The Essentials of an Efficient Market - Final

The Essentials of An Efficient Market and Implications for Investors, Firms and Regulators Presented By Sam Mensah, Ph.D SEM Financial Group/African Capital Markets Forum, Ghana UNECA Workshop on African Capital Markets Development 27-29 October, 2003, Johannesburg, SA www.african-cap.org [email protected] 1 Market Efficiency Concepts  Allocation Efficiency  Does capital flow to the projects with the highest risk-adjusted returns? Are transactions completed on a timely basis, accurately and at low cost? Does the observed market price of a security reflect all information relevant to pricing the security?  Operational Efficiency   Informational Efficiency  www.african-cap.org [email protected] 2 Theory of Efficient Markets  Financial economics focuses on informational efficiency An efficient market is a market that is efficient in processing information  Prices of securities observed at any point in time are based on a correct evaluation all information available at the time, i.e. prices “fully reflect” all available information  Also called “Efficient Markets Hypothesis (EMH)”  www.african-cap.org [email protected] 3 How Prices Adjust to New Information www.african-cap.org [email protected] 4 Patterns of Market Response Early Response (anticipated information)  Efficient Markets Response  Delayed Response and Reversion  Overreaction  www.african-cap.org [email protected] 5 Why do we need to appreciate EMH?  Fundamental attributes of a capitalist economy    Prices are accurate signals for capital allocation Both issuers and buyers of securities expect fair prices Persistence of glaring pricing anomalies erodes market confidence  Examples of pricing anomalies are common on African markets   Share prices unchanged on ex-dividends or ex-rights Share prices remain unchanged after new information is released   African capital markets will not develop unless both issuers and investors believe that securities are fairly priced Market regulators, policymakers and operators need to focus on improving pricing efficiency www.african-cap.org [email protected] 6 Economic Foundations of the EMH  EMH is an applications the theory of rational expectations to financial markets  A set of postulates are advanced to justify the EMH      Expectations of future returns are rational, i.e. equal to the optimal forecasts on the basis of the best available information On average, the expected return will equal the equilibrium return, i.e. the return based on factors such as risk, liquidity, etc Current prices will be set such that the optimal forecast of a security’s return using all available information will be equal to the security’s equilibrium return In an efficient market, all unexploited profit opportunities will be eliminated Stock prices follow a “random walk”, i.e. future changes in prices should for all practical purposes be unpredictable  Persistence of inefficiency means that investors are not using all information at their disposal in setting security prices, i.e. expectations are not “rational” www.african-cap.org [email protected] 7 Interpreting the EMH www.african-cap.org [email protected] 8 Efficient Markets and Information Sets www.african-cap.org [email protected] 9 What is the Empirical Evidence? Whether markets are efficient or indeed can be efficient has not been fully resolved  Extensive testing has taken place in advanced markets  Research on the efficiency of African capital markets is scanty  www.african-cap.org [email protected] 10 Tests in Advanced Markets  Tests generally support weak-form efficiency (i.e. past prices cannot be used to predict future prices)  Public information has been found to incorporated into and sometimes even anticipated by prices, therefore markets are strong-form efficient  Few portfolio managers are able to beat the market and do not do so with any consistency  But  insiders are able to earn above normal returns securities markets are inefficient at the strong-form level www.african-cap.org [email protected] 11 The African Evidence  Kofi Osei, 1998) found that stock prices in Ghana did not conform to random walk hypothesis, therefore market was weak-form inefficient  Addo (2001) tested ex-dividend day adjustment;   statistically significant price appreciation on exdividend day, contrary to theory Market is weak-form inefficient (persistence of historical prices)  Olowe (1999) found Nigerian Stock Exchange to be weak-form efficient www.african-cap.org [email protected] 12 Current State of Knowledge  Advanced markets are largely efficient but anomalies still exist  Seasonalities   Day of the week effects (returns are higher on average on the last trading day (Friday) and lower on the first (Monday) High returns to stocks in January  A small group of portfolio managers (US mutual funds) seem to consistently earn above normal profits www.african-cap.org [email protected] 13 The Controversy Continues Can markets be efficient – inefficiency is what propels markets towards efficiency as investors seek out profit opportunities  Behavioral approach suggests that markets don’t just trade on available news and rational response; they reflect irrational impulses (Greenspan’s “irrational exuberance”)  www.african-cap.org [email protected] 14 Implications for Investors  If EMH holds: Published reports of financial Analysts may not be valuable  Market tips are not valuable  Technical analysis is worthless with weakform efficiency  Fundamental analysis is worthless with semi-strong efficiency  There should be low returns to active portfolio management  www.african-cap.org [email protected] 15 What should Investors Do?  