Market Efficiency And Anomaly

Background: Efficient Market Hypothesis

The efficient market hypothesis generally states that the asset price has already reflected all the information (Fama, 1998).

This implies the stock price depends on all fundamentals and includes all information existing in the market. Any small deviations might be quickly diminishing with new information coming out. Therefore, the EMH rules out the profitable investment opportunity in the market, because the price is already the right price.

Is the market efficient or not?

The price might be incorrect in the real market. Actually, the anomaly, which is the deviation of the strategic price from the expected true price, seemingly does exist. Then an issue arises:

Whether the investor could beat the market?

To address this issue, we apply an asset pricing model such as CAPM to calculate the expected benchmark return we should get subject to some factors.

The anomaly can be expressed as:

\alpha=r_{real}-r_{benchmark}

This equation shows that alpha (anomaly), which is the alpha in CAPM, is the real-world return less the benchmark return.

Then, the efficiency can be examined by testing the existence of an anomaly. If an anomaly exists, it means the market is not quite efficient. Therefore, investment strategies could be applied to earn the abnormal return and beat the market. This test can be conducted by constructing a regression model as, \(r_{i,t} =\alpha+r_{f,t}+\beta \times (r_{m,t}-r_{f,t})\) and do joint hypothesis testing.

Here are some relative literature introducing that the market is inefficient. Schwert (2003) stated that the market is not efficient, indicated by the existence of anomaly; Jensen (1978) proofed the inefficiency after adjusting the inconsistent data and missed techniques; Latif et al. (2011) also demonstrated different types of anomalies generated from technical, fundamental and behavioural aspects.

Given that the market is inefficient, the question now is how investors could earn the abnormal profit.

How could investors earn the abnormal profit?

The strategy is to construct a financial portfolio earning the abnormal return (anomaly), and in that strategy, investors select stocks based on their certain characteristics. (two examples below).

The momentum strategy: stocks that performed well in the previous period would also outperform others in the following period (Jegadeesh & Titman, 1993). The contrarian effect is the opposite.

The value investing strategy: stocks with a high P/E ratio or P/B ratio are overvalued, vice versa. Stocks with such as low P/E ratio, Dividend Yield, P/B ratio, etc. are generally under-priced. Thus, buying those cheap stocks could result in a profitable opportunity.

There are numerous investment strategies as we discussed above, and investors could simply apply one strategy or even combine some of the strategies to construct a portfolio to beat the market.

How to test ‘beat the market’?

Applying back-testing to simulate the portfolio’s performance

Example of Backtesting

back-testing is the methodology by which people can see the performance of a certain strategy by some historical data (Campbell, 2005). Here is an example of back-testing below:

Firstly, investors could sort stocks by strategy. If they apply the momentum strategy, they simply sort stocks’ historical return \( (r_{t=1,i}) \) from high to low. Then, investors would make the quartile cut-off, selecting stocks in the first quartile (best-perform stocks) and keeping them into the next period. This periodical return would be the strategic return. After that, we sort the second period return \( (r_{t=2,i}) \), select a first quartile stock again, and keep them into the next period again and again.

Under this procedure, we could use the historical data to track strategy periodical performance. Then, we could examine the existence of an anomaly by subtracting strategic return from the benchmark return.

Reference

Campbell, S.D., 2005. A review of backtesting and backtesting procedures.

Fama, E.F., 1998. Market efficiency, long-term returns, and behavioral finance. Journal of financial economics, 49(3), pp.283-306.

Fama, E.F., 1998. Market efficiency, long-term returns, and behavioral finance. Journal of financial eco

Jegadeesh, N. and Titman, S., 1993. Returns to buying winners and selling losers: Implications for stock market efficiency. The Journal of finance, 48(1), pp.65-91.

Jensen, M.C., 1978. Some anomalous evidence regarding market efficiency. Journal of financial economics, 6(2/3), pp.95-101.

Latif, M., Arshad, S., Fatima, M. and Farooq, S., 2011. Market efficiency, market anomalies, causes, evidences, and some behavioral aspects of market anomalies. Research Journal of Finance and Accounting, 2(9), pp.1-13.

Lux, T. and Marchesi, M., 2000. Volatility clustering in financial markets: a microsimulation of interacting agents. International journal of theoretical and applied finance, 3(04), pp.675-702.

Schwert, G.W., 2003. Anomalies and market efficiency. Handbook of the Economics of Finance, 1, pp.939-974.

Why QE doesn’t drive inflation?

The U.S. uses Quantitative Easing to boost economic growth in facing a recession, e.g. 2008 Financial Crisis or the current Covid-19. They apply assets purchasing, include such as treasury and MBS (mostly long-term financial high credit assets), to pour a huge amount of money into the financial market, aiming to boost the demand (aggregate demand) and avoid delation that people hoard money for safety.

We would not consider why the U.S. purchases long-term assets because interest rates either in the long or short term would all go down by non-arbitrage conditions. (P.S. long term T-bond rate was even lower than the short term T-bill rate in the first and second quarter of 2021, the unusual situation would largely during to the inefficient market and incontinence of the long term U.S. economy, but most likely the non-arbitrage would be applied later. So, investment opportunities were to short the long term T-bond, as it was overvalued by QE, and it would be back to a relatively lower price than during that time)

Theoritically

Theoretically, there is an increasing supply of money in the loanable fund market by asset purchasing (QE), because CB would buy bonds and lend money. So, the supply of loanable funds increases (the supply curve moves to the right,), and result in a decrease in interest rate. Then, investment increases due to the low cost of using money (low-interest rate).

Then in the AD-AS market, an increase in investment to drive the AD curve moves to the right as well. Considering now the AS curve is upward sloping in the short run, the movement of the AD curve would indeed increase output, Y, (as the U.S. wants) and also increase the price level. As a result, the price level would increase and inflation appears! With continuous QE, even hyper-inflation would happen!

In addition, the U.S. also conducts helicopter drops that directly give money to individuals to boost consumption (that is another problem and I would discuss in the later blog post)

Facts

However, this is not the case in the real world that QE does not create inflation.

One assumption that inflation does not occur is that the economy would be highly deflated if there is no fiscal or monetary policy. The inflation from QE is just offset by the deflation from the “Crisis”.

Whether this assumption is true or not seems unable to be proved. Potential the current heating “Causality” study could help to show that.

Ideas

Some of my thinking and also perhaps further study are the following.

  1. Inflation is absorbed by the dominant position of the U.S. dollar and “oil-dollar connection”. The inflation is transferred to other countries such as emerging markets or U.S. debt holders such as China. Further study and data are needed there.
  2. How Marginal Propensity of Consume (MPC) is affected or determined?

8 November 2021

FZ

Monetary Policy

Why does monetary policy work?

$$ \uparrow M \Rightarrow \downarrow i \Rightarrow \uparrow C \uparrow I \Rightarrow \uparrow Y \uparrow Price$$

The monetary market would directly affect the loanable fund market. An increase in the money supply would result in an increase in the money supply, and thus a decrease in interest rate. Later, a lower cost of borrowing and investing would raise the aggregate demand. Therefore, GDP increase.

In addition, with the low-interest rate in the domestic country, the exchange rate goes lower, the domestic currency depreciates relative to the foreign currency. Exports become more competitive.

Through the above two ways, the expansionary monetary policy would decrease unemployment and increase outputs.

See further study

Monetary-Policy-and-UnemploymentDownload