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Stock Price Behavior and Market Effeciency

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CHAPTER 7, Lecture Notes
 Stock Price Behavior and Market Efficiency
 Chapter Sections:
 Introduction to Market Efficiency         A better name for this
 What Does “Best the Market” Mean?             chapter might be,
 Fluctuations of Market Efficiency           “Can You „Beat the
 Forms of Market Efficiency                           Market?‟”
 Why Would a Market Be Efficient?
 Some Implications of Market Efficiency
 Informed Traders and Insider Trading
 How Efficient are Markets?
 Market Efficiency and the Performance of Money Managers
 Anomalies
 Bubbles and Crashes
 All Stars of Investing
Random Walks & Efficient                                              2



Markets
   Random Walk Hypothesis
     The theory that stock price movements are
      unpredictable
        In the short term, yes, they appear random
        In the long term, no (We hope – Failure is not an option!)
   Efficient Market Hypothesis
     A market in which securities reflect all possible
      information quickly and accurately
     If there are large numbers of knowledgeable
      investors who react quickly to new information,
      security prices will adjust quickly and accurately
        The New York Stock Exchange is an efficient market
                                A Random Walk Down Wall Street
                                                                       3


Levels of Market Efficiency
   Weak Efficiency Hypothesis
     Past data on stock prices are of no use in
      predicting future prices
     However, stock prices do tend to demonstrate
      momentum
       Stock prices tend to rise more often than they fall
       And they tend to move far higher than is usually
        justified (mania, bubble) or far lower than is usually
        warranted (crash)
       “The market can stay irrational longer than you can
        stay solvent.” -- John Maynard Keynes
                     If this theory is true, then technical analysis
                    (which we will cover in Chapter 8) is useless.
                                                                         4


Levels of Market Efficiency                             (continued)

   Semi-strong Efficiency Hypothesis
     Abnormally large profits cannot be consistently
      earned using publicly available information
     In other words, no amount of analysis that you do
      to determine the future price of a stock will help
      you “beat the market”
     But there are many, many investors who have
       We’ll look at some of them later
     What does the theory say about those investors?
       They are just lucky!
          “The more I practice, the luckier I get.”

                     If this theory is true, then fundamental analysis
                          (which we covered in Chapter 6) is useless.
                                                                             5


Levels of Market Efficiency                               (continued)

   Strong Efficiency Hypothesis
     No information, public or private, allow investors
      to earn abnormally large profits consistently
        But one insider information trade can make you rich
            If you don’t get caught, that is…




    This is obviously false. If you had material nonpublic information
    (the legal term for insider information) about a company, you could
                                               make a fortune overnight!
                                            But you could also go to jail.
                                                                           6


Market Efficiency Rational
   The Random Walk and Efficient Market
    theorists are often also major proponents of
    index funds
     They point to the fact that many professional
      money managers simply do not “Beat the Market”
        Especially during bull markets
     From 1963 to 1998, the S&P 500 index
      outperformed general equity mutual funds 22 out
      of 36 times

          They reason that you are better off accepting (close to) the
      market‟s return with low-cost index funds since their theory tells
                 them that no one can consistently “beat the market.”
                                                                          7


Market Efficiency Rational                             (continued)

   Why can’t many pros beat the averages?
     Many mutual funds have high annual operating
      expenses and high turnover rates, and…
     Many mutual fund managements have a very
      short time horizon
        Consequently, many mutual fund managers have a
        very short lifespan
   But the premises and casual observations of
    the Efficient Market theories show them to be
    patently absurd
     Many money managers have “Beaten the Market”
       Over long periods of time (“the more I practice…”)

      Plus if markets are efficient and rational, how do you explain …?
                                                                       8


Manias
   Occasionally, investors get caught up in what are
    called “manias” (a.k.a. “bubbles”)
       The Internet bubble of the late 1990’s was the latest mania
       Before that, there was the “Nifty-Fifty” of the early 1970’s
       The mania of the 1920’s resulted in the Crash of 1929
       In the 1840’s, there were 400 railroad firms
       The “Granddaddy of all Manias” was the Dutch tulip bulb
        craze of the early 1600’s
         Extraordinary Popular Delusions & the Madness of Crowds
         The Botany of Desire
   Each time, the phrase was…                         So much for
     “It’s a New Era” or                        “Rational Efficient
     “It’s Different This Time” or                     Markets!”
     “The old ways of valuing stock are gone”
   Each time, they were wrong!
                                                                  9


Manias                                            (continued)


   Why do manias occur over and over again?
    Why haven’t investors learned their lesson?
     Any ideas?


