To What Extent Is Stock Market Anomalies Evidence of Market Inefficiency - Essay Example

? To what extent is stock market anomalies evidence of market inefficiency? Table of Contents Introduction 3 Inferences from long term returns 4 Problems related to modelling 4 Econometric Forecasting 4 Reliability of individual studies 5 IPO’s and SEO’s 5 Stock Split 6 Conclusion 7 References 8 Introduction Depending on the seasonality of the stock markets the deviation from the efficient market theory was analysed by Eugene Fama (1970, 1991). Thus a test was conducted to assess the anomalies of the stock market by Eugene Fama to detect the market inefficiencies. In this study different portfolios were tested resorting to the market capitalization of each market within stipulated time span. However, according to the normality test only 1% significance level was detected. Eugene Fama has taken the specific asset pricing model such as the APT (Asset Pricing Theory and the CAPM (Capital Asset Prising Model) as the standard paradigm. Since the stock prices of different firm over the markets is different, i.e. the market value for the riskier stocks are low providing higher rate of return and vice-versa but in a cross section market the inverse will be applicable. Thus based on the evaluation made by Fama we can analyse the factors responsible for the stock markets anomalies resulting from market inefficiency (Keim & Ziemba, 2000, pp.92-94) Momentum and Overreaction anomalies Through momentum of anomalies the short-term pattern of share pricing of the companies. According to the theory lead by Werner DeBondht and Richard Thaler the over reaction of investors to the public information is completely unnecessary as the stock prices are evaluated according to the past performance of the stock market which may not portray the true picture of the market information. Thus the stock prices with inflated or depressed pricing may result in realising good or bad information which cannot be depended upon. Through the implementation of the overreaction strategy the investors were suggested to buy the “loser” portfolios while selling off the “winner” portfolios. But again a contradiction arises related to the weak-form of efficiency of the securities tends to earn high returns not only in the short-term but also in the subsequent periods. However the existence of the momentum is rational not contradicting the market efficiency due to the fact that that the presence of shocks in the growth rates of the cash flows of the shareholders which is induced to the serial correlation that is not only short lived but also rational (McMillan, et al., 2011, p.contents). Inferences from long term returns According to the inferences drawn by Fama is that the market efficiency of the market is based on the joint model testing for the expected normal returns. The problem that arises with the expected normal return whose description provided for the systematic pattern is incomplete related to the average returns during the testing period resulting in a bad-model problem. A bad model problem results in spurious average abnormal return which tends to become the CARs (Cumulative Abnormal Returns) because of the mean associated with the CAR increases summing to the standard error. Constant pricing errors can be seen in the ARRs (Average of monthly abnormal returns) with the respective standard error. Bad modelling problems are the main reason behind the long-term buy and hold abnormal returns which results in the multiplication of the expected return problem related to the short-term return explanation. Problems related to modelling The problems related to the modelling of the bad-model are of two types; the first is that the asset pricing model of any kind does not completely describe the expected return from the market. In a particular market is tilted towards the small stocks then in the calculation of the CAPM the risk adjustments made can project false returns. Even in the case of the true model where the deviation from the model are predicted a situation of spurious anomaly can arise after the risk adjustment of the true asset pricing model. To overcome the above problems of bad modelling Fama’s market model was used to measure the expected market return of the country. According to Fama’s market model the intercept and the slope of regression helped in determining the stocks return in the market. Econometric Forecasting Economic forecasting is another way of determining the divergence of the stock in a specific market but lacks the evidence related to the financials and the macroeconomic variables. The forecasting of the power of the market result can be based both on in-sample evidence as well as out-of-sample evidence. Out-of-sample is related to the information which is quite accurate and is obtained from the process of back testing (square root of forecasted mean error). It is through the findings of Pesaran and Timmeran (1995) that significant abnormal profits are generated by the market without any discrepancies. With an AAR (Average annual return) ranging from 10% to 15% depending on the measures adopted for the same the buy-and-hold return from the market can turn out to be 7.5%. Thus from the given information we can infer that the profits generated from the market were not completely efficient over the period (Sollis, 2012, p.144). Reliability of individual studies The reliability of the individual studies can prove that the abnormal returns thus generated by the stocks may turn out to be the most fragile with the changing market situation. This can be understood by the detailed study of the following two anomalies of the market. IPO’s and SEO’s The most striking study of long-term return is the initial public offerings (IPOs) and the seasoned equity offerings (SEOs). On a comparative note we can find that the total wealth generated through SEOs and IPOs is 70% more than that of the strategy of buy-and-hold related to the size of the stocks. But when the benchmark controls the size of the stocks with respect to the book-to-market equity and the size of the stock the relative wealth tends to rise above 70% leading to the wash out of the anomalies in the market. The reduction in the initial public offerings (IPO) and seasoned equity offerings (SEO) anomaly explains the reason of poor returns from the small growth stocks during a particular sample period. Five year value weighted wealth