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SECONDARY CAPITAL MARKET (STOCK EXCHANGE) AND ITS
EFFICIENCY
ARIZONA STATE UNIVERSITY
FIN 540 - ADVANCED FINANCIAL MANAGEMENT
WEEK 7
9.1 INTRODUCTION:
Capital market is the name given to the market where long-term funding is raised by
businesses and local and national governments. Businesses obtain this type of funding through
the issuance of equity (shares) and debt (debentures, debentures, or bonds) to the public and
investment institutions (unit trusts, insurance businesses, and so on), usually in exchange for
cash. It is also a market where ownership of equity or debt (securities) can be transferred from
one investor to another. The market for new financing is called the primary capital market,
while the market that trades used securities is called the secondary capital market. We have
discussed these primary roles in Chapter 8. In this chapter we will limit ourselves to
considering the secondary aspects.
Secondary capital market:
The most important secondary capital markets around the world tend to be national
stock exchanges or official stock markets. However, this is not the case across the board in
secondary capital markets, certainly not in the UK, as we will see later in this chapter.
Nonetheless, the world's official stock exchanges are the primary forum for trading local and
international securities. Most of these official stock exchanges fulfill both primary and
secondary functions.
The existence of a secondary capital market is essential for businesses looking to raise
long-term funding. Potential long-term investors will generally not be prepared to issue shares
or debentures unless there is an opportunity to liquidate their investment at any time. Since it
is impractical for businesses to constantly hold cash to redeem securities, it is necessary to
have a secondary capital market where holders of securities can sell their investments. The
absence of secondary market facilities tends to make long-term fundraising impossible or, at
best, very expensive in terms of the returns demanded by investors. Some observers argue that
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underdeveloped countries are often hampered in their industrial and commercial development
by the lack of an established secondary capital market and, therefore, the lack of long-term
investment funding.
Price efficiency:
Potential investors not only need the opportunity to liquidate their securities whenever
they want; they will also be interested in whether their investment is priced efficiently.
Efficiency, in the context of pricing, implies that, at all times, all available information about
a business's prospects is fully and rationally reflected in the price of that business's securities.
That is, the market price of a particular security is the present value of the future economic
benefits that the security will provide to the owner. This will appeal to investors as they
generally prefer if the price, at any given moment, is set rationally and not just by chance.
Perhaps more important is the fact that, since capital markets are the link between managers
and investors, efficiency means that financial decisions made by managers will be reflected in
the prices of business securities and thus have a direct impact on shareholder wealth. Since
shareholder wealth maximization is generally accepted as the main criterion for management
decision-making, this reflection of management actions is important and has several
implications.
In this chapter we will briefly look at the mechanics of the London Stock Exchange
(LSE) in its secondary role before going on to see that it appears to be generally efficient. We
will then consider the implications for investors and fund managers of the efficiency (or
otherwise) of the LSE. Our discussion of the LSE is not intended to represent a
comprehensive guide to the workings of the market. Rather, it is intended to provide a broad
overview of how it works. It could be argued that most of the world's stock exchanges operate
in a similar way to the LSE.
9.2 LONDON STOCK EXCHANGE:
Like all capital markets that have a secondary role, the LSE is simply a market where
securities of private companies and public bodies can be bought and sold.
LSE Member
While in many markets members of the public can directly buy and sell on their own
behalf, at the LSE they are barred from entry. Only members of the LSE have direct access to
buy and sell securities. When members of the investing public wish to buy or sell securities
through the LSE, they can only do so by using a member as an agent.
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The rules governing the conduct of members are set and enforced by the Board which
is elected by the members. One of the functions of the Board is to authorize certain securities
as suitable for trading on the LSE. Authorized (listed) securities are securities that meet a
number of criteria set by the Board. The purpose of screening securities before authorizing
them is to try to prevent members of the investing public from losing money by buying
securities that are particularly dangerous.
There are currently around 2,000 companies listed on the LSE, and just 149 of these
account for around 83 percent of the total share value of all businesses (London Stock
Exchange, 2016). LSE members have two roles. The first is as a market maker or trader,
which in principle is equivalent to a trader in a street market. Each dealing business
specializes in a particular group of securities, just as traders in street markets tend to
specialize in fruit, meat or fish. The second role is that of an agent for people who wish to buy
or sell through the LSE (broker).
Dealing with LSE
Dealers
Dealers will usually be ready to buy or sell regardless of whether they are
can reach an agreement immediately. Therefore, dealers are usually prepared to sell securities
that they do not currently own (short sell) or buy securities for which they have no immediate
customers. It is only with securities that are traded very infrequently and with very large
orders that dealers may not be prepared to transact as either buyers or sellers. Reluctance on
the part of the dealing business to make a market in a particular security on occasion can
damage a dealer's reputation. This may adversely affect that dealer's future trading. Hence,
there are sanctions against dealers who fail to fulfill their function as market makers.
At any given time, a particular dealing business will usually hold a trading inventory,
either positive or negative, of some traded securities. If the inventory position is positive, then
the business is said to have a bullish position in that security. If the security has been sold but
the dealer has not bought it, it is said to have a bearish position.
Dealers are market makers who take risks. When dealers buy some securities, they
assess that they can subsequently sell them at a higher price. Similarly, when they sell
securities that they do not own (where they take a bearish position), their judgment is that they
can buy the securities that they are obliged to surrender, at a lower price. If they are wrong in
this judgment, it can be a costly mistake, as they may have to offer a very high price to
encourage sellers to enter the market. Members who only act as dealers make a living through
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profits from trading.