For the vast majority, public information cannot be used to beat market   Select diversified portfolio and avoid costs of analysis and transaction Many investors place their funds with managers who merely replicate an index thus lowering costs  Investors groups (institutional investors, shareholders associations, etc) need to press for greater volume of timely information to move markets closer to the semi-strong efficient markets level, thus boosting market confidence www.african-cap.org [email protected] 16 Market Efficiency • The value of investment advice – Forbes’ Magazine’s monkey portfolio Not all financial theory is good for the financial profession! 4 www.african-cap.org [email protected] 17 Implications for Corporate Finance  Key Corporate Finance Decisions:     Should firms try to time their security issues or is market timing a hopeless venture? How do markets react to different security issues? How can firms use this information to decide which securities they should issue to raise funds? What happens if firms are inefficient? Can firms exploit these inefficiencies in their financing decisions? Can financial managers “fool” the market by “cooking their books”? www.african-cap.org [email protected] 18 The Corporate Finance Evidence     Persistence of January effect means firms can take advantage Mean reverting interest rates means that when interest rates are high based on historical levels they are likely to come down Stock prices at historical lows are likely to go up BUT   Advantages are only reasonable at the margins. Gains are too low and noise is too high Financial managers should not ignore important considerations of funding to take advantage of market inefficiencies www.african-cap.org [email protected] 19 Can Financial Managers Cook the Books?  Change in accounting methods to boost profit (e.g. depreciation methods, pooling versus purchase) tend to elicit negative to neutral market reaction  Stock splits/Bonus shares – Neutral  Profit announcements: Delays create negative market reaction  Lesson: Financial managers are unlikely to “fool” market; but regulatory firmness is essential (ENRON cooked its books for over 4 years before the market caught up with it) www.african-cap.org [email protected] 20 Implications of Regulators  Regulators accept efficient markets as normative model; IOSCO Objectives and Principles of Securities Regulation stress: The protection of investors  Ensuring that markets are fair, efficient and transparent  The reduction of systemic risk  www.african-cap.org [email protected] 21 Quote  “In an efficient market, the dissemination of relevant information is timely and widespread and is reflected in the price formation process. Regulation should promote efficiency” (IOSCO Principles and Objectives of Securities Regulation) www.african-cap.org [email protected] 22 Regulatory Prescriptions     There should be full, timely and accurate disclosure of financial results and other information that is material to investors’ decisions Holders of securities in a company should be treated in a fair and equitable manner Accounting and auditing standards should be of a high and internationally acceptable quality The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers. www.african-cap.org [email protected] 23 Market Efficiency and Stages of Market Development  Recent research relates market efficiency to stage of market development Pre-emerging  Emerging  Advanced markets  www.african-cap.org [email protected] 24 The Five Phases of Market Maturity www.african-cap.org [email protected] 25 Stages of market Development (Contd)  Pre-emerging (Most sub-Saharan Africa excl. SA)     Immature market, market efficiency is low Low market professionalism Market inefficiencies not fully exploited Low returns to active management Markets starts to professionalize More analysis Returns to active management are high Market becomes more efficient  Emerging     www.african-cap.org [email protected] 26 Market Efficiency and Stages of Market Development (Contd)  Advanced markets (3 stages)  Too much active management    No more unexploited market opportunities Returns to active management fall Market efficiency peaks  Indexation penetration increasing (UK, Continental Europe, US)    Increasing reliance on indexation Some market opportunities go unexploited Returns to active management increase again but levels off Market is not fully efficient Some returns to active management still exist but at a lower level than earlier phase www.african-cap.org [email protected]  Equilibrium   27 What should Africa do to improve market efficiency? Need for more professionalism  Better regulatory enforcement  www.african-cap.org [email protected] 28 Building Professionalism and market Capacity     Extensive training needed Larger and strong investment houses with capability to organize information Participation by investment houses from advanced markets will be a plus for market efficiency (partnerships between SA and other sub-Saharan Africa investment houses may be a good start) More technical know-how is needed in our stock markets   ASEA should build technical know-how of members Formalized collaboration between ASEA, ACMF and development agencies (e.g. UNECA, ADB, etc) is needed to lift capacity and build professionalism) www.african-cap.org [email protected] 29 The Importance of Regulatory Enforcement  Without strong regulatory enforcement, market efficiency will be elusive  Major regulatory agencies such as US SEC have failed to detect major inaccuracies in company accounts and nondisclosure (ENRON, Worldcom)  African regulators are poorly resourced   Poor market surveillance Limited analytical and investigative capacities www.african-cap.org [email protected] 30