relatives for initial public offerings (IPO) is 0.86 or more where four out of the six benchmarks produces an excessive wealth relative of 0.9. Similarly for the seasoned equity offerings (SEOs) the five-year wealth relative is 0.88 where three out of six are in excess of 0.98. Hence we can observe that equally weighted firms provide huge returns from the initial public offerings (IPOs) and the seasonal equity offerings (SEOs) which infer that the anomaly of the stock market can be overcome with the application of the equal weighted initial public offerings (IPOs) and seasoned equity offerings (SEOs). The three factor model of Fama and French is used in the calculation of the portfolios abnormal return. When initial public offerings (IPOs) are backed by the venture capital the intercept of the regression shows a positive trend giving positive returns to the investors. But three problems related to this has to be considered i.e. the variance in the time frame, the number of firm involved in the event portfolio and most importantly the three factor model of Fama and French not being absolute in the changing environment of the market. However, the matching of the results of initial public offerings (IPOs) and seasoned equity offerings (SEOs) with the benchmark size does not imply that the returns thus generated are superior to the abnormal returns. In any case the abnormal returns being generated are due to bad model problem which cannot be escaped. Similarly, low returns are shared in both the dimensions of size and book-to-market equity of the respective stock in the market can result in producing different estimated for the firm. Moreover, with the initial public offerings (IPOs) and the seasoned equity offerings (SEOs) being value weighted the abnormal returns tend to become low for all benchmarks which are nothing different from zero. Thus, the existence of SEO and IPO are largely restricted to small firms (Fama, 1998, pp.283-306). Stock Split Stock split is a way by which the par value of the common stocks of the company reduces with the increased number of additional shares. The reason behind the stock split is to reduce the market value of the share of a concerned company. The first test related to the semi-strong market efficiency was carried out by Fama, Fisher, Jensen and Roll in the year 1969. By the use of the risk adjusted return concept the test for the market efficiency was carried out which led to the announcement of the stock split. This resulted in a positive abnormal rate of return even before the announcement was made. But with the implementation of the stock split strategy in the market no extraordinary return could be witnessed which puts back the theory from where it all started i.e. the prediction as laid by the efficient market hypothesis (EMH). As no significant changes was observed in 940splits made in months within the period from 1927 to1959. The poor returns generated in the market due to the stock split anomaly adapted by the firm. Thus it becomes very difficult to reap abnormal profits from the kind of information that is generated through the practice of stock split anomaly. But in the year 1997 Desai and Jain reported a positive performance from the stock split anomaly from 1975 to 1990. The magnitude of the upward movement was 3.06% which is quite smaller in comparison to 7% / 8% that was reported earlier. Through extensive analysis it has been found that though the stock split anomaly earned a positive abnormal return but unlike others was short lived. A continuous failure has been witnessed in the out-of-sample test concluding that the anomaly found is baseless unless the market has been an inefficient one. Stock split was generally done to put the security price in a range where the liquidity in the trading market will be highest. According to the analysis made by Copeland in the year 1979 the low rate of liquidity in the market was the reason behind the implementation of the stock split. Thus no other financial economist could prove otherwise the anomaly of stock split penned by Fama (Boehme & Danielsen, 2007, pp.485-506). Conclusion The whole theory of Fama and French revolves around the stock market inefficiencies due to the anomalies in the stock. But throughout we have been discussing about the simple principles involved in the efficient market hypothesis. In the 1970’s the observations related to the random security pricing theory became the financial paradigm. However, detecting the efficiency for the market is rather difficult. Through the theories laid above we can observe that an innumerable test has been carried out only to arrive at the anomalies of the stock market. This goes on to support the reasons for the short comings of the models implemented to get the positive expected return for the respective firm. Indeed through the study of the principles and interpretations led by Fama in 1998 the anomalies of the market needs adoption of the behavioural based theories of the stock market. So, it is advisable to continue the search of a better asset pricing model. Various analysts have tried to find out theories which will tally with the measurement of the efficient markets hypothesis but in vain. In the year 1994 Roll observed that it is very difficult to gain profitable return even by the extreme violation of the efficient markets hypothesis. Stock market anomalies generally do not persist in the future as they are related to the chance events. But from the above discussion it can be concluded that the profitability of the stock in relation to the efficient market hypothesis; anomalies of the stock market are a must. Thus the framework used by various economists is through the application of different efficient markets model. References Boehme R. D. & Danielsen B.R., 2007. Stock-Split Post-Announcement Returns: Underreaction or Market Friction? [Pdf]. United States: University of Houston. Available at: [15 June 2012]. Fama E. F., 1998. Market efficiency, long-term returns, and behavioural finance. [Pdf]. United States: University of Chicago. Available at: [15 June 2012]. Keim D. B. & Ziemba W. T., 2000. Security Market Imperfections in Worldwide Equity Markets. United Kingdom: Cambridge University Press. McMillan M. G., et al, 2011. Investments: Principles of Portfolio and Equity Analysis. Canada: John Wiley & Sons. Sollis R., 2012. Empirical Finance for Finance and Banking. Canada: John Wiley & Sons. Read More