Chapter

7 Stock Price Behavior

and Market Efficiency

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 “A market is the combined behavior of
thousands of people responding to
information, misinformation, and whim.”
— Kenneth Chang

“If you want to know what's happening in the

market, ask the market.”
— Japanese Proverb

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 Learning Objectives

You should strive to have your investment

knowledge fully reflect:

1. The foundations of market efficiency.

2. The implications of the forms of market efficiency.

3. Market efficiency and the performance of professional

money managers.

4. What stock market anomalies, bubbles, and crashes

mean for market efficiency.

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 Controversy, Intrigue, and Confusion

• We begin by asking a basic question: Can you, as an investor,

consistently “beat the market?”

• It may surprise you to learn that evidence strongly suggests that the
answer to this question is “probably not.”

• We show that even professional money managers have trouble

beating the market.

• At the end of the chapter, we describe some market phenomena

that sound more like carnival side shows, such as “the amazing
January effect.”

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 Market Efficiency

• The Efficient market hypothesis (EMH) is a theory

that asserts: As a practical matter, the major financial
markets reflect all relevant information at a given
time.

• Market efficiency research examines the relationship

between stock prices and available information.
– The important research question: is it possible for investors to
“beat the market?”
– Prediction of the EMH theory: if a market is efficient, it is not
possible to “beat the market” (except by luck).

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 What Does “Beat the Market” Mean?

• The excess return on an investment is the

return in excess of that earned by other
investments that have the same risk.

• “Beating the market” means consistently

earning a positive excess return.

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 Three Economic Forces that Can
Lead to Market Efficiency

• Investors use their information in a rational manner.

– Rational investors do not systematically overvalue or undervalue financial assets.
– If every investor always makes perfectly rational investment decisions, it would
be very difficult to earn an excess return.

• There are independent deviations from rationality.

– Suppose that many investors are irrational.
– The net effect might be that these investors cancel each other out.
– So, irrationality is just noise that is diversified away.
– What is important here is that irrational investors have different beliefs.

• Arbitrageurs exist.
– Suppose collective irrationality does not balance out.
– Suppose there are some well-capitalized, intelligent, and rational investors.
– If rational traders dominate irrational traders, the market will still be efficient.

These conditions are so powerful that any one of them leads to efficiency.

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 Forms of Market Efficiency,
(i.e., what information is used?)

• A Weak-form Efficient Market is one in which past prices and

volume figures are of no use in beating the market.
– If so, then technical analysis is of little use.

• A Semistrong-form Efficient Market is one in which publicly

available information is of no use in beating the market.
– If so, then fundamental analysis is of little use.

• A Strong-form Efficient Market is one in which information of any

kind, public or private, is of no use in beating the market.
– If so, then “inside information” is of little use.

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Information Sets for Market Efficiency

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 Why Would a Market be Efficient?

• The driving force toward market efficiency is simply

competition and the profit motive.

• Even a relatively small performance enhancement can

be worth a tremendous amount of money (when
multiplied by the dollar amount involved).

• This creates incentives to unearth relevant information

and use it.

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 Some Implications of Market Efficiency, I.
Does Old Information Help Predict Future Stock Prices?

• This is a surprisingly difficult question to answer clearly.

• Researchers have used sophisticated techniques to test

whether past stock price movements help predict future
stock price movements.

– Some researchers have been able to show that future returns are partly
predictable by past returns. BUT: there is not enough predictability to
earn an excess return.
– Also, trading costs swamp attempts to build a profitable trading system
built on past returns.
– Result: buy-and-hold strategies involving broad market indexes are
extremely difficult to outperform.

Technical Analysis implication: No matter how often a particular stock

price path has related to subsequent stock price changes in the past,
there is no assurance that this relationship will occur again in the future.
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 Some Implications of Market Efficiency, II.
Random Walks and Stock Prices

• If you were to ask people you know whether stock market prices are
predictable, many of them would say yes.

• To their surprise, and perhaps yours, it is very difficult to predict

stock market prices.

• In fact, considerable research has shown that stock prices change

through time as if they are random.

• That is, stock price increases are about as likely as stock price
decreases.

• When there is no discernable pattern to the path that a stock price

follows, then the stock’s price behavior is largely consistent with the
notion of a random walk.

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Random Walks and Stock Prices, Illustrated.

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 How New Information Gets into Stock Prices, I.

• In its semi-strong form, the EMH states simply that stock prices fully
reflect publicly available information.

• Stock prices change when traders buy and sell shares based on
their view of the future prospects for the stock.

• But, the future prospects for the stock are influenced by unexpected
news announcements.

