Chapter 8

The Efficient Market

Hypothesis

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

8-2

8.1 Random Walks and the Efficient Market

Hypothesis

8-3

Efficient Market Hypothesis (EMH)• Do security prices accurately reflect information?

– Informational Efficiency _____________________________________

– Allocational Efficiency

Gold and the _______________________.

Huge implications concerning the answers to these questions.

greater fool theory

Are price changes consistently predictable?

Are prices correct in that they ____________ ________________________ associated with the security?

accuratelyreflect the cash flows

8-4

Implications of Efficiency• Allocational efficiency

– If markets are not allocationally efficient then perhaps there is a ________________________ ___________ in capital markets.

– – –

•

role for greater government intervention

Possible rules changes to attempt to improve allocational efficiency

Tax on trading activity

More taxes on short holding period returns

Changes in corporate compensationDirect government involvement in capital allocation: Industrial Policy

8-5

Implications of Efficiency

• Informational efficiency– If markets are not informationally efficient

–

Investors may not be able to trust that market prices are up to date and investors should then conduct their own research (or hire a researcher) to validate the price.

Privileged groups of investors will be able to consistently take advantage of the general public.

Active strategies should outperform passive strategies.

8-6

Implications of Efficiency

• Informational efficiency– If markets are not informationally efficient

–

Maximize shareholder wealth maximize share price, so how does one go about maximizing shareholder wealth in this case?

Lack a benchmark to evaluate corporate decisions.

Corporations have to rethink their goals and how best to achieve them.

8-7

EMH and Competition

• •

Competition among investors should imply that stock prices fully and accurately reflect publicly available information very quickly. Why?

Else there are unexploited profit opportunities.

Once information becomes available, market participants quickly analyze it & trade on it & frequent, low cost trading assures prices reflect information.

Questions arise about efficiency due to:

• Unequal access to information

• Structural market problems

• Psychology of investors (Behavioralism)

8-8

• Why are price changes random?–

– –

Random Price Changes

In very competitive markets prices should react to only NEW information

Flow of NEW information is random

Therefore, price changes are random

Idea that stock prices follow a “Random Walk”

8-9

• Random Walk: stock price ______________________

• Stock prices actually follow a ____________________•

•

Random Walk and the EMHchanges are unpredictable

submartingale process

Expected price change is positive over time

But random changes are superimposed on the positive trend

E(pricej,t) > E(pricej,t-1) t = time period

A “pure” random walk implies informational efficiency

8-10

Security Prices

Time

Random Walk with Positive Trend

Evidence on Random Walk idea later.

8-11

Forms of the EMH

• Prices reflect all relevant information• Vary the ________________

– WeakThe relevant information is historical prices and other trading data such as trading volume. If the markets are weak form efficient, use of such information provides no benefit “at the margin.”

information set

8-12

Forms of the EMH• Prices reflect all relevant information• Vary the information set:

– Semi-strongThe relevant information is "all publicly available information, including past price and volume data."

If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin.

8-13

Forms of the EMH• Prices reflect all relevant information• Vary the information set:

– StrongThe relevant information is “all information” both public and private or “inside” information.

If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin.

SEC Rule 10b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported.

8-14

Relationships between forms of the EMH

• Notice that _______________________________ __________________ (but ________________)

• Strong form efficiency would imply that __________________________________________.

semi-strong efficiency implies weakform efficiency holds NOT vice versa

both semi-strong and weak form efficiency hold

8-15

8.2 Implications of the EMH (for Security

Analysis)

8-16

Types of Stock Analysis & Relationship to the EMH

• Technical Analysis:

– If the markets are weak form efficient or semi-strong form efficient or strong form efficient will technical analysis be able to consistently predict price changes? NO

Technical Analysis or TA is using prices and volume information to predict future price changes

TA assumes prices follow predictable trends

8-17

Basic Types of Technical Analysis

Identifying common price patterns

One of these patterns is real and one of these is computer simulated with random price changes. Can you tell which is which?

Point? • Less than meets the eye• Data mining

8-18

Basic Types of Technical AnalysisSupport and resistance levels• Support level:

– A price level below which it is supposedly unlikely for a stock or stock index to fall.

• Resistance level: – A price level above which it is supposedly

unlikely for a stock or stock index to rise.

A resistance level may arise at say $31.25 if a stock repeatedly rises to $31.25 and then declines, indicating that investors are reluctant to pay more than this price for the stock.

A stock price above $31.25 would then indicate a 'breakout' which would be a bullish signal.

8-19

Types of Stock Analysis & Relationship to the EMH

• Fundamental Analysis:

– If the markets are weak form efficient or semi-strong form efficient or strong form efficient will fundamental analysis be able to consistently predict price changes?

using economic and accounting information to predict stock price changes

If the markets are only weak form efficient?

Fundamental Analysis CAN predict price changes

If the markets are semi-strong or strong form efficient?

Fundamental Analysis CANNOT predict price changes

8-20

Fundamental Analysis

• Fundamental analysis assumes that stock prices should be equal to

• Fundamental analysis is thus the

the discounted value of the expected future cash flows the stock is expected to provide to investors.

“art” of identifying over- and undervalued securities based on an analysis of the firm's financial statements and future prospects.

8-21

Fundamental Analysis

• Fundamental analysis varies in technique but generally focuses on

forecasting the firm's future dividends or earnings,

discounting those future cash flows by the required rate of return (usually obtained from the CAPM),

and comparing the resulting estimated price with the current stock price.

8-22

Fundamental Analysis• If the estimated price is ______ than the current

price an investor should ___ the stock since it is ___________ and since its price should ________ to the "true" or "fundamental" value uncovered by the analyst.

• If the estimated price is ____ than the current price the stock should be ____ because the stock is currently __________ by the market.

• In either case if the analyst is correct the investor should receive an ________________.

undervalued increasebuy

greater

lesssold

overvalued

“abnormal return”

8-23

Fundamental Analysis

• Forecasts already exist and for FA to add value, your forecast must be better than the consensus forecast.

• Not enough to find a good company, you must find a company that is better than others believe, i.e., mispriced.

8-24

• Active Management– – –

• Passive Management– –

Implications of Efficiency for Active or Passive Management

Assumes inefficiency, use technical and/or fundamental analysis to pick securitiesSecurity analysis

Timing strategies

Investment Newsletters

Buy and Hold portfolios

Index Funds

Consistent with semi-strong efficiency

8-25

Even if the market is efficient a role exists for portfolio management– – –

Market Efficiency and Portfolio Management

Identify risk & choose appropriate risk level

Tax considerations

Other considerations such as liquidity needs or diversify away from the client’s industry.

8-26

Selected Problems

8-27

Problem 1

• Zero, otherwise returns from the prior period could be used to predict returns in the subsequent period.

8-28

Problem 2

• No. Why?• One would have to show that Intel

investors earned a higher rate of return than they should have for the risk taken. – Many investors bought Intel only after its

success was evident.– By chance some stocks will perform extremely

well.