Video Transcript: Efficient Markets
Hi, welcome back. In this video, we're going to discuss efficient markets. So let's discuss random walk. Right, random walk is the theory that stock price movements are unpredictable, so there is no way to know where prices are headed. Right, so there's no real reason or other than just trading action right by traders in the markets. There's no real predictable reason to why prices move in the market right, unless it's you know if if the company is doing well and the market is doing well, and the economy as a whole is doing well. You can see the trend, right? If it's upward, right? If it's if the company's performing strongly, the market is good, the economy strong, right? You can see the overall long-term movement and the upward trajectory, maybe of that stock, right? But then we're going to go, and we're going to look at a daily, or you know this is a yearly a stock chart, right? And and really, there's no predictable movements. Why is this happening the way that it is? Prices do look rather random, right? So what what what is driving the movement in the price other than traders, nothing really, right? It's just being bought and sold, so there's no real reason for this volatility, other than traders coming in and trading the stock and moving the price, right? You can see in this particular stock that from this March point or this May point here, right? It looks like it is trading around 3350 right? So at 3350 right? It's trading here 3350 okay. But let's say in this two year span, right? Where is it trading now? Right around 3625 okay. Right around 3625. So here you can see that this, and and in two years that it's had a slight upward swing. But who's to say that it won't revisit back down here, right? So so really, in in this in this sense, there is no real pattern or reason for the movement of the stock, other than simple trading action, right? So studies of stock price movements indicate they do not move in neat patterns. Obvious, right? Because people are buying and selling. It's an open market. So what pushes the price down is more sellers than buyers. What pushes the price up is more buyers than sellers, right? So you know there may be reasons for the stock to be more demanded than previous, right? So so obviously we saw a nice spike here, right? In in in March of 10, we saw a nice spike here. Maybe they reported very strong earnings, something like that. So the stock was in greater demand. But if you look over this kind of medium-term chart, the stock price is relatively flat, right? So there's not been a whole lot of gain. Maybe a 10% gain from the 33.50 to the 36.25 price from February of 2009 to April of 2011, right? There's not been a whole lot of movement. It's been pretty flat. It's been pretty steady, but you can see that the price is now around $36, where it was at $33.50 at the beginning of this chart. But it's relatively flat, right? And the only reason why the stock moves the way that it does is that buyers and sellers form a free market, and supply and demand dictate price, as we've been talking about, right? So this is the pure form of supply and demand, right? So if the stock is demanded and the demand is greater than the supply, obviously the price will go up, right? But if it's not as demanded and people are selling off their their stock shares and they're putting
more supply available for the market. Obviously, the price will go down, just like we spoke about in our supply and demand charts earlier, right? So, if the price goes up, right, there'll be less demanded. If there's a cheaper price, it'll be a more demand, right? So, you notice as as we saw this sharp uptick in price followed by a reciprocal downward pressure in price. You can see that on the way up at these cheaper prices, it was still demanded strong. But as soon as it hit around $38 the demand stopped. No one wanted to buy at the inflated $38 price. So then you see sell action happen all through here, so now demand now supply is outweighing demand, putting downward pressure on the stock price. So this, so and and these values are basically determined by trading action by traders that trade professionally on Wall Street or individuals that own their own account. This is the supply and demand of this stock in its purest form. So let's talk about efficient markets. Efficient market is a market in which securities or stocks, right? Stock or any kind of financial instrument can be known as a security, when which securities reflect all possible information quickly and accurately. So, if there is a let's let's say that Southwest Airlines has had you know 10 engine failures in their planes in the last week, right? So that information will be priced into the stock price very quickly, right? The market will absorb the information, and the subsequent stock value will move on the on the news, right? Or on the information that is gathered, right? Whether it's positive or negative. So, a stock price, if it's positive news, the stock price is more than likely to appreciate. If it's negative news, the stock price is more likely to go down. Right. So, so in an efficient market, securities reflect all possible information quickly and accurately. Right. This is an efficient market. To have an efficient market, you must have many knowledgeable investors actively analyzing and trading the stock, right? So, so there must be a lot of people that know the information that can gather the information quickly, that are actively investing and trading, and they're constantly analyzing stocks, right? So you have to have these kind of people or these instruments in efficient market in order to make it efficient, make it work, right? So we can price in information and news very quickly. Information is widely available to all investors, right? Particularly today, we have the internet, World Wide Web, Google, whatever, Amazon, whatever you want to use for your search engine. You can use that, and you can find information. It's widely available very quickly, right? So that we can inform ourselves if something is worth investing in or not. So events such as labor strikes or accidents tend to happen randomly, right? So we're an economy that offers a free market where people are going to be paid the value of their worth in most cases, right? Or so so so labor strikes should not happen frequently, right? Or let's say you know we have a an oil spill in the Gulf of Mexico, right? Which which that rarely happens. It's not very common, but it can, right? But those instances such as labor strikes or accidents are very controlled and they they don't happen very often, right? So so we have an efficient market