Transaction process:
Until the mid-1980s, almost all LSE transactions were conducted on the floor of the
LSE. Here, each dealer business would have its own 'kiosk' where brokers could transact on
behalf of their clients. To execute a transaction at the most favorable price, brokers would
need to visit all the kiosks, or at least most of the dealers handling a particular security, to
compare prices. Today, the 'cornerstone' of the LSE is the computerized dealing system,
although the transaction process remains essentially the same. The Stock Exchange's System
of Automated Quotations (SEAQ) allows dealers to display their prices to interested parties,
both members and non-members, and keep them updated. It also allows LSE members to
transact directly using terminals connected to SEAQ, without leaving their offices.
When members of the investor community want to buy or sell a particular security,
they usually send an email or call their broker. The broker can instantly access a display of
prices that are readily traded by various dealers. These prices will usually differ from dealer to
dealer. This is because the estimated value of the security in question will vary from dealer to
dealer. 'Hold' position The 'inventory' of a particular dealer, at any given moment, will also
affect the price offered. A dealer with a bearish position may be willing to pay a higher price
to buy a particular security than a dealer with a bull position. With respect to a particular
security and a particular dealer, the SEAQ screen will display two prices. At the lower price,
the dealer is ready to buy and at the higher price to sell. The same information is available to
all members and others who wish to subscribe. Brokers can tell clients what the best price is
in a security based on whether the client is a potential buyer or a potential seller. The client
can then immediately instruct the broker to execute the trade at the best price or do nothing. If
the client wishes to proceed with the transaction, the broker executes the transaction
immediately and without direct contact with the relevant dealer business (using the SEAQ
terminal). The effective contact between the broker and the dealer is through SEAQ. The
system automatically notifies the relevant dealer that a trade has taken place and provides a
record of the transaction details. Although anyone can be provided with SEAQ information,
only LSE members can use the information directly to trade through SEAQ.
The 'quote-driven' approach, of which SEAQ is the modern manifestation, has long
been the standard way the LSE operates. However, this approach has been criticized by
investors on the grounds that, as dealers seek to make a profit on each transaction, additional
and unnecessary costs must be borne by investors. There is an argument that, since ultimately
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every sale of a security by an investor goes from the market maker to the buying investor, it
would be cheaper for buyers and sellers to deal directly with each other, without involving
dealers.
In 1997 the LSE introduced an 'order-based' system, the Stock Exchange Electronic
Trading System (SETS), which is now run in conjunction with SEAQ. Here, prospective
buyers and sellers of shares of a particular business enter (through their respective brokers)
information about their wishes on an electronic screen for that share. This de-identified
information includes the number of shares they wish to buy or sell as well as the maximum
and minimum prices at which they wish to trade. If SETS can match the two entries, it will
automatically affect the transaction. Of course, a particular prospective seller may not want to
sell the same amount of shares that a prospective buyer wants to buy. Here SETS will execute
the transaction for the lower of these two quantities and leave the outstanding balance
displayed on the screen.
Critics of the SETS approach argue that dealer intervention ensures that there is
always a buyer or seller for a particular stock, i.e. a dealer. However, it is argued that in
practice, buying or selling a particular stock at a particular time would be difficult, even if
there is a dealer. Regardless of whether the transaction is done through SEAQ or SETS, a
broker must be involved. Only members of the LSE can trade. Brokers charge their clients a
commission, which is their source of income. These transaction fees tend to be high,
especially on small transactions, although such fees usually become proportionally lower on
large transactions.
Brokers offer their clients a wide range of professional services relating to
with investments, rarely see their role in the narrow sense as buying and selling agents. Of
course, they compete with each other for investors' business. Those who provide the best
service, in terms of advice and guidance, are likely to attract the bulk of the transaction
commission.
Derivatives:
Not only can investors buy and sell securities, they can also buy and sell derivatives
linked to the price of the security. Investors can, for example, buy and sell security options.
They can purchase the right (but not the obligation) to buy or sell a particular security at a
predetermined price before a specified date. If, for example, an investor believes that
Vodafone Group plc shares will increase in price, an option to buy a specified amount at a
specified price before a specified date can be purchased. This is known as a 'call' option. The
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price of such an option will depend on the quantity, the strike price and the exercise date. If,
on the exercise date, the market price of Vodafone Group shares is above the purchase price,
the investor will take up the option to purchase the shares. Options that give the right to sell
are known as 'put' options. In certain securities, the options themselves can even be bought
and sold (traded options). Stock options are another example of derivatives (see Chapter 1).
There are many derivatives related to security prices.
The LSE's place in the UK secondary market:
There is no legal requirement in the UK that all secondary market activity must be
conducted through the LSE. While the LSE has long and still dominates the UK secondary
market in terms of business transactions, there are other markets, albeit limited. For example,
there are commercial organizations that operate over-the-counter (OTC) markets, where they
act as market makers in various securities. Securities are bought from and sold to the investing
public, just as used furniture is bought and sold by dealers, without the involvement of agents.
There is some evidence - for example, the emergence of the OTC market - which suggests that
members of the investing public will simply look elsewhere if they feel that the LSE is not
providing the services they require, at the price they are prepared to pay.
9.3 CAPITAL MARKET EFFICIENCY:
When the price of a security over time rationally reflects all available and relevant
information, the market in which the security is traded is said to be price efficient. This means
that any new information that emerges about a particular business will be incorporated into
the market price of the security quickly and rationally, in terms of the size and direction of the
security's price movement.
Saying that a secondary capital market is efficient does not mean that the market is 'perfect' in
the sense of economists, although to be efficient the market must be displays most of the
features of a perfect market to some degree. It is also important to note that efficiency does not
imply perfect investor predictability. That is, the current price of a security is the best estimate
of its economic value based on available evidence. Note that 'efficient' in the current sense is
not related to 'efficient' in the sense of having no particular risk (see Chapter 7). It is
unfortunate that the same word has become a standard term to describe two very different
concepts.
