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

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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

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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)

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How Prices Adjust to New Information

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Patterns of Market Response

Early Response (anticipated information) Efficient Markets Response Delayed Response and Reversion Overreaction

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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
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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 securitys return using all available information will be equal to the securitys 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

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Interpreting the EMH

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Efficient Markets and Information Sets

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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

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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

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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

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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
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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 dont just trade on available news and rational response; they reflect irrational impulses (Greenspans irrational exuberance)

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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

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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
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Market Efficiency
The value of investment advice
Forbes Magazines monkey portfolio

Not all financial theory is good for the financial profession!

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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?
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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

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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)
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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

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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)

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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.
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Market Efficiency and Stages of Market Development

Recent research relates market efficiency to stage of market development

Pre-emerging Emerging Advanced markets

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The Five Phases of Market Maturity

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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

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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
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Equilibrium

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What should Africa do to improve market efficiency?

Need for more professionalism Better regulatory enforcement

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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)

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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

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