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small firms should be concentrated in January. In any case, exploiting these effects can be
more difficult than it would appear. The effect of trading costs on small stocks can easily wipe
out any apparent abnormal profit opportunity.

Book-to-market ratios Fama and French (1992) and Reinganum (1988) show that a
seemingly powerful predictor of returns across securities is the ratio of the book value of the
firm™s equity to the market value of equity. Fama and French stratify firms into 10 groups ac-
cording to book-to-market ratios and examine the average monthly rate of return of each of the
10 groups during the period July 1963 through December 1990. The decile with the highest
book-to-market ratio had an average monthly return of 1.65%, while the lowest-ratio decile
averaged only 0.72% per month. Figure 8.4 shows the pattern of returns across deciles. The
dramatic dependence of returns on book-to-market ratio is independent of beta, suggesting ei-
ther that high book-to-market ratio firms are relatively underpriced or that the book-to-market
ratio is serving as a proxy for a risk factor that affects equilibrium expected returns.
In fact, Fama and French found that after controlling for the size effect and book-to-
market effect, beta seemed to have no power to explain average security returns.4 This find-
ing is an important challenge to the notion of rational markets, since it seems to imply that a
The tendency for
factor that should affect returns”systematic risk”seems not to matter, while a factor that
investments in shares
should not matter”the book-to-market ratio”seems capable of predicting future returns. We
of firms with high
ratios of book value to will return to the interpretation of this anomaly.
market value to
generate abnormal
Postearnings announcement price drift A fundamental principle of efficient
markets is that any new information ought to be reflected in stock prices very rapidly. When
good news is made public, for example, the stock price should jump immediately. A puzzling

However, Kothari, Shanken, and Sloan (1995) found that when betas are estimated using annual rather than monthly
returns, securities with high beta values do in fact have higher average returns. Moreover, they found a book-to-
market effect that is attenuated compared to the results in Fama and French and furthermore is inconsistent across dif-
ferent samples of securities. They conclude that the empirical case for the importance of the book-to-market ratio may
be somewhat weaker than the Fama“French study would suggest.
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8 The Efficient Market Hypothesis

Cumulative abnormal return (%)


“4.00 3


“50 “40 “30 “20 “10 0 +10 +20 +30 +40 +50
Event time in trading days relative to earnings announcement day

F I G U R E 8.5
Cumulative abnormal returns in response to earnings announcements
Source: George Foster, Chris Olsen, and Terry Shevlin. “Earnings Releases, Anomalies, and the Behavior of Security Returns,” The Accounting Review 59
(October 1984).

anomaly, therefore, is the apparently sluggish response of stock prices to firms™ earnings
The “news content” of an earnings announcement can be evaluated by comparing the an-
nouncement of actual earnings to the value previously expected by market participants. The
difference is the “earnings surprise.” (Market expectations of earnings can be roughly meas-
ured by averaging the published earnings forecasts of Wall Street analysts or by applying trend
analysis to past earnings.) Foster, Olsen, and Shevlin (1984) have examined the impact of
earnings announcements on stock returns.
Each earnings announcement for a large sample of firms was placed in 1 of 10 deciles
ranked by the magnitude of the earnings surprise, and the abnormal returns of the stock in
each decile were calculated. The abnormal return in a period is the return of a portfolio of all
stocks in a given decile after adjusting for both the market return in that period and the port-
folio beta. It measures return over and above what would be expected given market conditions
in that period. Figure 8.5 is a graph of the cumulative abnormal returns for each decile.
The results of this study are dramatic. The correlation between ranking by earnings surprise
and abnormal returns across deciles is as predicted. There is a large abnormal return (a large
increase in cumulative abnormal return) on the earnings announcement day (time 0). The ab-
normal return is positive for positive-surprise firms and negative for negative-surprise firms.
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278 Part TWO Portfolio Theory

The more remarkable, and interesting, result of the study concerns stock price movements
after the announcement date. The cumulative abnormal returns of positive-surprise stocks
continue to grow even after the earnings information becomes public, while the negative-
surprise firms continue to suffer negative abnormal returns. The market appears to adjust to
the earnings information only gradually, resulting in a sustained period of abnormal returns.
Evidently, one could have earned abnormal profits simply by waiting for earnings an-
nouncements and purchasing a stock portfolio of positive earnings-surprise companies. These
are precisely the types of predictable continuing trends that ought to be impossible in an effi-
cient market.
Some research suggests that the postannouncement drift in security prices might be related
in part to trading costs. Bernard and Thomas (1989) find that postannouncement abnormal re-
turns increase with the magnitude of the earnings surprise until it becomes fairly large. Be-
yond this point, they speculate, the change in the perceived value of the firm due to the
earnings announcement is so large that transaction costs no longer impede trading and prices
change more rapidly. They also point out that postannouncement abnormal returns are larger
for smaller firms, for which trading costs are higher. Still, these results do not fully explain the
postannouncement drift anomaly. First, while trading costs may explain the existence of post-
announcement drift, they do not explain why the total postannouncement abnormal return is
higher for firms with higher earnings surprises. Second, Bernard and Thomas show that firms
with positive earnings surprises in one quarter exhibit positive abnormal returns at the earn-
ings announcement in the following quarter, suggesting that the market does not fully account
for the implications of current earnings announcements when it revises its expectations for
future earnings. This suggests informational inefficiency, leaving this phenomenon a topic
for future research.