that really makes sure that things are moving in the economy according to plan, right? So investors have to react quickly and accurately to new information, right? So when new information is put out about the product or whatever it is that we're the company sells or whatever they're doing. Right, investors can price that information in quickly and then can digest that information through the stock price and can and can determine if they want to continue to hold the security, if they want to buy it, or if they want to sell it, so the efficient market hypothesis is information reflected in prices, right? Not only the type and source of information, but also the quality and speed with which it is reflected in the prices. So the quicker that we can price in the information in the news, the more efficient our market or our prices become the more information that is incorporated into prices, the more efficient the market becomes. Right. So there are three types or three levels of efficient markets. Right. There's a weak form, a semi-strong form, and a strong form. So we'll discuss the weak form first, right? The weak form of efficient markets, right? So, so past data on a stock price, there's really no use in predicting future stock price changes, right? So, there's no way that past performance is indicative of future results, right? There's no way that that can happen typically because that information that happened in the past is already priced in, that information has already been digested by investors, and the price has already moved based on that previous data. Right. So the weak form also says that everything is random. There is no pattern. It just happens on the basis of supply and demand, and however traders feel the stock price should move, right? And then in this strategy, you should simply buy and hold, right? Because there's nothing priced in. There's no information that we can use to change the value, and we should unders we should especially in American equities. Potentially, we should consider that the economy will continue to be strong. So, with the weak form of efficient markets, the strategy could be or should be buy and hold. Okay, semi-strong form of efficient markets, right? So, so abnormally large profits cannot be consistently earned using public information. Why? Because any price anomalies, right, are quickly found out, and the stock market price adjusts, right? So there's not. So information is so widely available and so easily accessed that that any news or any information will be priced into the the stock price very quickly, right? So there's not an opportunity to corner the information, be the only person that has it, and then buy the stock and watch it appreciate because most in most investors are privy to the information at the same time, right? So let's look at a strong form of efficient markets right. So in the strong form right, there is no information. There is no information that is public or private that allows investors to consistently earn abnormally high returns. So in strong form, they are they are saying that we are saying that they're all of the all of the information or news that may come out about a company, positive or negative, will be automatically priced in almost instantaneously when the news breaks. Right. So so there's not an opportunity
to gather the information, hold it for myself, know that I'm the only one that has this information, and I'll buy the stock at a lower price. And then once the information breaks, the stock price will go up. Right. That's kind of the semi strong form. But the strong form says that there is no information, public or private, that allows investors to consistently earn abnormally high returns, right? Because the information is so readily available and easily accessible to the public that that the information that is put out into the market to digest is immediately priced in, right? So there's no way to make abnormally high returns because all information about the market is priced in immediately because all investors have access to the same information at the same time and have the same access. Right. This seems to be evidence that the market is not strong form efficient, which is true. Right? Because because it's it's not perfectly priced. Right. So there are opportunities in markets to gather information where other people may not have access to the information, right? So, so I think our markets really do resemble a semi-strong form, right? Where where where abnormally large profits cannot be consistently earned using public information, right? Because because we may be able to have access to the public information more quickly, right? But it's not going to happen all the time, so I can't depend on that, right? But also, we find examples where information is maybe leaked, right? And you know, people use information to to get ahead of the market, right? And and and they they they may have an opportunity to create those as normal profits, whereas