Why should capital markets be efficient?
Prices are determined in the capital market by the forces of supply and demand. If the
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consensus view of those active in the market is that the share price of a particular business is
too low, then demand will drive the price up.
In secondary capital markets like the LSE, security prices are observed by many
people, many of them skilled and experienced. Almost all of these people are driven to
observe the market by that great motivator - financial gain. Information about businesses
reaches these observers in a variety of ways. From the business itself comes financial reports,
press releases, and leaks (intentional or otherwise). Information about the industry and
economy in which the business operates will also be relevant to the assessment of the value of
a particular security. Such industry and economic information will emerge from a variety of
sources.
When observers see what they perceive to be a price that is not
rationally, with respect to their assessment of future dividend projections, they are likely to
take advantage of it or advise others to do so. For example, an investment analyst employed
by a unit trust might assess the value of Tesco plc shares at £2.00 but note that the current
share price is £1.75. The analyst may then contact the fund manager to suggest buying some
of these shares on the basis that the share price is currently too low and there are profits to be
made. The increased demand caused by large-scale buying tends to drive up the share price.
Our analyst is just one of a large number of experts who constantly compare the market price
of Tesco shares with their own assessment of the value of the shares. Most of these experts
will take action themselves or cause action to be taken by those they advise if they notice a
difference. The stock market price at all times represents the consensus view. If people believe
that this price is irrational, they will take steps to benefit from their belief: the greater their
perception of irrationality, the more dramatic the steps they will take.
Efficiency and consensus: predicting American football results - ask the crowd or call a
friend
Efficiency has been interpreted by some as a requirement that there is at least one
person active in the market who has knowledge, skills and good judgment. This need not be
the case. Beaver (1998) points out that what is required for efficiency is a large number of
observers who mostly have rational perceptions even though their other perceptions of
security are misguided. He argues that misguided perceptions are random and may not be
shared by others. Rational perceptions, on the other hand, will be common, perhaps not to
everyone, but still to a large number of observers. Since the price of a security reflects a
weighted average of the perceptions of all parties active in the market towards a particular
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security, misperceptions, being random, will tend to cancel each other out (they will be
diversified out) and thus have no overall effect on the price. More rational perceptions will not
be random and therefore will not cancel each other out and will, therefore, be reflected in the
stock price.
Beaver illustrates and supports this point with what is at first sight an irrelevant report
on some predictions of the outcome (win, loss or draw) of American football matches. The
Chicago Daily News, every Friday during the period 1966 to 1968, reported the predictions of
each of its 14 or 15 sports staff regarding the outcome of matches to be played on the coming
weekend. The newspaper also published the consensus view of the sports staff, which was the
most popular view of each match. When the success of these predictions was summarized
over three years, the results were as shown in Table 9.1.
It is interesting to note that the consensus view has performed better than all
individuals in the last three years. Indeed, the consensus outperformed everyone except one or
two individuals in a given year (the consensus was equal to two individuals in 1966 and
outperformed by one individual in 1967 and 1968). This table clearly shows that the
performance of successful people is not consistent, suggesting an element of luck in the year
of their success. Luck may not be the only reason for this success, as Biondo performed better
than average in the last three years. But despite the possibility of skill in one individual, in
three years consensus easily trumps all.
It seems that some forecasters are more skilled than others. It also seems that the
consensus performs better than the best individual. This is despite the fact that the consensus
incorporates the forecasts of all individuals, both skilled and unskilled. Rather than having the
effect of lowering the quality of forecasts from the best individuals, combining forecasts to
reach a consensus improves the quality of forecasts. Beaver argues that this happens because
special factors (such as personal loyalty to a particular soccer team), which might influence
the weather forecasts of even the best forecasters, tend to disappear when a large number of
individuals are involved in consensus formation. The consensus therefore represents a clearer
and more objective forecast than any single individual could provide, consistently. This is
similar to the portfolio effect of equity investments that we encountered in Chapter 7. In the
context of portfolios, random factors (specific risk, in the case of investments) are removed,
leaving only common factors (systematic risk).
Beaver (1998) also refers to a similar effect with predictions of UK gross domestic
product made by 30 economists. Here the consensus beat the number 29 and was equal to one
of the economists. Another example of this seems to arise in the context of the TV quiz show
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Who Wants To Be A Millionaire? According to Surowiecki (2004), the 'friends' (who are
chosen by the contestants based on their expertise) answered 65 percent correctly, while the
audience (each a random selection of a large number of people) gave the correct answers to 91
percent of the questions posed to them. This is again explained by the portfolio effect. Perhaps
the contestants chose to ask the audience easier and clearer questions, but the difference in
success rates is still striking.
Efficiency and reaction speed:
Efficiency not only requires prices to react rationally to new information, but also to
react quickly. Of course, the speed of receiving and analyzing data, as well as sending,
receiving and analyzing actions, through buying or selling, is extremely fast. Since there are
many informed and motivated observers capable of taking quick action, we have good reason
to believe that a sophisticated secondary capital market like the LSE will be efficient in
pricing securities. The question now is: is it efficient in practice?
9.4 CAPITAL MARKET EFFICIENCY TESTING
Forms of efficiency:
Efforts to assess efficiency do not only address whether capital markets are efficient or
not, but rather the question of the extent to which capital markets are efficient. Roberts (1967)
suggested that efficiency and its testing should be addressed under three headings:
•
Weak form. If the market is efficient at this level, any information that may be contained
in past price movements is already reflected in the price of the security.
•
Half-strong form. This form of efficiency implies that all relevant publicly available
information is incorporated into the security price.
•
Strong form. If the market is strong-form efficient, this means that all relevant
information, including information that is only available to those in a privileged position
(for example, managers of businesses whose shares are listed), fully reflected in the security
price.
