introduction to Investment Theory

© William N. Goetzmann
YALE School of Management

Chapter VIII: Information and the Efficiency of the Capital Markets


I. A World of Arbitrageurs

Recall the original motivation for the APT: because active investors search for opportunities to exploit arbitrage in expectations, they will not allow securities to plot far from the security market line (or plane). Thus, the security market line must be approximately correct, for if it were not, the opportunities to make money would be huge.



Opportunities for exploiting this "Arbitrage in Expectations" are likely to be fairy rare. However, when they arise, or are discovered through research, investors will seek to exploit them. Enormous potential rewards to arbitrage in expectations will motivate firms to do research about expected returns, and research about betas. This research will include analysis about cash flows and discount rates, as well as idiosyncratic information such as the health of the CEO, the relative merits of the product and so on. Arbitrageurs will seek out any information that will change their expectations about future returns sufficiently to allow profitable exploitation through buying or shorting the security.

When such opportunities arise, there is a powerful motivation to seize the chance quickly. There is no telling how fast other arbitrageurs can find out what you have when they start buying, the price of an underpriced asset will rise, and the chance to make money will go away -- at least in theory. The issue we address in this chapter is "How well does this arbitrage work, and how quickly do mispricings go away?"


II. Mispricings Created by the Arrival of Information

One answer to these questions is provided by looking at how market participants react to news that is suddenly revealed to the public. Major corporate events can immediately change expected future cash flows. For instance, a major disaster such as the Bophol chemical spill immediately drove down the Union Carbide stock price. In fact, prices react within a matter of minutes to such news, and the reaction is over within the day! In empirical "event studies" which focus on corporate news releases, there is little evidence that you can make money by investing on yesterday's news. This means, for instance, that when you read in the Wall Street Journal that a company announced the discovery of a new cure for the common cold at a news conference yesterday, arbitrageurs have already bought the shares, and driven the price up.

Often there is major news about the discount rate used to discount the future cash flows in valuation. For instance, when the Federal Reserve cuts the discount rate, we expect the net present value of corporate securities to increase -- that is stocks should jump. When discount rate changes are announced, stock prices react that day, and not the next day. This empirical evidence strongly indicates that, at least in the highly liquid, open-information economy of the U.S. capital markets, stock prices are Efficient.


III. Watch My (Invisible) Hand

The market is said to be efficient if it rapidly and completely impounds all relevant information into asset prices. This is nothing more than saying that Adam Smith's "invisible hand" of the market place works quickly! If prices are unfair (i.e. the asset is overpriced) then arbitrageurs will short the asset, until reduced demand for purchasing it caused the price to fall. The opposite, of course is true for underpriced securities. This informational efficiency is different than, say, the economic concept of Pareto efficiency, which concerns allocation. To say that a market is efficient is to make a statement about the speed at which new information filters into the price. The degree of market efficiency depends upon a number of things. First, an illiquid market is not likely to be efficient. Speed of reaction clearly depends upon the ability of the participants to buy and sell the securities. Second -- and this is psychological -- it depends upon the existence of at least some investors with cool-headed, careful economic judgment. Suppose investors quickly hear about the latest disaster, such as the collapse of Barings, but the could not reasonably evaluate its effect on the net present value of the company. An inefficient market may over-react to bad or good news -- not because information is slow to arrive, but because careful economic reasoning does not prevail. Of course, if you can keep your head while those around you are losing theirs, you may make a profit in this type of inefficient market. There is some evidence that the U.S. stock market over-reacts to bad and good news, however it is still not clear whether this pattern may be exploited by a clever arbitrageur. In fact, if there were clear evidence on this point, I am sure the opportunity to exploit the passions of fellow investors would soon disappear!

The greatest investor of all at exploiting market over-reaction was Nathan Rothschild, the London banker. He was known to have the most sophisticated information network in Europe, and everyone knew he would have the latest news about the outcome of the battle of Waterloo. Would he buy or sell Bank of England securities? One day Rothschild came out and quietly sold. Suddenly, astute investors got wind of this, and reacted with a flurry, dumping everything they owned. Rothschild then quietly bought in the panic. He made a killing! By the 18th century, financial news traveled fast -- in Rothschild's case, it may have even traveled by carrier pigeon. Studies of the efficiency of stock prices in this era indicate that when prices moved on the Amsterdam Stock Exchange on Monday, by Thursday they would move on the London Exchange -- this is about the time it took for a fast messenger to travel the distance from city to city, crossing the English Channel.