• Prices could adjust to unexpected news in three basic ways:

– Efficient Market Reaction: The price instantaneously adjusts to the new
information.
– Delayed Reaction: The price partially adjusts to the new information.
– Overreaction and Correction: The price over-adjusts to the new
information, but eventually falls to the appropriate price.

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How New Information Gets into Stock Prices, II.

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 Event Studies, I.

• Researchers have examined the effects of many types of

news announcements on stock prices.

• Such researchers are interested in:

– The adjustment process itself
– The size of the stock price reaction to a news announcement.

• To test for the effects of new information on stock prices,

researchers use an approach called an event study.

• Let us look at how researchers use this method.

• We will use a dramatic example.

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 Event Studies, II.

• On Friday, May 25, 2007, executives of Advanced Medical Optics, Inc. (EYE), recalled
a contact lens solution called Complete MoisturePlus Multi Purpose Solution.

• Advanced Medical Optics took this voluntary action after the Centers for Disease
Control and Prevention (CDC) found a link between the solution and a rare cornea
infection.

• The medical name for this cornea infection is acanthamoeba keratitis.

• The event study name for this cornea infection is AK.

• EYE Executives chose to recall their product even though no evidence was found that
their manufacturing process introduced the parasite that can lead to AK.

• Further, company officials believed that the occurrences of AK were most likely the
result of end users who failed to follow safe procedures when installing contact lenses.

• On Tuesday, May 29, 2007, EYE shares opened at $34.37, down $5.83 from the
Friday closing price.

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Event Studies, III.

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 Event Studies, IV.

• When researchers look for effects of news on stock prices, they must make
sure that overall market news is accounted for in their analysis.

• To separate the overall market from the isolated news concerning Advanced
Medical Optics, Inc., researchers would calculate abnormal returns:

Abnormal return = Observed return – Expected return

• The expected return is calculated using a market index (like the Nasdaq 100
or the S&P 500 Index) or by using a long-term average return on the stock.

• Researchers then align the abnormal return on a stock to the days relative to
the news announcement.
– Researchers usually assign the value of zero to the news announcement day.
– One day after the news announcement is assigned a value of +1.
– Two days after the news announcement is assigned a value of +2, and so on.
– Similarly, one day before the news announcement is assigned the value of -1.

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 Event Studies, V.

• According to the EMH, the abnormal return today should only relate
to information released on that day.

• To evaluate abnormal returns, researchers usually accumulate them

over a 60 or 80-day period.

• Figure 7.5 contains a plot of cumulative abnormal returns for

Advanced Medical Optics, Inc. beginning 40 days before the
announcement.
– The first cumulative abnormal return, or CAR, is just equal to the
abnormal return on day -40.
– The CAR on day -39 is the sum of the first two abnormal returns.
– The CAR on day -38 is the sum of the first three, and so on.
– By examining CARs, researchers can see if there was over- or under-
reaction to an announcement.

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Event Studies, VI.

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 Event Studies, VII.

• As you can see in Figure 7.5, Advanced Medical Optics, Inc.’s

cumulative abnormal return hovered around zero before the
announcement.

• After the news was released, there was a large, sharp downward
movement in the CAR.

• The overall pattern of cumulative abnormal returns is essentially

what the EMH would predict.

• That is:
– There is a band of cumulative abnormal returns
– A sharp break in cumulative abnormal returns, and
– Another band of cumulative abnormal returns.

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 Informed Traders and Insider Trading, I.

• If a market is strong-form efficient, no information of any

kind, public or private, is useful in beating the market.

• But, it is clear that significant inside information would

enable you to earn substantial excess returns.

• This fact generates an interesting question: Should any

of us be able to earn returns based on information
that is not known to the public?

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 Informed Traders and Insider Trading, II.

• In the U.S. (and in many other countries) it is illegal to

make profits on non-public information.
– It is argued that this ban is necessary if investors are to have
trust in U.S. stock markets.
– The United States Securities and Exchange Commission (SEC)
enforces laws concerning illegal trading activities.

• It is important to be able to distinguish between:

– Informed trading
– Legal insider trading
– Illegal insider trading

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 Informed Trading

• When an investor makes a decision to buy or sell a

stock based on publicly available information and
analysis, this investor is said to be an informed trader.

• The information that an informed trader possesses

might come from:
– Reading the Wall Street Journal
– Reading quarterly reports issued by a company
– Gathering financial information from the Internet
– Talking to other investors

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 Legal Insider Trading

• Some informed traders are also insider traders.

• When you hear the term insider trading, you most likely
think that such activity is illegal.

• But, not all insider trading is illegal.