This is an ascending level of efficiency such that, if a market is efficient in the strong form,
then it must also be efficient in the semi-strong and weak forms.
The approach taken with the test:
Propositions such as those relating to capital market efficiency cannot be tested
directly. How do we test whether all available information is reflected in security prices?
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Researchers may not personally have all available information or even know that some of it
exists. However, we can test whether the behavior of security prices is consistent with
efficiency or not. Most tests that have been conducted have tried to do so.
The test aims to assess whether it is possible to generate abnormal returns by
exploiting any possible inefficiencies. Abnormal return, in this context, means a return that
exceeds the return that could be earned, in the same period that the test is conducted, from a
security of similar risk. Returns usually mean capital gains plus dividends received during a
period, expressed as a percentage of the price of the security at the beginning of the period.
This type of test poses several methodological problems. So many factors act
simultaneously on the price of a particular security that it is difficult to know to what extent
the price is influenced by the specific factor of interest to the researcher and to what extent
other factors are involved. For our present purposes, let us accept what most qualified
observers believe, that the major researchers in this field, some of whose work we will
discuss, have addressed the practical issues well enough that their results can be considered to
provide significant insights. If this does not seem to be the case, we will discuss it. Readers
interested in looking at methodological issues in detail should consult the references given
during and at the end of this chapter.
Weak form efficiency testing
Technical analysis
It has long been believed that security prices move in cycles or patterns that can be
predicted by those who study the matter carefully. Many people feel that past patterns of
securities price behavior repeat themselves, so that if repeated, this can put investors in a
position to make very large investment gains. Not surprisingly, adherents of this philosophy
use graphs and charts of past security prices to facilitate early recognition of such patterns in
order to benefit from them. These people are often referred to as chartists.
Others seek to develop trading rules that may be easier to apply than those of the
chartists. For example, some people believe that the price of a particular security tends to
hover around a certain value, rarely deviating by more than a small percentage. If the price
starts to move out of the x percent range, they believe that this implies a big move is
imminent. They believe they can capitalize on this by buying or selling in the direction of the
breakout. Transaction rules such as These are usually called filter rules. More generally, the
use of techniques such as filter rules and charts is known as technical analysis.
If the market is efficient, this means that there is no benefit to be gained from analyzing the
market.
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Technical. It is because of the large number of observers at work that if there is information
contained in past price movements, it will be retained in the current price as a result of buying
and selling. Only new information will affect the stock price. Since new information is
random, security prices are expected to follow a random path or random walk. New
information must be random or it is not new information. That Christmas card manufacturers'
sales are greater towards the end of the year than at other times is not new information. This
pattern tends to happen every year and is predictable.
Find repeating patterns
Suppose the price of a particular security follows the cyclical pattern shown in Figure
9.1 for several years. There is clearly a regular pattern here. What should we do if we see this
pattern at time t? Surely we should buy some securities and hold them until the next peak, sell
them and buy again at the next low and so on until we get tired of making money! It seems too
good to be true and, of course, it is. In real life we shouldn't be the only ones to notice this
repetition of peaks and valleys; in fact there will be many, many of us who do. When we try to
sell at the peak, others will also do the same. As only a few potential buyers are interested in
the peak price, the price will drop. Realizing this, we all have to sell early to try to overcome
the price drop, which will only cause the price drop to occur earlier. The logical conclusion is
that prices will actually never rise to their peak. Expecting the bottom to be reached and not
wanting to miss it, we should buy earlier and earlier, thus keeping prices high and ensuring
that the bottom is never reached either. The end result of all this is that if there are enough
investors who follow past price patterns and attempt to exploit the repetition of those price
patterns, then the repetition will not occur. In practice, the security's price profile will most
likely be close to the horizontal dashed line shown in Figure 9.1.
Weak form efficiency test results:
The first recorded discovery of randomness in competitive markets was made by
Bachelier when he observed it as a characteristic of commodity prices on the Paris Exchange
as early as 1900. His discovery was not well known until interest in the topic resurfaced a few
years later. Kendall (1953), accepting the then popular view that LSE security prices moved in
regular cycles, tried to identify a pattern, but found that there was no such pattern; prices
appeared to move randomly.
Efficiency and randomness imply that there should be no systematic correlation
between price movements on one day and another. For example, some observers seem to
believe that if the price of a security goes up today, it will most likely go up again tomorrow:
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in other words, there is a price trend. Similarly, there are those who feel that the opposite is
true and that a price increase today means a price decrease in the future. Of course, these
attitudes do not reflect a belief in efficiency. Figures 9.2, 9.3 and 9.4 illustrate the distribution
of price movements one day (t) plotted against the next day (t+1) for a particular security over
a period.
Each point on the chart is one day's price movement for a particular security,
compared to the next day's price movement for the same security. Figure 9.2 reflects a
positive correlation, indicating that an increase in the price of a security on one day will be
followed by another increase the next day. Figure 9.3 shows a negative correlation such that
an increase in price on one day means a decrease on the next day and vice versa. Figure 9.4
shows what would be expected if the security is traded in a weakly efficient market: there
appears to be randomness between the price movements one day and the price movements the
next. Sometimes a rise is followed by a rise, sometimes a fall, but there is no pattern.
Many tests attempt to identify the relationship between price movements over two or
more consecutive days or weeks. These tests tend not to find significant relationships, either
positive or negative. These studies suggest that security price movements closely resemble the
patterns that emerge from a random number generator. Perhaps the most respected test of
serial correlation was conducted by Fama (1965), based on US stock prices. Brealey (1970)
and Cunningham (1973) conducted similar tests on security prices on the LSE and found
evidence of weak-form efficiency.
