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130

More of the Same

Lets look at other studies that claim the market adjusts quickly to new information. The first was performed by Ball and Brown in 1968. The two investigators examined the normal rates of return from 1946 to 1966 for 261 firms. They divided the stocks into two groups, those whose eamings in a given year increased relative to the market, and those whose eamings decreased. The performance was measured after each year end. They found that stocks whose eamings increased outperformed the market, while those that decreased unde erformed the market. The researchers concluded the stock prices had already anticipated most of the news of eamings announcements.

The theorists overlooked one simple fact, well known to practitioners. Companies normally report quarterly (or, rarely, semiannually), not annually. The SEC has for many years required public companies to report this information within 90 days. Furthermore, even back then.

-4 to -0, the higher prices are accepted as evidence that positive information pushes prices higher. For the 4 months during the stock split announcements themselves, when prices are rising fastest, the analysis concludes investors cannot profit from the information. After the split is distributed, they state the market correctly 1 1 18 the information. The conclusion reached, naturally, is that markets are efficient.

The major criticism of this study is that the researchers built a sweeping conclusion, by measuring the wrong date, that the split information would not affect the stock prices. As a result, the study does not "prove" that stock splits have no effect on stock prices-in fact the chart indicates that they very well might have, although, as noted, until the proper measuring point is used the jury is out on this question. What is more important is how the study has been used as strong support of efficient markets given the questions that have just been raised.

Finally, even if the researchers had measured from the right time periods and they could show that stock splits had no effect on prices- which the evidence seems to dispute-there is another serious problem with the study and others similar to it that attempt to demonstrate market efficiency by examining a simple event. We will examine this question shortly.

This study is considered by many as the best known supporting EMH. Without it and others that also have significant problems, the second pillar of EMH-that investors process information quickly and correctiy-collapses.



analysts provided research reports on how companies were faring, supplemented often by press releases from company spokesmen. The researchers state that investors correctly judged the prospects of companies and thus determined the movement of their stock prices, when most times they actually had the information in hand to do so. To conclude the market is efficient from this rather obvious finding is stretching the point.

Another supposedly awesome bit of evidence to support the hypothesis was a study by Myron Scholes in 1972. Scholes analyzed the effect of secondary offerings of stock and concluded that, on average, a stock declined 1 % or 2% when such an offering is made. The largest declines resulted from the sale of stock by corporations or corporate officers. He also stated that the full price effects of a secondary are reflected in six days. Scholes concluded that since the SEC does not require the identification of the seller until six days after the offering, the market anticipates the informational content of the secondary, and is therefore efficient. Here again is a sweeping conclusion based on nominal price movements over a short period of time.

Secondary offerings normally bring stock prices down temporarily; this is almost a platitude. What is important is whether the stocks are brought down appropriately. How do they perform relative to the market 3,6, or 12 months later? Too, many brokers disclose beforehand who the sellers are. To state the market anticipates this information, because the SEC does not require it, is a chancy conclusion. Often this information is provided anyway.

Several other studies examined how quicldy markets integrate new information into stock prices. The first considers how companies react to the announcement of merger and tender offers. Fama, in his 1991 review of efficient markets, states,

[I]n mergers and tender offers, the average increase in stock prices of target firms in the three days around the announcement is more than 15%. Since the average daily retum on stocks is only .04% (10% per year divided by 250 trading days), different ways of measuring expected retums have htde effect on the inference that target shares have large abnormal retums in the days around merger and tender announcements.

EMH theorists, including Professor Fama, undoubtedly the most respected one of the day, make a major mistake in assuming that because stocks do respond to new information that they are also responding correctly. The event studies provide no evidence that this is the case. They simply show that a merger or an acquisition moves prices. To use a



Other Evidence Against Efficiency

While evidence of efficiency is quite a bit rarer than the theorists might admit, the evidence that markets do not adjust quickly to new information keeps mounting. Additionally Michaely, Thaler (one of the pioneers of behavioral finance), and Womack studied the subject in 1994. The three researchers measured how stocks behaved after a dividend cut or increase during the 1964 to 1988 period. In the year after the announcement of a dividend cut, the average stock unde erformed the market by 11%, and by 15.3% for the three-year period. In the year following a dividend increase it outperformed by 7.5%, and by 24.8% for the three years afterwards.-* This study indicates again that markets do not adjust to new information quickly.

A number of other studies have shown that the market is slow to digest new information. Several researchers have found that when a company reports an eamings su rise (that is, a figure above or below the consensus of analysts forecasts), prices move up when the 8 18 8 are positive, or down when they are negative, for the next three quar-ters.25 Abarbanell and Bemard, as noted in chapter 6, have shown that analysts dont adjust their eamings estimates quickly after past mis-takes. The "buy and hold" contrarian strategies presented in chapters 8 and 9 demonstrated that "best" and "worst" stocks continued to out-

chess analogy, its like concluding that if I move a chess piece after a move by Gary Kasparov or "Deep Blue" (take your pick), the fact that I pushed the piece puts me on their level of play. Nonsensical yes, but also the essence of the "proofs" of the theory.

The correct measurement would be not how firms respond in the three days around the initial merger or acquisition announcement, but how they respond relative to the price offered and the possibility of a higher offer (as was often the case through much of the 1980s, particularly with a hostile tender offer). The 15% that stocks appreciate around the date of the initial announcement of an offer is only a fraction of the approximately 30% or larger increase that shareholders receive when the offer is consummated. Even allowing for the occasional offer that is dropped, the first tender price appears far too low. The market again seems to be incorrect in its initial pricing of tender offers and mergers.

No evidence is provided that the initial reaction to the news is the correct reaction, as prices move up far too frequently from the trading levels following the announcements. This premise spawned a generation of risk arbitrageurs, who have made enormous retums on their capital.



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