efficient market hypothesis slides

11-1

THE EFFICIENT MARKET

HYPOTHESIS

CHAPTER 11

11-2

Outline of the Chapter

• What is the Efficient Market Hypothesis?

• Versions of the EMH

• Methods employed to identify underpriced

securities

• Event studies

• Empirical Tests of EMH

– Weak-form

– Semistrong-form

• Mutual fund and analyst performance

11-3

Random Walks and the Efficient Market

Hypothesis

• Efficient Market

Hypothesis (EMH):

stock prices already

reflect all the

available information

– Stock prices should

follow a random walk

– Price changes

should be random

and unpredictable

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Hypothesis (Continued)

• Stock prices fully and accurately reflect publicly available information.

• Once information becomes available, market participants analyze it.

• Competition assures prices reflect information.

• Degree of efficiency differs across various markets.

– Emerging markets, and small stocks are less intensively analysed so the stocks in emerging markets and the small stocks may be less efficiently priced.

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• There are three forms of efficiency which

differ by their notions of what is meant by the

term “ all available information”.

– Weak-form efficiency indicates that stock

prices already reflect all information that can

be derived by examining market trading data

such as the history of past prices and trading

volume.

• In a weak-form efficient markets if historical

data such as past prices conveys an

information related to the future it has to be

known by the all investors and caused an

immediate change in the stock prices.



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– Semistrong-form efficiency indicates that all publicly available information regarding the prospects of a firm must be already reflected in the stock price.

• Information includes past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices.

– Strong-form efficiency states that stock prices reflect all information relevant to the firm, even including information available only to company insiders.

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• If an investor earns abnormal returns by using historical data then the market is _______

• If an investor earns abnormal returns by using publicly available information then the market is_________.

• If an investor earns abnormal returns by using private information (inside information) then the market is ____________.

11-8

Implications of the EMH

• Technical Analysis:

– Search for repeating and predictable patterns in

stock prices.

– Technical analysts study records or charts of past

stock prices to find patterns they can exploit to

make profit.

– Key assumption is that stock prices respond

slowly to the changes in the supply and demand

factors.

• Prices of stocks do not change that quickly

– Using stock prices and volume information to

predict future prices

– Technical analysis should not work even in a

_________

11-9

Implications of the EMH (Continued)

• Technical Analysis (Continued)

– Trends and Corrections

• Trying to find the trends in stock prices.

• Searching for the momentum, tendency for rising

asset prices to raise further.

• Methods employed:

– Dow Theory, Moving Averages, Breadth

– Sentiment Indicators


– Trin Statistic, Confidence Index, Put/Call Ratio

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• Dow Theory

– Three factors affect the stock prices according to this

theory.

• Primary trend: long-term movement of prices

• Secondary (intermediate) trends: short-term deviations of

prices from the underlying trend

• Tertiary (minor) trends: daily fluctuations

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Implications of the EMH (Continued)• Dow Theory (Continued)

– Efficient Market Hypothesis says that if there is a pattern

investors would try to use this and make profit

• Moving Averages

– Average level of the index (stock price) over a given interval

of time (e.g. 52 weeks)

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• Moving Averages (Continued)

– When moving average line cuts the stock prices line from

below it is time to _________.

– When moving average line cuts the stock prices line from

above it is time to ___________.

• Breadth

– A measure of the extens to which movement in a market

index is reflected in the price movements of all the stocks in

the market.

– Spread=number of stocks those prices increased-number

of stocks those prices decreased

• If advances are larger than declines then the market is

stronger

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• Trin Statistic

– The more investors participate in market advance or retreat

(transactions) the more the significance of the movement.

– The increase in the market index is a better signal for

continuing price increases if complimanted by increase in

a trading volume.

– The decrease in the market index is considered more

bearish when associated with higher volume.

– Trin statistic=[volume declining/number declining]/[volume

advancing/number advancing]

– If trin statistis>1 then the market is considered ________

• Shows _______ pressure

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• Confidence Index

– Assumption: actions of the bond traders will be followed by

the stock market traders.