Most of the rules used by technical analysts have been tested. For example,
Alexander (1961) used a filter rule and found that abnormal returns can occur, but as soon as
transaction costs are considered, the gains disappear. Dryden (1970), using a filter test on UK
securities prices, came to a similar conclusion.
Counter-evidence of weak-form efficiency:
There is growing evidence of investors' tendency to overreact to new information. For
example, there is evidence that the publication of news that lowers the price of a particular
stock tends to cause the price to fall more than is reasonable. This overreaction is then
corrected by a small but significant price increase. It appears that investors who exploit the
tendency to overreact by, for example, buying stocks immediately after 'bad' news, can make
very large gains when the overreaction is corrected (see, for example, Dissanaike, 1997,
1999).
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There is also evidence of the 'weekend' or 'Monday' effect, where there are
significantly higher returns to buying a stock on Monday morning and selling it on Monday
evening, or selling it in the morning and buying it back in the evening, than the normal
expected return of a stock in a single day (see, for example, Mehdian and Perry, 2001; Sun
and Tong, 2002; Brusa, Liu and Schulman 2003, 2005). The problem in generating abnormal
returns from exploiting this apparent weakness is that the effect appears inconsistent. In some
periods (and for stocks in some business sizes) the returns are positive, but in other periods
(and for different business sizes) the returns are negative. Although the Monday effect appears
to be an anomaly, it does not provide evidence of a lack of market efficiency. Picou (2006)
and Coakley, Jing-Ming and Wood (2012) show similar anomalies around holiday periods.
Fama (1998) asserts that some of the anomalies seen may be due to the use of 'bad
models'. If researchers say that abnormal returns result from a particular investment technique,
they compare the returns from using that technique to the expected returns of a particular
security. Typically, the capital asset pricing model (CAPM) will be used to determine the
expected return. As we discussed in Chapter 7, Fama and French (2004) point out that the
CAPM is not a perfect model in practice.
Park and Irwin (2007) review more than 130 weak-form efficiency tests that have been
published since the 1950s. Most of these tend to show that stock markets are generally
efficient. However, Park and Irwin do cast doubt on the quality of most of the research
methodologies.
Conclusion on weak form efficiency:
The general conclusion from the weak form test is that the evidence on capital
markets, including LSEs, is consistent with weak form efficiency. While there is some
inefficiency, it is generally not of economic significance as it tends to cease to exist when
transaction costs are taken into account.
It is important to note that randomness does not mean that prices are set irrationally.
On the contrary, as new information becomes available randomly, its reflection in security
prices should also be random if the market is efficient. After certain price movements, it is
possible to explain, with reference to real events, why those movements occurred. Here
randomness should not be confused with arbitrariness. Prices that are moving with the trend
and repeating past patterns suggests that available information is not fully reflected in these
prices, leading to inefficiencies and arbitrary pricing.
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Semi-strong form efficiency testing:
Semi-strong form efficiency tests center on the question of whether new information,
which is expected to affect security prices, actually does:
•
in the expected direction;
•
based on the expected amount; And
•
at the expected speed.
A fertile area to test whether security prices react rationally to new information is when some
management actions may appear to indicate something that, on closer examination, turns out
not to be the case. If security prices seem to reflect a superficial view of the action, rather than
a rational view, this means that the market is inefficient (in a semi-strong form) due to
investor naivety. In other words, it means that managers can trick investors by engaging in
window dressing activities.
Bonus distribution issue:
A capitalization issue, or bonus share, simply involves a bookkeeping entry that
provides an increase in shareholding to existing shareholders without increasing each
individual's portion of business ownership. For example, an investor who owns 100 common
shares in a business that has a total of 1 million shares issued owns one ten-thousandth of the
equity value of the business. If the company does a one for two bonus issue, our shareholder
now owns 150 shares, but since the total number of shares issued is now 1,500,000, this
number still represents one ten-thousandth of the equity. Since the total value of equity does
not change due to the bonus issue, logically the share price should be adjusted so that the three
shares after the issue are worth the same as the previous two shares. Naive investors may feel
that the bonus shares offer a real advantage and see a price of two-thirds of the pre-issue price
post-issue as a real bargain. This will cause them to enter the market as buyers thus forcing the
price up. Research conducted on the LSE by Firth (1977a) and on Wall Street by Fama,
Fisher, Jensen and Roll (1969) did not find such naivety; it found that security prices reacted
in a logical manner.
Changes in accounting procedures:
Another example where a superficial interpretation of an event could be wrong is when
profits appear to increase due to a change in accounting procedures. Sunder (1973) observed a
number of American businesses that had changed their inventory valuation method so that
they appeared to show higher profits than if the old method had been applied. This seems to
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be a perfect trap to catch naive investors, as the economic impact of the change would be
detrimental as the corporate tax burden (which is based on accounting profits) would increase.
Rationally, a change in accounting policy should cause a decrease in stock prices for these
businesses because the change would adversely affect their cash flow (increased tax
payments). Sunder found that a plausible reason was that, for these businesses, the change
adversely affected the stock price. Sunder also sampled a group of businesses that had
changed their inventory valuation methods in the opposite way and found that this, as logic
demands, led to the opposite impact on stock prices.
Using UK data, Morris (1975) found that stock prices had been adjusted to account for
the reduction in earnings figures to adjust for inflation, even before the adjustments were
made public.
Reaction speed:
Efficiency can only be said to occur if new information immediately, or at least
rapidly, affects security prices. Dann, Mayers and Raab (1977) conducted some research on
the effect of trading a large number of shares of a particular business in the US market. These
trades were much larger in terms of the number of shares involved than typical stock market
transactions. The researchers noted, among other things, that the turbulence caused by such
trades, the period during which the market assesses the impact of the trade, lasts about fifteen
minutes at most. This means that unexpected events, even if they occur in the heart of the
capital market (in this case Wall Street), have been assessed and reflected in new prices within
a quarter of an hour. Large block trades are perceived to have informational content because
the purchase or sale of a large number of securities may imply that the investor initiating the
trade has some new information that triggers the action.
