Table of contents
2 Efficiency of markets
3 Discussion of the research question
4 Implications for managerial decisions
List of figures
Figure 1: Efficient Market Hypothesis ...3 Figure 2: P/E ratios...6
In this paper it will be examined if markets are macro-inefficient and micro-efficient at the same time. In order to give a thorough understanding about efficient markets, there will be an overview in the following chapter. After that, the research question is discussed and managerial implication are given.
2 Efficiency of markets
There are diverse types of efficiency in capital markets as they can be allocational, transactional or informational efficient. The latter one is mostly used in the academic literature and will be focused in this essay. It is about the linkage of a specific information set on the one hand and an aggregate capital market variable, e.g. a stock price, on the other hand. In neoclassical finance, informational efficiency presupposes an entirely rational environment where agents are expected to process all available information ultimately (Mama 2010).
Efficient capital markets, in the described informational sense, exist, if prices adapt to new information immediately and thus contain all available information. On top of that, the Efficient Market Hypothesis (EMH) states that new information and its timing is unpredictable – as well as the subsequent movements in security prices (Clarke et al. 2001). Fama (1965) mentioned efficient markets in stressing that ‘on the average, competition will cause the full effects of new information on intrinsic values to be reflected "instantaneously" in actual prices.’ That doesn’t imply that the market price is always equal to the intrinsic value, it can deviate substantially under the condition, that the differences are random (Damodaran 2012). Another important assumption of efficient markets is that there is a large number of profit-maximizing investors who operate independently (Imperiale 2005).
Because there are market fluctuations every day while investors over- or underreact to the news, it is not possible to predict stock price movements ex-ante if markets are not completely efficient. ‘Investors are subject to waves of optimism and pessimism that cause prices to deviate systematically from their fundamental values and later to exhibit mean reversion.’ (Malkiel 2003) “Markets can be very emotional over the short-run.” (Imperiale 2005)
There are different types of market efficiency. The weak form states that past price movements are already reflected in the actual price (ibid.). If that holds, the techniques of technical analysts, who try to gain value from past prices data only, are without purpose. “The inconsistent performance of technical analysts suggests this form holds.” (Russel/Torbey 2002). The second form is called semi-strong efficiency and includes the weak form assumptions and additionally all publicly available information. The strong efficiency contains the weak and semi-strong form and on top of that also information which is material and non-public. In other words, there are no secrets within the strong form of market efficiency and every meaningful internal corporate event would lead to a price movement, leading to a diminishing of insider trading (Hillier et al. 2016). Hence, the strong form cannot hold in a world with an “uneven playfield” (Russel/Torbey 2002). In the following figure the three different forms are presented. It is important to note, that the semi-strong form has formed the basis for most empirical research (Ibid.).
Abbildung in dieser Leseprobe nicht enthalten
Figure 1: Efficient Market Hypothesis, source: scepticlawyer.com.au 2016
3 Discussion of the research question
After explaining the efficiency of markets, the next step is now to differentiate between the micro and macro levels of markets. The micro level refers to the individual securities traded in a market. There is evidence that particular stock prices are interrelated with efficient market theory (Shiller 2003). Micro efficiency evolves if the few investors who detect small anomalies in stock prices take profit by conducting arbitrage trades. That leads to the extinguishment of the present inefficiencies and creates micro efficiency, as Samuelson (1998) stated in his famous dictum concerning micro-efficiency and macro-inefficiency (Jung/Shiller 2002). “Over the interval of U. S. history since 1926, individual-firm dividend-price ratios have had some significant predictive power for subsequent growth rates in real dividends: this is evidence of micro-efficiency. “(Ibid.)
To examine the presence of micro-efficiency, a closer look to the pricing on a company level is necessary. Basically, a firm’s fundamentals, like its book-to-market value, explains a large part of its future earnings. Thus, the future dividend situation can be better predicted for a single company than for an aggregate market. As the dividend projection is a good indicator for future price movements and - by using a discounted cash flow approach – also an important variable for company valuation, one can calculate a fair value price by incorporating this data (Shiller 2003). The group of traders who conduct their buying and selling decisions on such a rational and fact-based way is called “informed investors”, they work very effective as they are responsible for the long-term share price development. They typically have different opinions about the correct intrinsic value, but as a group they can drive the actual share price towards a realistic range which represents the approximate discounted value of the predicted future dividend cash flows. This range is extended to both sides by around 10% as insecurity about the real intrinsic value and trading costs are keeping informed investors from reacting to fast (Koller et al. 2015).
The opposing group is called “noise traders”. They are typically not interested in fundamentals as they focus purely on recent news and certain events which could lead to short-term share price movements they want to capture. One example of noise trading is a momentum strategy. In this tactical type of investing, price trends are detected and followed assuming that the movement will continue. By doing this, trends are accelerated until the mentioned range of the intrinsic value plus 10% is reached and informed investors are slowing down and eventually stopping the price movement by taking opposite positions representing their fundamental view (Ibid.). Knowing this behavior of those two groups, one can conclude that the rational behavior of the informed investors prevails in defining a correct market price for individual securities, leading in fact to micro-efficient markets.
On the other hand, there are situations imaginable, where the described effect doesn’t occur. This could firstly be the case when the group of noise traders is extraordinarily large, so that the few informed traders cannot stop the irrational price movement, leading to a single-stock-bubble. In practice, informed investors, who are especially responsible for large institutional accounts, are usually managing tremendous amounts, so that they can hardly be outnumbered by noise traders (Ibid.). In turn, the large investment size could also be a drawback in that context as small cap companies are usually not suiting to large institutional investors and thus are not regarded by them, giving more space for noise traders and the described resulting inefficiency. This effect is enforced by the actual trend of cutting back on analyst staff as a consequence of regulation and cost pressure. Many small and mid cap companies are only covered by a handful of analysts in these days (Frericks 2018), which supports uninformed investor opinions and subsequently micro-inefficiency in that segment.
Secondly, the model assumes that informed investors are short selling, if the upper boundary of the price range is reached. As short selling can lead to large losses, it could be that the full price correcting potential is not used (Koller et al. 2015). “If, for example, the share price doesn’t return to its fundamental value while they can still hold on to a short position - the so-called noise-trader risk - they may have to sell their holdings at a loss.” (Goedhardt et al. 2005) On top of that, there may be regulatory restrictions which keep investors from taking short positions. Even if that leads to micro-inefficiency, it usually lasts only a distinct time period, before the market eventually corrects the mispricing (Koller et al. 2015).