The Short-term and Long-term Market

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1 A Presentaton on Market Effcences to Northfeld Informaton Servces Annual Conference he Short-term and Long-term Market Effcences en Post Offce Square Boston, MA Charles H. Wang, Ph.D., Co-Drector of Research May, 2004

2 he heorem of No radng heorem: If players are all ratonal and for profts, there would be no trade takng place Most nvestors are reasonably ratonal. Irratonalty as narrowly defned by behavor fnance usually s ratonal n a larger context. Overreacton s a sudden change of rsk appette Most nvestors trade for proft n the short-term. here s no compellng reason an nvestor to trade today nstead of tomorrow other than rsk-returns concerns Corollary: for every trade, there s a buyer and a seller. One s smarter than the other he fact tradng stll takes place means the theorem must be wrong 2

3 he heorem of No radng Alternatve explanatons Why markets exst: here are nose traders and nformed traders Buyers and sellers have dfferent nvestment horzons IBM prce goes from $00 to 80 n a day and to 20 n a year, a short-term sell and long-term buy Implcatons: Both buyer and seller could be rght: thnk twce before you trade It s mpossble to perfectly tme the market We always leave money on the table 3

4 Short-term and Long-term Market Effcences If only I were Newton: he long-term return s the ntegral of the short-term return R ) = r t) dt 0 If one could trade nstantaneously wthout transacton costs, the total return would be astronomcal: A ) Mathematcs? statstcs? fnance = r t) dt 0 4

5 Short-term and Long-term Market Effcences Separaton of the long and short terms Long-term stock returns are not the ntegral of short-term returns Stock prce s not a dfferentable functon: mssng out a few days could make a bg dfference Geometrc mean and mathematcal mean are dfferent: no suffcent statstcs to connect the short term and long term ransacton costs wegh n for contnuous rebalancng he drvers of stock market returns are dfferent In the long-term stock market converges to the far value In the short-term stock market reacts to news and s affected by rsk appettes It s dffcult to fnd global maxmum/mnmum, mpossble to perfectly tme the market 5

6 Short-term Market Return Dynamcs Chart. hree-year Rollng Wndow Frst-order Daly Autocorrelatons S&P 500 Index Returns: Nov-72 Nov-74 Nov-76 Nov-78 Nov-80 Nov-82 Nov-84 Nov-86 Nov-88 Nov-90 Nov-92 Nov-94 Nov-96 Nov-98 Nov

7 Long-term Return Dynamcs Autocorrelatons Chart 3. Frst-order Autocorrelatons of MSCI Country Index Returns 8 Developed Market Average: m 3m 6m 2m 24m 36m 48m 60m Holdng Perods 7

8 Drvers of Short-term and Long-term Market Effcences Drvers of Market Effcences Short-term market effcences Increasng nformaton flow: fnancal databases, nternet Better tradng technology: technology advancement, programmng tradng More actve nvestment strateges: hedge funds, ndex arbtrages Same players chasng opportuntes worldwde Long-term market effcences Busness cycles and consumpton-based captal asset prcng models Behavoral fnance and nterpretaton of nformaton Who are the margnal players? Insttuton matters: bureaucracy and nsttutonal rgdty 8

9 Insttutonal rgdty and Behavoral Fnance How mportant s asset allocaton? Brnson et al 986 and 99) orgnal research: 90% Ibbotson and Kaplan 2000), Krtzman and Page 2003): not much How do we choose fund managers? Do wnners repeat? Goetzmann and Ibbotson 994), Danel et al 997): weak evdence Industry reacts to past performance and often swtches styles and managers n the wrong tme How do managers select stocks? Separaton of fundamental and quanttatve research No proper nvestment horzons and sngle-perod optmzaton Markets aren t good at subtracton and summaton 9

10 he erm Structure of Market Correlatons he permanent and temporary components of stock returns R µ t) t) = = µ t) + ε µ t t) ) + δ t) Stock returns are lttle or postvely autocorrelated n the short term and negatvely autocorrelated n the long term How about correlatons? 0

11 erm-structure of Market Correlatons 0.76 Chart 4. U.S. 2 Average Industry Portfolo Correlatons July 926-December Average Industry Correlaton Holdng Perod n Number of Months

12 erm-structure of Market Correlatons Chart 6: Correlaton Structure of U.S. Large and Small Cap Portfolos July 926-December Correlaton Holdng Perod n Number of Months 2

13 3 he erm Structure of Market Correlatons )) ), ) 2 ) 2 ) ) )) ), 2 2 t R t R corr j j R R corr j j j j j = he Long-term and Short-term Correlatons

14 he Short-term and Long-term Effcences II In the short-term markets worldwde react n a smlar fashon Common rsk appettes Domnance of nose over nformaton Markets are hghly correlated In the long-term economc fundamentals emerge and swngs n emoton don t matter that much Each ndustry or market wll march to ts own drumbeats Markets correlatons largely reflect correlated economc fundamentals 4

15 Conclusons Investment horzon matters for market effcences It s mportant to combne quanttatve and fundamental research: dfferent sources of nformaton Understand the drvng forces of stock returns n countres and ndustres Go beyond the conventonal wsdom Look nward for assumptons and methodology Look outward for new deas and new ways of acqurng nformaton 5

16 Bblography Brnson, G. P, L. R. Hood, and G. Beebower 986, Determnants of Portfolo Performance, Fnancal Analysts Journal, vol. 42, no. 4 July/August), pp Brnson, G. P., B. D. Snger, and G. L. Beebower, 99, Determnants of Portfolo Performance II: An Update, Fnancal Analysts Journal, vol. 47, no. 3 May/June), pp Goetzmann, W. N., and R. G. Ibbotson, 994, Do Wnners Repeat? Journal of Portfolo, vol. 20, no. 2 Wnter), pp Ibbotson, R. G, and P.D. Kaplan 2000, Does Allocaton Polcy Explan 40, 90, or 00 Percent of Performance? Fnancal Analysts Journal, vol. 56, no. January/February), pp Krtzman, M, and S. Page, Allocaton vs. Securty Selecton: Evdence from Global Markets, 2003, Journal of, vol. 4, no. 3. Wang, C. H., 999, erm Structure of Internatonal Market Correlatons, Workng Paper, Yale School of 6

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