More recently, Busse and Green (2002) found that good news is usually contained in
the relevant stock price within one minute. Bad news can take up to 15 minutes before it is
actually reflected. The 'news' in this case is analysts' opinions broadcast on television during
normal Wall Street trading hours. Conclusion of half-strong form efficiency
From the studies we have reviewed here, whose results are similar to the conclusions
drawn from studies conducted in the world's secondary capital markets, the evidence seems
consistent with the view that security prices adjust rationally and quickly to new information.
Importantly, they seem to ignore false new information, i.e. data that appears relevant but is in
fact irrelevant. Thus, the general conclusion is that capital markets, including LSEs, are
efficient in the semi-strong form.
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Strong form efficiency testing:
Strong-form efficiency would imply that there is no private information in the context
of information relevant to security pricing. As soon as information becomes available to any
person or group, it is reflected in the price of a particular security or securities related to it.
Those who may have access to information that is not generally available include:
•
insiders who are in a privileged position with respect to such information (this may
include managers, staff, auditors, and other professional advisors); and
•
expert and professional investors.
Intuition suggests that managers who have information that is not yet publicly available can
turn this knowledge into very high investment returns compared to investors who do not have
such information. Similarly, we might expect that investment fund managers would be more
successful, given their experience and research resources, than if they selected investments at
random. Insiders
In the UK, insider dealing is frowned upon by public opinion, the law and the ethical
standards of professional bodies. Therefore, if insider dealing continues to occur, it is done
clandestinely and therefore cannot be directly observed by researchers. In the US, a different
attitude was usually taken (until the 1960s) towards insider dealing, although insiders were
required to register their status when making transactions. Tests of successful insider
transactions on Wall Street have been conducted. Both Jaffe (1974) and Finnerty (1976) find
that insiders are consistently able to earn abnormal profits as a result of their greater access to
information.
Professional:
Regarding professional investors, many studies have been conducted on the
performance of investment units and trusts. These are organizations that attract funds from the
investing public, which are then invested mainly in securities. These studies, including one by
Firth (1977b) on the performance of unit trusts in the UK over the period 1965 to 1975, did
not find superior performance. Some researchers have found that the investment results made
by these experts are in fact less favorable than the results of investment strategies based on
random selection of securities. For example, Blake and Timmermann (1998) looked at the
performance of 2,300 professionally managed investment funds in the UK over a 23-year
period. They found that on average the funds underperformed, in terms of investment returns,
compared to what was expected for the level of risk involved.
Advice from professional investment advisors has also been assessed and found to
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generally not generate abnormal returns on a consistent basis.
Conclusion on strong form efficiency:
The conclusion of strong-form efficiency is that insiders in possession of genuine new
information can utilize it to their advantage, thus suggesting the existence of inefficiencies in
the capital market. However, those who do not have access to such information will not be
able to achieve better than average returns, regardless of whether they are 'experts' or not. We
have not reviewed all the studies that have been conducted; however, other studies reach
similar conclusions to the studies we have considered.
9.5 THE EFFICIENT MARKET PARADOX:
An important paradox of capital market efficiency is that if a large number of investors
did not seek to make abnormal profits through technical analysis and analysis of new
information (fundamental analysis), efficiency would not exist. Just because so many people
are actively looking for inefficiencies to exploit for their own benefit, there is little
opportunity to profit from them.
9.6 CONCLUSION AND IMPLICATIONS FOR CAPITAL MARKET EFFICIENCY:
The conclusion from testing the efficiency of the LSE and capital markets in general is
that the evidence is consistent with efficiency in all forms, except that only publicly available
information appears to be reflected in security prices. Information that is not yet publicly
available is not necessarily reflected. Research results, particularly those from the US, may
indicate the existence of small inefficiencies in capital markets. Some observers believe that if
evidence of inefficiency emerges, it may reflect the changing nature of LSE investors.
Efficiency requires a large number of independent investors. LSE investments are
increasingly likely to be concentrated in the hands of a relatively small number of large
institutional investors, most of whom are based in and around the City of London. This, some
believe, has led to prices being determined not by independent market forces but by 'herd
instinct'. Welch (2000) found evidence that recommendations from analysts regarding certain
securities tend to have an impact on subsequent recommendations from other analysts.
Despite evidence to the contrary, it remains true that, for most practical purposes, we
can say that LSEs efficiently price the securities traded there, in weak and semi-strong forms.
Keep in mind that, given the way the stock market operates, which we discussed earlier in this
chapter, this evidence-based conclusion is not surprising. Logically, we should expect it to be
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efficient.
Implications for investors:
Capital market efficiency implies that investors should not waste time looking for
extremely high returns on investment, either by observing historical information on security
price movements or by analyzing new economic information. It is only when an investor has
access to information that has not yet been made public that above-average profits can be
made - except by sheer chance. Even placing trust in an investment analyst or investing
through one of the investment houses, on a regular basis, will not be profitable - and is likely
to be costly.
If the above statement is true, why do so many investors engage in seemingly futile
activities? There are several possible explanations for this seemingly irrational behavior.
•
Ignorance of efficiency evidence. Many investors seem to be unfamiliar with evidence of
capital market efficiency and so it is natural that they do not take it into account. Few
people or organizations are interested in publishing such evidence and many have interests
to the contrary. It is not helpful for newspapers and journals, which deal partly or mainly with
giving advice on which securities to buy or sell, to point out that this advice will only prove
valuable by chance and so, on average, will be worthwhile. No value. Other investment advisors,
brokers and the like, are placed in the same position.
•
A careful examination of a security's past price movement chart shows a repeating pattern.
