Financial markets

Financing and investment decisions are different because:

• You can easily go back to a financing decision and reverse it in a short period of time while you can not do so with investment decisions

• It is easier to make money thanks to investments than it is by using financial markets: it is much more difficult to find a financing strategy with a positive NPV than it is to find an investment having a NPV.

COMPETITIVE MARKETS

In a competitive market the prices of stocks change randomly: you can not find a patter predicting how the stock’s price will change in the future. If it was possible to do so, every investor could analyse the past data to construct a pattern, invest and make money. When investors try to do so, the prices of the financial assets change thus making any advantage or knowledge of past performance useless because stock prices in the present already reflect the past pattern, stocks in the future include more than that. A market in which stock prices adapt to the available information about stocks is called an efficient market. There are various levels of market efficiency:

• Weak market efficiency: in those markets investors can not make profits on the market by studying past performance because the market does reflect already those information.

• Semistrong market efficiency: those markets reflect not only the trend stocks followed in the past but also the information available publicly via internet or other sources. This means that, as soon as an announcement about a company or an industry is publicly available, prices on the market will adjust.

• Strong market efficiency: if a market is strongly efficient, it will display prices influenced by past performance, publicly available performance and any possible factor in the firm and the economy. In those kind of markets investors can make some profits every once in a while but it is in theory impossible to find someone who could beat the market consistently.

WHAT EFFICIENCY IS ABOUT

If in efficient markets prices change randomly, it means that the variance of those returns should increase linearly as we increase the time span we are considering. To understand why, suppose that a stock could either increase its price by $3 or reduce it by $3 in a month. If you consider a month, the possible total change vary from -3 to +3. If you consider the time span of a year returns could vary from -36 to +36. However in reality it is not like that. In the medium term (like two months) prices tend to be more variable than expected while in the long run (like 1 year) prices seem to return to their original levels. In order to test whether the market is semistrong, you have to isolate the effect an announcement about a company has on its stock. In order to do so you could simply monitor the stock prices before the announcement and shortly after it. By testing a large number of stocks you can determine the nature of the market. When doing so, we can consider the influence of market movements on single stocks as minimal because, in a few days period, the daily market returns are really small. When you increase the time period in which you monitor the price of the stock you have to be aware of those market movements. If this happens you can simply check the real change the announcement induced by subtracting from the return on stock the returns of the market:

Adjusted stock return = return on stock – return on the market (if you assume stock has β=1)

But if you just do so you do not take into account the fact that the firm could not be perfectly reactive to the market movements. Therefore you have to compute the influence of the market again using the beta of the firm’s stock.

Expected stock return = α + β*return on the market

In that formula, α is a measure of how much the stock’s price changed when the market index stayed constant. If the actual return on the stock is ȓ and that the return on the market is ȓm we can describe the change induced by the announcement as:

Announcement influenced stock return = actual stock return – expected stock return = ȓ - (α + βȓm)

Generally announcements like the acquisition of another firm make the price of the acquiring firm increase by the so called takeover premium. You can see the magnitude of this premium by how much the price of the stock changes in the day of the announcement.

Many professional investors and mutual fund managers try to take advantage of those opportunities but records show that mutual funds provided their owners lower return than a market index could (also because of the fees you pay when hiring a mutual fund manager). This is why many investors decide just to buy an index that tracks the market which also offers the advantage of being almost fee-free. However the market needs some investors who try to take advantage of new information available because otherwise the prices of the stocks could not adjust to announcements.

WHAT IF MARKET EFFICIENCY IS NOT PERFECT

We said that in an efficient market it is not possible to find assets offering expected return higher or lower than the cost of capital you would employ. This means that every financial asset should trade at its fundamental value leaving no opportunity to make easy money:

However, in the past stocks of firms which small market capitalizations performed better than stocks with higher market capitalization even if they bore the same level of risk and that, therefore, should have had the same opportunity cost. This is possible because investors might have demanded higher rates of return when investing in those companies. However this effect disappeared once it has been documented publicly because investor tried to get advantage of it as soon as possible.

ANOMALIES

There are some anomalies in the market even in efficient markets. An example of that is the fact that once a company issues its first stocks (IPO) prices rise because a lot investors try to buy it but, after a while the returns on the same stock become lower than the ones of the market index. Another anomaly is the one of stocks which are “Siamese twins”: they are securities that are based on the same cashflow but that trade separately. In principle those securities should move exactly in the same way but what happened for example with the Royal Dutch Petroleum and the Shell Transport and trading, which were two companies sharing the profits and dividends of the oil industry but that traded (before they merged in 2005) at very different prices.