               “[market manias] will happen over and over
               again because the public is infinitely stupid.”
                   – Leonard Kaplan, president of commodities
               brokerage firm Prospector Asset Management in
                                            Evanston, Illinois.
                                                                                10


Manias                                                         (continued)

   Benjamin Graham sez…
    “The speculative public is incorrigible. It will buy anything, at
    any price, if there seems to be some „action‟ in progress. It will
      fall for any company identified with „franchising,‟ computers,
        electronics, science, technology, or what have you, when the
       particular fashion is raging. … the abuses are so largely the
                  result of the public‟s own heedlessness and greed.”
                                     – The Intelligent Investor, 1972 edition
    Replace “franchising,” computers, etc. with biotechnology, Internet, etc. and
                Good Ol‟ Ben could have been writing in 2000 instead of 1972.
                                                                        11


Crashes
   How do most manias end?
     Yep – You guessed it! They usually end with a
      crash.
     “The bigger the party, the bigger the hangover”
        They are not fun but the odds are you will live
         through at least one during your investing career



    “With this many strong years, I have the concern that there are a
    vast majority of companies that are significantly overvalued on a
        long-term basis.” -- Jon Lovelace, August 1999, mutual fund
                manager with almost 50 years experience at the time
                                                           12
               Eleven Worst Days of the Dow Jones
Crashes                Industrial Average
                                             (continued)

    Date       Net Change      Close       % Decline
 19-Oct-1987         -508.00    1,738.74      -22.61%
 28-Oct-1929          -38.33      260.64      -12.82%
 29-Oct-1929          -30.57      230.07       -11.73%
 6-Nov-1929           -25.55      232.13        -9.92%
18-Dec-1899            -5.57       58.27        -8.72%
12-Aug-1932            -5.79       63.11        -8.40%
 14-Mar-1907           -6.89       76.23        -8.29%
 26-Oct-1987         -156.83     1793.93        -8.04%
 21-Jul-1933           -7.55       88.71        -7.84%
 15-Oct-2008         -724.00     8577.91        -7.78%
 18-Oct-1937          -10.57      125.73        -7.75%
Index Funds, Market Indices,                                13




Manias, and Crashes
   Recall: Index funds and ETFs rely on indices
     “Instead of trying to beat the market, just buy the
      market and be happy with the market return”
   But sometimes an index can become skewed
     Especially when a sector or region becomes “hot”
           MSCI EAFE 12/31/89            S&P 500 3/31/00

           Japan, 59.8%                  Info Tech, 33.3%
           P/E: 51.9                     P/E: 59.2



                                         All else, 66.7%
            All else, 40.2%              P/E: 19.3
            P/E: 13.0
Anomalies, Silly Theories,                                       14




Oddities
   Timing Theories
       The Monday Effect – Best day to buy (or is it sell?)
       The January Effect – As goes January, so goes the year
       “Sell in May and Go Away!”
       September and October – Worst months of the year
       November to March – Best months of the year
       The “Santa Claus” Rally – “Turn-of-the-year” effect
   Super Bowl Theory
     National League Wins – bullish
     American League Wins – bearish
   Hemlines of skirts
     Mini skirts – bullish (1920’s, 1960’s)
     Long skirts – bearish (1930’s, 1970’s)
   Politics and the Stock Markets
                                                         15


All Stars of Investing
   Peter Lynch
     Fund Manager of Fidelity’s Magellan mutual fund
     “Buy what you know”
   Warren Buffet
     “Don’t buy a stock; buy a company”
     Puts emphasis on the value of the entire company
   Benjamin Graham
     He was Warren Buffet’s teacher
     “Father of Value Investing”
     Wrote “The Intelligent Investor” and “Security
      Analysis”
   John Templeton
     One of the first mutual fund managers to invest
      globally
                                                                16


All Stars of Investing                           (continued)

   Bill Miller
     Fund Manager of Legg Mason Value Trust
     For 15 years calendar years in a row, he beat the
      S&P 500, an unprecedented record
        He became (unfortunately for him, as far as I was
         concerned) the financial media’s mega-star
        Luckily for him (as far as I’m concerned), he didn’t
         beat the S&P 500 in 2006
        He also lagged badly in 2007 and 2008
     But before his 15-year record setting run, he lagged
      the S&P 500 two years in a row
        And so far, this year, he’s up over 30%!
                                                               17


All Stars of Investing                         (continued)