This is true in some cases, but it is also true that plotting random numbers sometimes
produces the same result. In other words, chance alone sometimes causes a pattern to
repeat itself; this does not mean that profits can be made by trying to find repeats.
•
Proponents of certain technical regulations have proven successful. Efficiency does not
mean that investments cannot be successful, it is just that more than average success is a
matter of luck. During certain periods, and generally throughout the twentieth century,
investments in securities traded on the LSE would have yielded positive returns. The value
of the securities generally increased, not to mention the dividends or interest receipts that
investors would also benefit from. It should therefore come as no surprise to us that,
despite efficiency, following most investment advice over a long period of time would
have resulted in positive returns. Indeed, efficiency implies that it is impossible to find
investment advice that can be followed and generate lower-than-average returns over the
long term, given the level of risk involved, unless it happens by chance.
•
We all know the cases of people who have been very successful in capital market
investments. Those who are highly successful tend to get noticed; those who fail
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miserably tend to try to keep this a secret. In both cases it seems to be just luck - good and
bad respectively. Those who are unsuccessful tend to acknowledge this fact; those who are
successful - being human - may be more likely to believe that skill in choosing and timing
investments is the cause of their success.
Even in matters of sheer chance, one can still be successful, even astonishingly successful.
Suppose a coin toss championship is held in the UK and the entire population of 60 million
takes part. The rules are that we are all grouped into 30 million pairs, each of whom tosses a
coin. The member of each pair who names the correct coin advances to the next round. This
process is repeated until a winner emerges. We know that a winner must emerge, but do we
really believe that skill is involved? Most likely we would judge the winner to have very good
luck even though the probability of success is very small. A strategy for investors in
marketable securities
The evidence we reviewed in this chapter, and what we found out about diversification
and risk reduction in Chapter 7, leads to the following strategy being preferred:
•
Divide the total amount to be invested between 15 and 20 and invest the resulting amount
in different securities. Try to invest in a variety of different industries. By doing this the
investor will eliminate almost all the specific risks attached to each security.
•
Invest in stocks whose beta matches the investor's risk/return preference.
•
Do not trade securities. Only change securities in the portfolio to 'rebalance' if the value of
individual security holdings becomes significantly different from each other as a result of
relative security price movements in the portfolio. This is to maintain broad value equality
of 15 to 20 different holdings. Don't be tempted to take advantage of well-performing
securities or get rid of underperforming ones. Evidence of efficient markets shows clearly
that the current price is the best available estimate of the value of a security, given future
projections. The evidence is also clear that, unless the investor is an insider, the current
market value is a better estimate of the security's value than the investor's own estimates.
The evidence is clear that active trading entails high transaction costs and does not
generate security price values (see, for example, Barber and Odean, 2000). A buy-and-
hold policy has proven to be the best.
Small investors may find it uneconomical, in terms of transaction costs (intermediary fees),
which tend to have economies of scale, to follow the first recommendation above. In this case,
the use of investment funds may be the best approach. Investment fund managers charge an
annual fee, usually based on the size of each investor's holding, but they can achieve
transaction economies of scale. If this approach is taken, investors should choose a fund that
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has a buy-and-hold strategy.
Implications for financial managers
This is very important and the main reason why we discuss capital market efficiency
in this book. Broadly speaking, the impact is:
•
It is difficult to fool investors. Investors rationally interpret what company management is
doing, so 'window dressing' will not cause security prices to rise.
•
The market values the business rationally. If management wants to issue new shares, then
the existing share price is an appropriate issue price. If the general price level is
historically low, then it makes no sense to wait for a recovery before issuing new equity.
If security prices move randomly, there is no reason to believe that just because prices
have been higher in the past that they will return to previous levels.
•
Management should act in a way that maximizes shareholder wealth. Since this is the
generally accepted criterion for making investment decisions in business, if managers
make decisions that logically encourage this, then provided they release information about
what they have done, security prices will reflect the managers' actions. In other words, if
managers act in a way that puts shareholders' interests first, this will actually increase their
interests through the stock price.
•
It may be in the manager's interest to hide unpleasant information. The strong-form
inefficiency revealed by research suggests that not all available information is captured in
security prices. Therefore, management may have an interest in hiding unfavorable
information. Whether this is really valid in the long run is doubtful as most information
emerges sooner or later. Perhaps, the widespread feeling among investors that managers
are prepared to hide unfavorable information will ultimately hurt those managers.
•
The secondary capital market provides guidance on the required rate of return on risky
investments. Just as if we wanted to value a used car, we might look at the prices of
similar cars in the used car market, it is logical to try to assess the value of an asset with
risky expected returns by looking at the prices of similar assets in the secondary capital
markets. This provides the main justification for the use of CAPM, in determining the
appropriate discount rate to apply to cash flows, in the assessment of real investment
decisions made by businesses.
The general conclusion regarding efficiency is that management and security holders are
directly connected through security prices. Significant management actions will be
immediately reflected in security prices. The evidence is clear that security prices react
quickly and rationally to new information. The implications of secondary capital market
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efficiency for managers will be referred to at various points throughout the rest of the book.
9.7 BEHAVIORAL FINANCE
Behavioral finance origins
The broad conclusion is that the LSE, and similar secondary capital markets in other
countries, tend to be efficient in pricing securities. However, at the same time, there are
clearly some anomalies and deviations from what we would expect if markets were truly
efficient. We have already encountered some examples of this earlier in this chapter. These
include the tendency of markets to overreact to news and the 'weekend effect'.
The existence of these anomalies, and others, has prompted researchers to look beyond
common business finance thinking, a process that began in the 1980s - when the anomalies
became apparent. These researchers began to look beyond existing theories of business
finance. This led them to look at theories, many of which were supported by evidence, in the
field of human psychology. Thus emerged the body of knowledge known as behavioral
finance.