MARKET BUBBLES

When you compute the value of a common stock based on the dividend they pay, the rate at which those dividends grow and the opportunity cost you will:

Notice that because the g is at the denominator and r and g are generally pretty close in value, a small change in the expected growth of those dividends will influence the price of the share by a large margin. Therefore, in order to price stocks generally investors use past data and adjust it according to the information available each day. If investors are confident that those prices are correct, the price of the stock changes smoothly while, if they think the price is not right they will start buying or selling the stock rapidly making the price volatile until they don’t reach an equilibrium. When you are testing market efficiency, it is impossible to measure the value of stocks alone but you can test how the prices of single stocks are related to prices of other similar stocks. A bubble is a situation in which many investors start buying the security making its price increase. Once a bubble is created, many investors will try to take advantage of it making by buying the security and thus making the price increase again. Bubbles obviously can not last forever and when they explode the price of the stock falls and who holds it at that time will lose a lot of money.

A LITTLE BIT OF PLYCHOLOGY

There are some cases in which stocks’ prices are different from their expected value. This is because the prices depend on the investors in the market and various studies in behavioural psychology suggest that people are not always rational. People behaviour depends on various factors among which:

• How much they tolerate risk: when people device to invest their money, they will not only be interested on their holdings but also on the performance those securities registered in the past. In particular, investors change their opinion about an asset depending on whether it generated revenues or losses. In the latter case, investors demand higher returns to compensate for those losses. Furthermore, when investors suffer a loss, they will be reluctant to buy again the same security because they are scared of other losses in the future. Conversely, when investors gain from their investments they can be overoptimistic and start behaving like gamblers accepting higher risks.

• How they weight recent events. When judging future outcomes, investors usually try to predict what is going to happen by looking how the same stock or similar stocks performed in similar situations. Therefore they tend to put too much importance on recent events. Because of that investors generally are slow in readapting old beliefs based on past evidence to the new ones.

• What they think about themselves. Many investors suffer from overconfidence: they think that they can systematically beat the market by picking only the best stocks. If this happens they might overestimate their judging ability and be overoptimistic about the future. This could lead also to an underestimation of possible negative events.

What investors feel about the market influences their decisions and those decisions influence the market prices.

ARBITRAGE

Arbitrage is defined as a strategy that investors employ in order to exploit market inefficiencies and earn some profits. When an investor tries to exploit an arbitrage, he will buy a stock and sell it immediately in order to gain a sure profit. Think about a stock priced $10 in a market and $11 in another: you would buy the stock in the first market and sell it in the second, thus earning a sure profit of $1. When the market is efficient, every time that there is a “non predicted” price, investors trying to take advantage of it will push the price to that value. This is because, by buying under priced stocks they push their prices up and by selling the overpriced ones they push their prices downwards. If you think that a stock is overpriced but you do not own it, you can still try to profit by selling short. When you want to sell short a stock you borrow it from another investor with the promise to give it back to him. Therefore if you take those shares, sell them high and then buy them again at a lower price, you earned a profit. If however, when you have to buy the share back, its price has increased you will incur in a loss.

WHAT AN EFFICIENT MARKET IMPLIES IN THE END

• PAST PERFORMANCE DOES NOT DETERMINE FUTURE PERFORMANCE: how the stock performed in the past gives no clue on how the stock will perform in the future. Stock prices do not follow a linear trend nor a cyclical one. When you have an information that is not publicly available you will have the possibility to see how it will affect the price of the stock. If for example the managers of a firm know something positive about their firm that other people don’t, they know that once the information becomes public, the stock price will rise. Because of that it is better for managers to wait if they are willing to issue new stocks because otherwise they will offer a sort of “discount” to investors.

• MARKET PRICES ARE ACCURATE. Because market prices reflect all the information available you can trust that each stock is fair. Because of this, there is no way thanks to which investors can achieve consistent better performance of the market.

• INVESTORS HAVE MANY POSSIBILITIES. Rationally speaking, investors can pick their own stocks and therefore have no incentive to hire someone to buy them at their place. For the same reason investors prefer to diversify their portfolios themselves without asking firms to differentiate their businesses. The same is also true for debt: single investors can ask for debt themselves without asking firms to use it to increase their profit potentials. This is true also because as the firm uses debt, the stocks become riskier.

• STOCKS ARE COMPARABLE. Because investors pick stocks according to their risk and return and nothing else, they can easily substitute between them. Because of that, the demand of stocks is very elastic. If the returns on a stock are too low nobody will buy it, if a stock offers higher returns, investors would rush to buy it.