– Company insiders can make perfectly legal trades in the stock of their company.
– They must comply with the reporting rules made by the SEC.
– When company insiders make a trade and report it to the SEC, these trades are
reported to the public by the SEC.
– In addition, corporate insiders must declare that trades that they made were
based on public information about the company, rather than “inside” information.

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 Who is an “Insider”?

• For the purposes of defining illegal insider trading, an insider is

someone who has material non-public information.

• Such information is both not known to the public and, if it were

known, would impact the stock price.

• A person can be charged with insider trading when he or she acts on

such information in an attempt to make a profit.

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 Illegal Insider Trading

• When an illegal insider trade occurs, there is a tipper and a tippee.

– The tipper is the person who has purposely divulged material non-public information.
– The tippee is the person who has knowingly used such information in an attempt to profit.

• It is difficult for the SEC to prove that a trader is truly a tippee.

• It is difficult to keep track of insider information flows and subsequent trades.

– Suppose a person makes a trade based on the advice of a stockbroker.
– Even if the broker based this advice on material non-public information, the trader might not
have been aware of the broker’s knowledge.
– The SEC must prove that the trader was, in fact, aware that the broker’s information was
based on material non-public information.

• Sometimes, people accused of insider trading claim that they just

“overheard” someone talking.

• Be aware: When you take possession of material non-public information, you

become an insider, and are bound to obey insider trading laws.

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It’s Not a Good Thing: What did Martha do? (Part 1)

• The SEC believed that Ms. Stewart was told by her friend, Sam Waksal, who
founded a company called ImClone, that a cancer drug being developed by
ImClone had been rejected by the Food and Drug Administration.

• This development would be bad news for ImClone shares.

• Martha Stewart sold her 3,928 shares in ImClone on December 27, 2001.
– On that day, ImClone traded below $60 per share, a level that Ms. Stewart
claimed triggered an existing stop-loss order.
– However, the SEC believed that Ms. Stewart illegally sold her shares because
she had information concerning FDA rejection before it became public.

• The FDA rejection was announced after the market closed on Friday,
December 28, 2001.

• This news was a huge blow to ImClone shares, which closed at about $46
per share on the following Monday (the first trading day after the information
became public).

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It’s Not a Good Thing: What did Martha do? (Part 2)

• In June 2003, Ms. Stewart and her stock broker, Peter Bacanovic, were
indicted on nine federal counts. They both plead not guilty.

• Ms. Stewart’s trial began in January 2004.

• Just days before the jury began to deliberate, however, Judge Miriam
Cedarbaum dismissed the most serious charge of securities fraud.

• Ms. Stewart, however, was convicted on all four counts of obstructing justice.
– Judge Cedarbaum fined Ms. Stewart $30,000 and sentenced her to five months in
prison, two years of probation, and five months of home confinement.
– The fine was the maximum allowed under federal rules while the sentence was
the minimum the judge could impose.
– Peter Bacanovic, Ms. Stewart's broker, was fined $4,000 and was sentenced to
five months in prison and two years of probation.

So, to summarize:
Martha Stewart was accused, but not convicted, of insider trading.
Martha Stewart was accused, and convicted, of obstructing justice.

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 Are Financial Markets Efficient, I?

• Financial markets are the most extensively documented of all human

endeavors.

• Colossal amounts of financial market data are collected and reported

every day.

• These data, particularly stock market data, have been exhaustively

analyzed to test market efficiency.

• But, market efficiency is difficult to test for these four basic reasons:
– The risk-adjustment problem
– The relevant information problem
– The dumb luck problem
– The data snooping problem

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 Are Financial Markets Efficient, II?

• Nevertheless, three generalities about market efficiency

can be made:

– Short-term stock price and market movements appear to be

difficult to predict with any accuracy.

– The market reacts quickly and sharply to new information, and

various studies find little or no evidence that such reactions can
be profitably exploited.

– If the stock market can be beaten, the way to do so is not

obvious.

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 Some Implications if Markets are Efficient

• Security selection becomes less important,

because securities will be fairly priced.

• There will be a small role for professional money

managers.

• It makes little sense to time the market.

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 Market Efficiency and the Performance
of Professional Money Managers, I.

• Let’s have a stock market investment contest in which you are going
to take on professional money managers.

• The professional money managers have at their disposal their skill,

banks of computers, and scores of analysts to help pick their stocks.

• Does this sound like an unfair match?

• You have a terrific advantage if you follow this investment strategy:

Hold a broad-based market index.
– One such index that you can easily buy is a mutual fund called the
Vanguard 500 Index Fund (there are other market index mutual funds)
– The fund tracks the performance of the S&P 500 Index by investing its
assets in the stocks that make up the S&P 500 Index.