Strong-Form Tests: Inside Information
It would not be surprising if insiders were able to make superior profits trading in their firms™
stock. In other words, we do not expect markets to be strong-form efficient. The ability of in-
siders to trade profitability in their own stock has been documented in studies by Jaffee
(1974), Seyhun (1986), Givoly and Palmon (1985), and others. Jaffee™s was one of the earli-
est studies to show the tendency for stock prices to rise after insiders intensively bought shares
and to fall after intensive insider sales.
To level the playing field, the Securities and Exchange Commission requires all insiders to
register all their trading activity, and it publishes these trades in an Official Summary of Insider
Trading. Once the Official Summary is published, the trades become public information. At
that point, if markets are efficient, fully and immediately processing the information released,
an investor should no longer be able to profit from following the pattern of those trades.
Seyhun, who carefully tracked the public release dates of the Official Summary, found that fol-
lowing insider transactions would be to no avail. While there is some tendency for stock prices
to increase even after the Official Summary reports insider buying, the abnormal returns are
not of sufficient magnitude to overcome transaction costs.

Interpreting the Evidence
How should we interpret the ever-growing anomalies literature? Does it imply that markets
are grossly inefficient, allowing for simplistic trading rules to offer large profit opportunities?
Or are there other, more subtle interpretations?

Risk premiums or inefficiencies? The price“earnings, small-firm, book-to-market,
and reversal effects are currently among the most puzzling phenomena in empirical finance.
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8 The Efficient Market Hypothesis

There are several interpretations of these effects. First note that, to some extent, these three
phenomena may be related. The feature that low-price, low capitalization, high book-to-market
firms, and recent stock market “losers” seem to have in common is a stock price that has fallen
considerably in recent months or years. Indeed, a firm can become a small firm, or can become
a high book-to-market firm, by suffering a sharp drop in its stock price. These groups there-
fore may contain a relatively high proportion of distressed firms that have suffered recent
Fama and French (1993) argue that these anomalies can be explained as manifestations of
risk premiums. Using an arbitrage pricing approach,5 they show that stocks with greater sensi-
tivity to size or book-to-market factors have higher average returns and interpret these returns
as evidence of a risk premium associated with these factors. Fama and French argue that a so-
called three-factor model, in which risk is determined by the sensitivity of a stock to (1) the mar-
ket portfolio, (2) a portfolio that reflects the relative returns of small versus large firms, and (3) a
portfolio that reflects the relative returns of firms with high versus low ratios of book value to
market value, does a good job in explaining security returns. While size or book-to-market ra-
tios per se are obviously not risk factors, they perhaps might act as proxies for more fundamen-
tal determinants of risk. Fama and French argue that these patterns of returns may therefore be
consistent with an efficient market in which expected returns are consistent with risk.
The opposite interpretation is offered by Lakonishok, Shleifer, and Vishney (1995), who ar-
gue that these phenomena are evidence of inefficient markets”more specifically, of system-
atic errors in the forecasts of stock market analysts. They present evidence that analysts
extrapolate past performance too far into the future and therefore overprice firms with recent
good performance and underprice firms with recent poor performance.

Anomalies or data mining? We have covered many of the so-called anomalies cited
in the literature, but our list could go on and on. Some wonder whether these anomalies are re-
ally unexplained puzzles in financial markets, or whether they instead are artifacts of data
mining. After all, if one spins the computer tape of past returns over and over and examines
stock returns along enough dimensions, some criteria will appear to predict returns simply by
In this regard, it is noteworthy that some anomalies have not shown much staying power
after being reported in the academic literature. For example, after the small-firm effect was
published in the early 1980s, it promptly disappeared for much of the rest of the decade. Sim-
ilarly, the book-to-market strategy, which commanded considerable attention in the early
1990s, was ineffective for the rest of that decade.
Still, even acknowledging the potential for data mining, there seems to be a common thread
to many of the anomalies we have considered that lends support to the notion that there is a
real puzzle to explain. It seems that value stocks”defined either by low P/E ratio, high book-
to-market ratio, or depressed prices relative to historic levels”seem to have provided higher
average returns than “glamour” or growth stocks.
One way to address the problem of data mining is to find a data set that has not already
been researched, and see whether the relationship in question shows up in that new data. Such
studies have revealed size, momentum, and book-to-market effects in other security markets
around the world. Thus, while these phenomena may be a manifestation of a systematic risk
premium, the precise nature of that risk is not fully understood.

A behavioral interpretation Those who believe that the anomalies literature is in
fact an indication of investor irrationality sometimes refer to evidence from research in the

We discussed arbitrage pricing models in Chapter 7, Section 7.5.
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
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280 Part TWO Portfolio Theory

Fortune-Rated Firms and Market Efficiency
Go to the Federal Reserve Bank of New York™s website at http://www.newyorkfed.org/
rmaghome/curr-iss/cib-l.html. Access the research article entitled “Are High-Quality Firms
Also High-Quality Investments?” which presents a test of the efficient market hypothesis
using the rankings of the most respected firms in Fortune magazine.
After reading this article, answer the following questions:
1. This is a test of what type of efficient market?
2. Briefly describe how the authors performed their test of the efficiency of the market.
3. Contrast the results of the test analysts™ opinions versus executives for the firms in
the Fortune reports. What would you expect to see happen over time given the
results of this study?

psychology of decision making. Psychologists have identified several “irrationalities” that
seem to characterize individuals making complicated decisions. Here is a sample of some of
these irrationalities and some anomalies with which they might be consistent.6
1. Forecasting errors. A series of experiments by Kahneman and Tversky (1972, 1973)
indicate that people give too much weight to recent experience compared with prior
beliefs when making forecasts, and tend to make forecasts that are too extreme given the
uncertainty inherent in their information. DeBondt and Thaler (1990) argue that the P/E
effect can be explained by earnings expectations that are too extreme. In this view, when


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