The following article by Mark Hulbert entitled 'So You Think You Can Outsmart the Market. Good Luck' appeared in The New York Times on July 24, 2005.

So You Think You Can Outsmart the Market. Good Luck

"Remember the debate about the accounting treatment of employee stock options? The fight was intense. One side said that companies should be required to count options as expenses, in order to give a truer picture of profits, while the other said that such a move would lead to some companies' financial ruin. Well, the rules did change: the shifts were announced in December and took effect in June.

The stock market, however, has had remarkably little reaction to the enactment of the new rules.

There is a lesson to be learned in this collective shrug, and it isn't a pleasant one for investors. Put simply, it is that the odds of outguessing the stock market are steep.

Until the rule changed, of course, companies were not required to record an expense when they granted stock options to their employees.

Supporters of the old accounting rule said it gave start-up companies a fighting chance to succeed, because they typically do not have enough cash to attract and keep highly qualified employees. Companies in the technology sector, in particular, lobbied strongly against changing the rule.

Proponents of the change argued that accounting for options as an expense was a matter of honesty. Allowing a company to hide the expense of those options enabled it to report artificially higher profits, they said, giving it an unfair advantage.

Last December, the Financial Accounting Standards Board voted unanimously to change the rule, and the Securities and Exchange Commission is requiring companies to expense options granted during fiscal years beginning after June 15. That means the new rule has already taken effect for companies whose fiscal years began on July 1; the remaining companies will fall under its provisions within the next 12 months.

So far, the change has had little perceptible impact on stock prices.

Investors do not appear to be behaving any differently toward companies where the rule has already taken effect. In fact, the technology sector has outperformed blue-chip stocks since the board's announcement in mid-December. The Dow Jones U.S. Technology index has risen 0.4 percent over that time, versus a loss of 0.2 percent for the Dow Jones industrial average.

There are many possible explanations for the muted reaction. One is that many investors were already taking option grants into account when interpreting companies' income statements, according to Clifford S. Asness, a managing principal at AQR Capital Management in Greenwich, Conn. Even before the rule change, companies were required to divulge details of their option grants in footnotes to their accounting statements. So what they are now being required to report on their bottom line could have been easily deduced by ''anyone willing to spend 10 minutes with a financial statement,'' Mr. Asness said.

To be sure, not all investors were willing to do that work. Some dug no further than the headlines on companies' news releases, and no doubt their naivete inflated the share prices of companies that relied heavily on options. After all, according to Owen A. Lamont, a professor of finance at the Yale School of Management, it was in the hope of influencing this ''dumb money'' that many companies fought the new accounting rule so vehemently.

We should not exaggerate the market impact of these naive investors, however. With thousands of hedge funds looking for overvalued stocks to sell short, there is plenty of ''smart money,'' in Professor Lamont's parlance, to take the opposite side of the dumb money's bets. Before the rule change last December, this smart money could have sold short the shares of companies that tended to grant the most options. To the extent that it did so, Professor Lamont said, these companies' shares would have been beaten down in advance of the accounting change. That, in turn, would have reduced the reaction the market would have had after that change was announced.

Yet another reason for the barely perceptible impact is provided by Jennifer N. Carpenter, an associate professor of finance at New York University's Stern School of Business. In the long run, the change could very well help the companies that grant the most options to their employees, Professor Carpenter said, because the ''discipline of having to expense options may lead firms to grant them more thoughtfully and efficiently.''

What should we make of all this? Mainly that stocks' movements are very hard to predict. Even if investors had known in advance that the accounting standards board was going to change the rule, and when it would take effect, it is still not clear that anyone could have made much money.

This conclusion dovetails with the results of past research into what makes the equity markets go up or down. One widely cited study was conducted in the late 1980's by three economists -- David M. Cutler and Lawrence H. Summers of Harvard (Mr. Summers is now Harvard's president) and James M. Poterba of the Massachusetts Institute of Technology. The professors found that news events accounted for a surprisingly small amount of the stock market's movements.

None of this relieves investors of the need to view companies' financial data skeptically. At the same time, it's important to remain skeptical about our own analysis whenever we interpret the data differently than the market as a whole. More often than not, we're wrong.

Although they have fallen recently, expenses associated with employee stock options have been a significant portion of earnings for companies in the Standard & Poor's 500-stock index.

REQUIRED:

a) Hulbert states: "Some [investors] dug no further than the headlines on companies' news releases, and no doubt their naivete inflated the share prices of companies that relied heavily on options." This suggests that 'nave' investors may have been paying too much for certain stocks. Yet according to efficient market theory, the nave investor is 'price protected.' Explain. (3 marks)

b) The article states that "So far, the change [in employee stock option accounting policy] has had little perceptible impact on stock prices. Use efficient market theory to explain why the announcement of this change in policy did not seem to affect stock prices. (2 marks)

c) Efficient market theory argues that publicly known information about the past cannot be used to earn abnormal profits. However, the article suggests that even knowledge of future events may not enable an investor to earn abnormal returns. Hulbert states: "Even if investors had known in advance that the accounting standards board was going to change the rule, and when it would take effect, it is still not clear that anyone could have made much money. Explain why even such 'prospective' information may not enable investors to generate abnormal profits. (2 marks)

d) In spite of the substantial evidence supporting efficient market theory, several studies have suggested that the markets may not be as efficient as the theory argues. In particular, researchers have identified several efficient market 'anomalies.' Explain what is meant by the term 'efficient market anomaly'. Identify one such anomaly and explain why such anomalies tend not to persist. (3 marks)