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Market Efficiency and the Performance
of Professional Money Managers, II.

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 Market Efficiency and the Performance
of Professional Money Managers, III.

• The previous slide shows the number of these funds that beat the
performance of the Vanguard 500 Index Fund.

• You can see that there is much more variation in the dashed blue
line than in the dashed red line.

• What this means is that in any given year, it is hard to predict how
many professional money managers will beat the Vanguard 500
Index Fund.

• But, the low level and variation of the dashed red line means that the
percentage of professional money managers who can beat the
Vanguard 500 Index Fund over a 10-year investment period is low
and stable.

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Market Efficiency and the Performance
of Professional Money Managers, IV.

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Market Efficiency and the Performance
of Professional Money Managers, V.

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 Market Efficiency and the Performance
of Professional Money Managers, VI.

• Two previous slides show the percentage of managed equity funds

that beat the Vanguard 500 Index Fund.

– In only six of the 21 years (1986—2006) did more than half beat the
Vanguard 500 Index Fund.

– The performance is worse when it comes to a 10-year investment

periods (1977-1986 through 1997-2006).

– In only two of these 21 investment periods, did more than half the
professional money managers beat the Vanguard 500 Index Fund.

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Market Efficiency and the Performance
of Professional Money Managers, VII.

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 Market Efficiency and the Performance
of Professional Money Managers, VIII.

• The previous slide presents more evidence concerning the

performance of professional money managers.

• Using data from 1977 through 2006, we divide this time period into:
– 1-year investment periods
– Rolling 3-year investment periods
– Rolling 5-year investment periods
– Rolling 10-year investment periods

• Then, after we calculate the number of investment periods, we ask

two questions:
– what percent of the time did half the professionally managed funds beat
the Vanguard 500 Index Fund?
– what percent of the time did three-fourths of them beat the Vanguard 500
Index Fund?

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 Market Efficiency and the Performance
of Professional Money Managers, IX.

• The previous slides raise some potentially difficult and uncomfortable

questions for security analysts and other investment professionals.

• If markets are inefficient, and tools like fundamental analysis are valuable,
why can’t mutual fund managers beat a broad market index?

• The performance of professional money managers is especially

troublesome when we consider the enormous resources at their disposal and
the substantial survivorship bias that exists.

– Managers and funds that do especially poorly disappear.

– If it were possible to beat the market, then the process of elimination should lead
to a situation in which the survivors can beat the market.
– The fact that professional money managers seem to lack the ability to outperform
a broad market index is consistent with the notion that the equity market is
efficient.

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 What is the Role for Portfolio
Managers in an Efficient Market?

• The role of a portfolio manager in an efficient market is to build a portfolio to

the specific needs of individual investors.

• A basic principle of investing is to hold a well-diversified portfolio.

• However, exactly which diversified portfolio is optimal varies by investor.

• Some factors that influence portfolio choice include the investor’s age, tax
bracket, risk aversion, and even employer. Employer?
– Suppose you work for Starbucks and part of your compensation is stock options.
– Like many companies, Starbucks offers its employees the opportunity to purchase
company stock at less than market value.
– You can imagine that you could wind up with a lot of Starbucks stock in your
portfolio, which means you are not holding a diversified portfolio.
– The role of your portfolio manager would be to help you add other assets to your
portfolio so that it is once again diversified.

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 Anomalies

• We will now present some aspects of stock price behavior that are
both baffling and potentially hard to reconcile with market efficiency.

• Researchers call these market anomalies.

• Three facts to keep in mind about market anomalies.

– First, anomalies generally do not involve many dollars relative to the
overall size of the stock market.
– Second, many anomalies are fleeting and tend to disappear when
discovered.
– Finally, anomalies are not easily used as the basis for a trading strategy,
because transaction costs render many of them unprofitable.

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 The Day-of-the-Week Effect:
Mondays tend to have a Negative Average Return

• The day-of-the-week effect refers to the tendency for

Monday to have a negative average return—which is
economically significant.

• Interestingly, the effect is much stronger in the 1950-1979

time period than in the 1980-2006 time period.
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 The Amazing January Effect, I.

• The January effect refers to the tendency for small-cap stocks to

have large returns in January.
• Does the January effect exist for the S&P 500?

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 The Amazing January Effect, II.

• But, what do we see when we look at returns on small-cap stocks?

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 The Turn-of-the-Year Effect, I.

• Researchers have deeply explored the January effect to see

whether:
– the effect is due to returns during the whole month of January, or
– due to returns bracketing the end of the year.