in the strong form of economic or efficient markets, we can see that everything is priced in immediately, right? So, so this is the reason for insider trading laws, right? Because if we have somebody that has information that's public or will be public before the public does. Right, we that person or that group of people or that entity will be able to take advantage of that information and buy the stock at a lower price and eventually sell it. Once the once the news or the information breaks, then they can execute the trade and and sell their stock for a higher price, right? So this is why we have insider trading laws to limit that kind of activity. So market anomalies, right? So let's see how the calendar affects stock market prices and returns, right? Stock returns may be closely tied to the time of year or the time of week, right? So there are stocks that are cyclical, right? So right before the Christmas season, you may have people selling off utility stocks and buying retail stocks because they know that during the holiday season, retail stocks will go up because you know sales are going to surge because of the holidays, right? So that's a certain time. Or if let's say we expect company ABC to have stronger than estimated profit and revenue, right? And their earnings are sometime this week, right? They're reporting earnings to the market sometime this week, and we want to make an investment on the knowledge or the maybe the thought that they may have stronger than expected earnings, right? Then we may position ourselves by that stock, let earnings report, let stock price go up, then trade it, right? So you know
the calendar affects the market, right? Questionable if really provides opportunity. Sure, like you know, it's it's a it's a random walk, right? It's a free market, so so does it really create opportunity? Maybe in the short term, sure, right? But if prices get too high, the market will automatically adjust them back down and bring them into equilibrium. So the January effect, weekend effect, etc. Right? So small firm effect. The size of a firm impacts stock return. Sure, because if a if a firm is small, right, if a firm is small, they're not going to have the ability to grow at a rapid pace. Let's say the more maturing firm, right? So smaller firms may offer higher returns than larger firms, even after adjusting for risk. So it's really tough to invest in a small firm because they have you know not a lot of opportunities or not the same opportunities that a larger firm would have, but because because they don't have the same opportunities, you can you can risk adjust those returns right. So after you so so a smaller firm is not as stable as a is a large mature firm, so therefore that smaller firm is more risky an investment, right? So earnings announcements, we kind of covered this, right? Earnings announcements back in you know we were talking about the calendar effect, and you know it affects the time of week, right? Because a lot of companies report earnings around the same time, right? So, so price will be adjusted for earnings very quickly, right? So people can position themselves to take advantage of price swings after or before earnings, right? So usually, good quarterly earnings reports may signal buying opportunity, right? So if they're coming out beating market estimates, they can say that the firm is performing or outperforming the market, which is a very strong characteristic to have for a company, right? So we can look at the price to earnings effect, right, or the value effect. So the the price divided by their earnings, right? So the the share price, right? The share price, the price per share in the market divided by earnings, right, or sales, right. So the P/E ratio to value stocks, right. So each company has a P/E ratio, and you can compare the P/E ratio between companies, right, to an industry average. So let's say Wells Fargo and Bank of America are, you know they're both you know they're both banks obviously right and let's say Wells Fargo has a P/E ratio of 17.5 and Bank of America has a P/E ratio of 16 but they are both relatively the same as far as profit margin and sales revenue is concerned right so because Bank of America has a lower P/E ratio, you may say that the stock is undervalued. Of the Bank of America stock is undervalued compared to Wells Fargo because it has a high because Wells Fargo has a higher P/E ratio. So if I'm comparing two equities that I want to buy in the market, I may say, okay, look, this this company has a 17.5 P/E, but the sales and revenue and profit margins are very close to Bank of America, and they have a price-to-earnings ratio of 15. So, in my opinion, I would buy the Bank of America stock because the P/E ratio is selling at a discount to the 17.5 P/E of Wells Fargo, so you can use those metrics right to to signal buy, sell, hold opportunities, right? So if Wells Fargo has a higher P/E ratio but similar earnings
than Bank of America, and Bank of America's P/E ratio is 15, and Wells Fargo's P/E ratio is 17.5. I would buy Bank of America because they have a lower P/E ratio, right? Because their price is lower than the earnings like Wells Fargo. Let's say that Wells Fargo and Bank of America have the exact same earnings, right? The exact same earnings figure. They had the exact same amount of sales, right? But Wells Fargo's P/E ratio is 17.5, right? Because their stock price is higher, right? Than Bank of America, who has the exact same sales figure as Wells Fargo, but their price is their price earnings ratio is at 15? Buy the 15 price earnings ratio because it's less than Wells Fargo. So you may want to hold the Bank of America stock until it grows to a 17.5 P/E ratio of Wells Fargo, then sell it. That's just a trading trading strategy that people use to invest all the time. Right.