   What do all these people have in common?
     Courage to not follow the crowd
        The “conventional wisdom” is usually not very wise!
     A eye for unrecognized value
        Almost a “sixth sense”
   Gary Kasparov was once asked why he and
    Anatoly Karpov were the two best chess
    players in the world
     His answer was astonishingly simple and direct
        “We attack better than anybody else and we defend
         better than anybody else”
     These people bought the best companies and they
      avoided the worst companies
                                                              18


All Stars of Investing                         (continued)

   Speaking of avoidance…
     As a mutual fund investor, I am not looking to find
      the next Peter Lynch or Bill Miller or Warren Buffet
     I am looking to avoid the next Charles Steadman
   Charles Steadman ran his own mutual fund,
    the Steadman American Industry Fund, from
    December 1959 to July 2000
     His cumulative total return was -42.9%
     He would have done much better simply placing his
      investors’ funds into a savings account at a bank
       He would have done better putting it in a mattress!
     Maybe he came from the life insurance industry…
                                                                  19


Warren Buffet sez…

 “Be fearful when others are
 greedy. Be greedy when others
 are fearful.”


   His mentor, Benjamin Graham said it this way, “Buy when
 most people including experts are overly pessimistic, and sell
                          when they are actively optimistic.”
                                                                  20


John Templeton sez…

 “Bear markets are born of
 pessimism, grow on skepticism,
 mature on optimism and die on
 euphoria. The time of maximum
 pessimism is the best time to buy.”
     On a similar note, he also said, “To buy when others are
  despondently selling and sell when others are avidly buying
 requires the greatest fortitude and pays the greatest reward.”
                                                               21


Famous Myths & Stupid Sayings
   “It can’t go any lower”
     Oh, yes it can! It can go to zero!
   “It can’t go any higher”
     Oh, yes it can! If the earnings are continuing to
      grow, there is no limit to how high the price can go
   “It’s only $3 a share – What can I lose?”
     It doesn’t matter how low the price is, the price can
      go to zero and you can lose all your money
        Remember: Price is irrelevant; valuation is the key
   “It has to come back”
     Have any of you ever heard of Penn Central?
                                                               22


Famous Myths & Stupid Sayings
                                                (continued)

   “It’s always darkest before the dawn”
     Sometimes it’s always darkest before it’s pitch black
   “When it rebounds to $10, I’ll sell”
     A stock has no idea you bought it at $10
     If you wouldn’t buy it now at this price, sell it now!
   “If it goes down 10%, sell”
     Stock prices fluctuate greatly, even blue chips
        If you sold each stock that lost 10%, you’d almost
         always sell your winners along with your losers
   “It’s taking too long”
     Patience is an investor’s most important trait
        Besides, it gives you a chance to buy more!
                                                           23


Famous Myths & Stupid Sayings
                                             (continued)

   “Look at all the money I’ve lost – I didn’t buy it”
     Coulda’, Woulda’, Shoulda’
     You didn’t lose a cent by not buying a stock that did
      well – Don’t fret over it!
   “I missed that one, I’ll catch the next one”
     The “next” one rarely makes it
     Why wait for the next Microsoft? Buy Microsoft!
   “The stock’s gone up, I must be a genius”
     “Never mistake a bull market for brains”
        Old Wall Street saying
   “The stock’s gone down, I must be an idiot”
     Ditto (but in reverse)
                                                                24


Famous Myths & Stupid Sayings
                                                 (continued)

   “It’s Different This Time”
     Well, technically, yes. It is different every time.
       But that doesn’t mean you should pay an
        astronomical price for a company that probably will
        never make a dollar of profit (Hint: Internet stocks)
   “It’s a New Era”
     Ditto (When you hear this one, it’s time to sell)
   “It’s a Permanent Trend”
     Ain’t No Such Thing! Markets move in cycles.
   “Stocks are too risky”
     Even with all the shenanigans and stupidity, they
      are still the best long-term investment
                                                                25


CHAPTER 7 – REVIEW
 Stock Price Behavior and Market Efficiency
 Chapter Sections:
 Introduction to Market Efficiency         Next week: Chapter 8,
 What Does “Best the Market” Mean?        Behavioral Finance and
 Fluctuations of Market Efficiency             the Psychology of
 Forms of Market Efficiency                             Investing
 Why Would a Market Be Efficient?
 Some Implications of Market Efficiency
 Informed Traders and Insider Trading
 How Efficient are Markets?
 Market Efficiency and the Performance of Money Managers
 Anomalies
 Bubbles and Crashes
 All Stars of Investing

				
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