IV. Benefits of an Efficient Market

So far, arbitrageurs sound like vultures waiting to swoop in for the kill. They take risks to exploit new information at the expense of the less informed. The costs seem to be rewarding opportunism at the expense of other investors. Are there any benefits to having a market operate efficiently? Arguments in favor of efficient capital markets are: (1) the market price will not stray too far from the true economic price if you allow arbitrageurs to exploit deviations. This will avoid sudden, nasty crashes in the future. (2) An efficient market increases liquidity, because people believe the price incorporates all public information, and thus they are less concerned about paying way too much. If only the market for television sets were as efficient as the market for stocks! A lot less comparison shopping would be needed. (3) Arbitrageurs provide liquidity to investors who need to sell or buy securities for purposes other than "betting" on changes in expected returns.

Currently, China is seeking to limit access to global financial information in Shanghai (site of its major stock exchange). The government wishes to keep certain kinds of information from market participants. Is this desirable? Will this be possible?

V. Market Efficiency & Corporate Managers

Market efficiency has implications for corporate managers as well as for investors. This takes a lot of the "gamesmanship" out of corporate management. If a market is efficient, it is difficult to fool the public for long and by very much. for instance, only genuine "news" can move the stock price. It is hard to pump-up the stock price by claims that are not verifiable by investors. "Fake" news will not move the price -- or if it does, the price will quickly revert to the pre-announcement value when the news proves hollow. Publicly available information is probably impounded in the price already. This is hard for some managers to believe. An example is Sears' attempt to sell the Sears Tower in Chicago in the late 1980's. The company believed that, since it carried the property on its balance sheet at greatly depreciated values, the public did not credit the company with the full market price of the building and thus Sears stock was underpriced. This proved to be false -- in fact, it seems that Sears was overestimating the value of the building and the stock price was relatively efficient! Another lesson: accounting tricks don't fool anybody. Don't worry about timing accounting charges and don't worry about whether information is revealed in the footnotes or in the statements. An efficient market will quickly figure out the meaning of the information, once it is made public.


VI. Three Degrees of Efficiency

What kind of information is impounded in the stock price? It turns out that there are lots of different levels of market efficiency, depending upon the source or the information being impounded. The best way to illustrate this is by example. Suppose you had a hyper-efficient market that impounded All private information. This means that even a personal note passed between the CEO and the CFO regarding a major financial decision would suddenly impact the stock price! If so, this is called Strong-Form Efficiency. Few people believe that the market is strong-form efficient, but it is nice to have this benchmark!

How about all public information? That is, all information available in annual reports, news clippings, gossip columns and so on? If the market price impounds all of this information the market is called Semi-Strong Form Efficient. Most people believe that the U.S. equity markets by and large reflect publicly available information. But consider this -- is information I put on the Internet public? Are government files available under the freedom of information act public? There must be subtle shades of semi-strong market efficiency, but they are not typically differentiated. Each new piece of information an analyst gathers should be carefully considered with regard to whether it is already impounded in the stock price. The easier it was to get, the more likely it is to have already been traded upon.

The final form of market efficiency is Weak Form Efficiency A weak-form efficient market is one in which past security prices are impounded into current prices. Since past prices are deemed public information, weak form efficiency implies semi-strong form efficiency and semi-strong form efficiency implies strong form efficiency.

Weak form efficiency implies that you can't make excess profits by trading on past trends. Funny, a lot of people do just that. They are called technical analysts, or chartists. What would you do if you noticed that every time the market went up by 1%, the next day on average, it went up again by 1/2 %? What would you do if you noticed that every time the market went down by 1%, the next day on average, it went down again by 1/2 %? If your answer is that you would buy on an up day and sell on a down day, you have the makings of an active technical trader! Academics have been testing trading rules like this for forty years, and traders have been exploiting them for even longer. The concept behind the simple rule described above is momentum. Although it is a widely used concept for technical investing, there is no evidence that any short-term market-timing rule actually makes money. The reason for this is the following: What if everyone followed the same strategy? Wouldn't the opportunity go away? It turns out that daily to stocks are returns are weakly autocorrelated (i.e. they have momentum, but the costs of exploiting this pattern are high. You have to buy and sell stocks every day, and in doing so, you have to pay brokerage fees. Thus, while major patterns in stock prices should not exist, weak patterns that are too costly to arbitrage may persist. If these simple trends are arbitraged away, then the market will follow a random walk, i.e. past deviation from expected returns tell you nothing about future deviations from expected returns.

Charles Henry Dow, Wall Street Journal founder and creator of the Dow index (in 1896) noted that his stock price index alternated between bull and bear markets. He hoped to time this market, and his dream has long outlived him. The financial press (and web) are rife with market timing newsletters, purporting to find long-term patterns in the stock market. Recent research has suggested that markets may actually follow to multiple-year cycles. But can you make money? It is still hard to tell! Current hedge fund operators and high-tech investors use sophisticated "artificial intelligence" and "neural nets" to find patterns. Some make money. Is it luck? If it works, why do they offer you the opportunity to buy their software?