For example, it is well proven that:
•
People tend to ignore or minimize evidence that they have made an incorrect judgment.
This may cause them to fail to act rationally to new information regarding the price of a
security. It may also cause them to join the 'herd' of others who share the same view of
events.
•
People tend to be slow in adjusting their beliefs to new information. This can lead to a
slow reaction to new information which has an impact on security prices.
•
People tend to be overconfident in their own abilities. This tends to cause people to buy
and sell securities when a 'buy and hold' strategy would likely be more economically
beneficial. They do this because they believe they have superior skills and judgment
compared to other investors.
•
People tend to be more influenced by one recent experience compared to knowledge built
up from many experiences. This may lead them to make judgments about security prices
that underestimate newly discovered, yet still valid, information.
•
People may irrationally refuse to accept the fact that they have incurred losses. This may
lead them to avoid selling investments at a loss as it provides clear evidence of past
misjudgments.
Proponents of the behavioral finance approach argue that human psychology plays a large role
in investment behavior and, therefore, in setting market prices for securities.
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The traditionalists answered back:
The rise of behavioral finance led to counter-arguments from traditionalists. They
argue that people generally act in a rational manner to maximize their wealth utility. Even if
many, or even all, people behave irrationally as individuals, their irrational behavior will be
diversified. This is because their irrationality tends to be inconsistent among them, i.e., their
irrationality will characterize each person.
Traditionalists further argue that, although irrationality occurs consistently among
many individuals, and this tends to result in irrational security prices, there are still enough
'clear-sighted' investors in the market who can benefit from such irrational prices. Those who
are clear-sighted can, for example, buy a security at an unreasonably low price and wait until
the rest of the investor community 'catches up' and the price rises. This will result in greater
profits for the clear-sighted. The fact that there are anomalies to pricing efficiency suggests a
weakness in the traditionalists' argument, at least to some extent. Most likely this weakness
lies with the 'clear-sighted' investors. There is an argument that, in practice, it may be difficult
for investors to act in a way that makes irrationally priced securities rationally priced. This is
because such activities may put them at risk of losing the security.
Conclusion on behavioral finance:
What impact does all this have on behavioral finance? It is clear that secondary capital
markets do not work with perfect pricing efficiency. It is also clear that humans, even when
acting in a business/economic context, do not always think and act with clear rationality. It
would be wrong to conclude that there is no connection between these two facts. Despite the
validity of behavioral finance, it seems that it is not yet developed enough to be able to
identify trading rules that can systematically exploit the anomalies caused by its existence.
London Stock Exchange (LSE) Summary:
•
Like other stock exchanges, the LSE acts as both a primary and secondary market.
•
LSE members are either market-making traders, who act as 'stallholders', or
brokers, who act as agents for their investor clients.
•
LSE transactions can be 'quote-driven', using SEAQ and involving dealers, or 'order-
driven', where buyers and sellers deal directly with each other through the SETS approach.
•
Brokers act on behalf of their clients in all transactions and charge a commission for their
work.
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•
The LSE is not the only secondary capital market, although it is by far the largest and
most important. It has to compete with its competitors in the business.
Capital market efficiency (CME):
•
CME means that markets price securities rationally so that the current price of each
security at any given moment represents the best estimate of its 'true' value.
•
CME would imply that all available information about the value of a particular security is
quickly and rationally factored into its price.
•
It is reasonable to believe that the CME could exist in practice because many skilled
individuals who have the financial weight to influence the prices of securities continuously
assess the value of those securities and monitor their market prices.
•
The current price of any security represents the consensus view of the security's current
value - the price is the result of the actions of buyers and sellers, each with a different
perception of the security's value.
Evidence at CME:
•
Research studies have been conducted to look at efficiency at three different levels:
•
weak form (WF);
•
half-strong form (SSF); And
•
strong form (SF).
•
WF efficiency would occur if it is not possible to earn abnormal returns from a security
investment by relying on past security price movements (e.g., with the use of charts) or
technical rules to indicate when to invest buying and selling.
•
Evidence shows that the world's leading markets are efficient in WF.
•
SSF efficiency will occur if it is impossible to earn abnormal returns from securities
investments by relying on analyzing publicly available information to indicate when to
buy and sell.
•
Evidence shows that the world's leading stock markets are efficient in SSF.
•
SF efficiency would occur if it were impossible to earn abnormal returns from securities
investments by relying on analyzing information available only to insiders to indicate
when to buy and sell.
•
Evidence shows that the world's leading market is not efficient in SF.
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CME Implications:
•
The implication for investors: only if they have access to information that is not publicly
available can they expect, except by chance, to earn better-than-average returns, given the
risk class of the security in question.
•
Implications for financial managers:
•
It's hard to fool investors.
•
The market values businesses rationally.
•
Efforts to increase share value should have such an impact.
•
Managers may have a short-term interest in hiding adverse information.
•
LSEs rationally value assets with risky returns.
Behavioral finance:
•
The existence of obvious anomalies in security prices led to the development of
behavioral finance theory.
•
Behavioral finance considers investor behavior and, therefore, security prices are based on
a degree of irrationality.
•
Irrational behavior includes an investor's tendency to do so
⮚
ignoring or minimizing evidence has made an incorrect judgment;
⮚
reacts slowly to new information;
⮚
overconfidence in their own abilities;
⮚
too affected by current events;
⮚
are irrationally reluctant to admit their own mistakes.
•
Traditionalists argue that this irrationality should not affect the price of securities because
it will diversify away. Even if this is not true, the actions of 'clear-sighted' investors will
push prices to rational levels.
•
The continued existence of the anomaly suggests that there seems to be merit in the idea of
behavioral finance.