• Researchers look at returns over a specific three-week period and

compare these returns to the returns for the rest of the year.

• As shown on the next slide, we have calculated daily market returns

from 1962 through 2006.
– “Turn of the Year Days:” the last week of daily returns in a calendar year
and the first two weeks of daily returns in the next calendar year.
– “Rest of the Days:” Any daily return that does not fall into this three-week
period.

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 The Turn-of-the-Year Effect, II.

• As you can see, the “Turn of the Year” returns are higher than the
“Rest of the Days” returns.

• The difference is biggest in the 1962-1983 period.

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 The Turn-of-the-Month Effect, I.

• Researchers have also investigated whether a “Turn-of-the-Month”

effect exists.

• On the next slide, we have separated daily stock market returns into
two categories.
– “Turn of the Month Days:” Daily returns from the last day of any month or
the following three days of the following month
– “Rest of the Days:” Any other daily returns

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 The Turn-of-the-Month Effect, II.

• “Turn of the Month” returns exceed “Rest of the Days” returns.

• The turn-of-the-month effect is apparent in all three time periods.
• Interestingly, the effect appears to be stronger in the 1984-2004
period than in the 1962-1983 period.
• The fact that this effect exists puzzles EMH proponents.

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 Bubbles and Crashes

• Bubble: occurs when market prices soar far in excess of

what normal and rational analysis would suggest.
– Investment bubbles eventually pop.
– When a bubble does pop, investors find themselves holding
assets with plummeting values.
– A bubble can form over weeks, months, or even years.

• Crash: significant and sudden drop in market values.

– Crashes are generally associated with a bubble.
– Crashes are sudden, generally lasting less than a week.
– However, the financial aftermath of a crash can last for years.

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The Crash of 1929

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The Crash of 1929—The Aftermath

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 The Crash of 1987

• Once, when we spoke of the Crash, we meant October 29, 1929.

That was until October 1987.

• The Crash of 1987 began on Friday, October 16th.

– The DJIA fell 108 points to close at 2,246.73.
– First time in history that the DJIA fell by more than 100 points in one day.

• On October 19, 1987, the DJIA lost about 22.6% of its value on a
new record volume (about 600 million shares)

• The DJIA plummeted 508.32 points to close at 1,738.74.

– During the day on Tuesday, October 20th, the DJIA continued to plunge
in value, reaching an intraday low of 1,616.21.
– But, the market rallied and closed at 1,841.01, up 102 points.

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The Crash of 1987—Aftermath

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 Circuit Breakers

• As a result of the Crash of 1987, there have been some

significant market changes.

• One of the most interesting changes was the introduction

of the NYSE circuit breakers.

• Different circuit breakers are triggered if the DJIA drops

by 10, 20, or 30 percent.
– A 10 percent drop will halt trading for at most one hour
– A 20 percent drop will halt trading for at most two hours
– A 30 percent drop will halt trading for the remainder of the day

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 The Asian Crash

• The crash of the Nikkei Index, which began in 1990, lengthened into
a particularly long bear market.

• It is quite like the Crash of 1929 in that respect.

• The Asian Crash started with a booming bull market in the 1980s.

• Japan and emerging Asian economies seemed to be forming a

powerful economic force. The “Asian economy” became an investor
outlet for those wary of the U.S. market after the Crash of 1987.

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The Asian Crash—Aftermath

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 The “Dot-Com” Bubble and Crash, I

• By the mid-1990s, the rise in Internet usage and its global growth
potential fueled widespread excitement over the “new economy.”

• Investors seemed to care only about big ideas.

• Investor euphoria led to a surge in Internet IPOs, which were

commonly referred to as “DotComs” because so many of their
names ended in “.com.”

• The lack of solid business models doomed many DotComs.

• Many of them suffered huge losses.

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The “Dot-Com” Bubble and Crash, II

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 Chapter Review, I.

• Foundations and Forms of Market Efficiency

• Some Implications of Market Efficiency

– Does Old Information Help Predict Future Stock Prices?
– Random Walks and Stock Prices
– How does New Information get into Stock Prices?
– Event Studies

• Informed Traders and Inside Trading

• How Efficient are Markets?

– Are Financial Markets Efficient?
– Some Implications of Market Efficiency

• The Performance of Professional Money Managers

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 Chapter Review, II.

• Anomalies
– The Day-of-the-Week Effect
– The Amazing January Effect
– Turn-of-the-Year Effect
– Turn-of-the-Month Effect

• Bubbles and Crashes

– The Crash of 1929
– The Crash of October 1987
– The Asian Crash
– The “Dot-Com” Bubble and Crash

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