VII. Evidence For Market Efficiency

A simple test for Strong Form Efficiency is based upon price changes close to an event. Acts of nature may move prices, but if private information release does not, then we know that the information is already in the stock price. For example, consider a merger between two firms. Normally, a merger or an acquisition is known about by an "inner circle" of lawyers and investment bankers and firm managers before the public release of the information. When these insiders violate the law by trading on this private information, they may make money. They also make it to the SEC's wall of shame.



Unfortunately, stock prices typically move up before a merger, indicating that someone is acting dishonestly. The early move indicates that the market has a tendency towards strong-form efficiency, i.e. even private information is incorporated into prices. However, the public announcement of a merger is typically met with a large price response, suggesting that the market it not strong-form efficient. Leakage, even if illegal, does occur, but it is not fully impounded in stock price. By the way, until recently, insider trading was legal in Switzerland.

Is the stock market semi-strong form efficient?

The most obvious indication that the market is not always and everywhere semi-strong form efficient is that money managers frequently use public information to take positions in stocks. While there is no evidence that they beat the market on a risk-adjusted basis, it is hard to believe that an entire industry of information production and analysis is for naught. It seems likely that there is value to publicly available information, however there are probably degrees to which information really is public knowledge. What is surprising is that recent studies have shown some evidence that excess returns can be made by trading upon very public information. These tests usually take the form of "backtesting" trading strategies. That is, you play a "what-if" game with past stock prices, and pretend you followed some rule, using information available only at the time of the pretend trade. One common rule that seems to perform well historically is to buy stocks when the dividend yield is high. This apparently has made money in the past, even though the information about which stocks have high yields and which have low yields is widely available. Another rule that generates positive excess returns in back-tests is to buy stocks when the earnings announcement is higher than expected. This seems simple, since current announcements and even forecasts are widely available as well.

Does this mean that it is easy to become rich on Wall Street? Hardly! The profitability of these simple trading rules depends upon the liquidity of the stocks involved, and trading costs ("frictions"). Sometimes the costs outweigh the benefits. While many investment managers explain that they pursue a strategy of buying "Value" stocks (such as low P/E firms) few of these managers have consistently superior track records.

The assumption of semi-strong form efficiency is a good first approximation for a market with as many sharp traders and with as much publicly available information as the U.S. equity market.

Is the stock market weak form efficient?

Weak form efficiency should be the simplest type of efficiency to prove, and for a time it was widely accepted that the U.S. stock market was at least weak form efficient. Recall that weak form efficiency only requires that you cannot make money using past price history of a stock (or index) to make excess profits. Recall the intuition that, if people know the price will rise tomorrow, then they will bid the price up today in order to capture the profit. Researchers have been testing weak form efficiency using daily information since the 1950's and typically they have found some daily price patterns, e.g. momentum. However, it appears difficult to exploit these short-term patterns to make money. Interestingly, as you increase the horizon of the return, there seems to be evidence of profits through trading. Buying stocks that went down over the last two weeks and shorting those that went up appears to have been profitable. When you really increase the horizons, stock returns look even more predictable. Eugene Fama and Ken French for instance, found some evidence that 4 year returns tend to revert towards the mean. Unfortunately, this is a difficult rule to trade on with any confidence, since the cycles are so long -- in fact, they are as long as the patterns conjectured by Charles Henry Dow some 100 years ago! Does this all lend credence to the chartists, who look for cryptic patterns in security prices -- perhaps. But in all likelihood there is no easy money in charting, either. Prices for widely trades securities are pretty close to a random walk, and if they were not, then they would quickly become so, as arbitrageurs moved in to buy the stock when it is underpriced and short it when it is overpriced. But who knows. Maybe a retired rocket scientist playing around with fractal geometry and artificial intelligence will hit upon something -- of course if he or she did, it wouldn't become common knowledge, at least for a while!


VIII. Conclusion

The efficient market theory is a good first approximation for characterizing how prices is a liquid and free market react to the disclosure of information. In a word, "Quickly!" If they did not, then the market is lacking in the opportunism we have come to expect from an economy with arbitrageurs constantly collecting, processing and trading upon information about individual firms. The fact that information is impounded quickly in stock prices and that windows of investment opportunity are fleeting is one of the best arguments for keeping the markets free of excessive trading costs, and for removing the penalties for honest speculation. Speculators keep market prices close to economic values, and this is good, not bad.


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© W. Goetzmann, Financial Management I
YALE School of Management