– The average yield on 10 top-rated corporate bonds/the

average yield on 10 intermediate-grade corporate bonds

– When bond traders are optimistic they require smaller

default premiums on the lower graded bonds thus the yield

spread narrows. The confidence index approaches to

________.

– Higher values of confidence index is a sign for _______.

11-15


• Put/Call Ratio

– Outstanding put options/outstanding call options

– Call option: give investor the right to buy a stock at a fixed

price.

• Exercised when prices increase

– Put option: give investor right to sell a stock at a fixed

price.

• Exercised when prices decrease

– If the put/call ratio increases above a historical

average then it is accepted as a signal for ________.

11-16


• Fundamental Analysis

– Uses earnings and dividend prospects of the

firm, expectations of future interest rates, and risk

evaluation of the firm to determine proper stock

prices.

– The fundamental analyst tries to determine the

present discounted value of all the payments a

stockholder will receive from each share of stock.

– Then the analyst compare the fair price he

computed with the market price and if the market

price is lower then he recommend to _____ the

shares since they are __________.

11-17


– However if the market is semistrong-form efficient

then the stock prices should already reflect all the

information employed by the analyst to value the

stock.

– Thus the analyst has to find the firms that are

better than everyone else’s estimate in order

fundamental analysis to work.

– The analysts can make money only if his analysis

is better than that of his competitors since the

market price already reflect all commonly available

information.

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• The Efficient Market Hypothesis implies passive

investment strategy.

– Passive investment strategy makes no attempt to

outsmart the market.

– It aims to find a well-diversified portfolio and buy-

and-hold this portfolio.

– The stock prices are at fair levels with given

information, they reflect all the information

available.

– So, there is no need to try to find over-

underpriced stocks, no need to buy and sell

securities frequently and generate large

brokerage fees.

11-19


• Even if the market is efficient a role exists for

portfolio management:

– Role of diversification: Portfolio managers can

select securities that diversifies the unsystematic

risk of the portfolio and provide the systematic risk

level that the investor asks for.

– Tax considerations: High-tax bracket investors

generally will not want the same securities that

low-bracket investors find favorable.

– Other considerations:

• Different risk profiles of investors.

11-20

Event Studies

• What is an event study?

– It is a technique of empirical financial research that

enables an observer to assess the impact of a

particular event on a firm’s stock price.

• Relation with the EMH

– If security prices reflect all currently available

information, then price changes must reflect new

information.

– We can measure the importance of an event of interest

by examining price changes during the period in which

the event occurs.

– The event can be dividend change, mergers,

acquisitions, change in regulations...

11-21

Event Studies (Continued)

• How event study methodology works?

– The abnormal return due to event is estimated.

– The abnormal return is the difference between the

stock’s actual return and the benchmark.

– The benchmark rate is what the stock’s return would

have been in the absence of the event.

• Benchmark rate can be broad market index as in single-

index model, or rate of return computed according to

CAPM or any other multifactor model such as Fama-

French three factor model.

11-22


– rt=a+brMt+et

• rMt: the market’s rate of return

• et: part of a security’s return resulting from firm-specific

events

• b: measures sensitivity to the market return

• a: the average rate of return the stock would realize in a

period with a zero market return.

– The abnormal return (firm-specific) is the unexpected

return that results from the event.

• We need to estimate et to determine abnormal return.

– et=rt-(a+brMt)

• et: measures the stock’s return over and above what one

would predict based on broad market movements in that

period, given the stock’s sensitivity to the market due to

the event.

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– Example:

• An analysts estimated that a=0.05%, and

b=0.8.

• If the market increases by 1% then what

will be the expected return of the stock?

• If the stock actually increases for 2% what

will be the abnormal return of the stock due

to the firm-specific news?

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• Problems related to the event studies:

– It is really difficult to isolate the effects of single event

on the stock prices.

• The stock prices are usually affected from macro and

microeconomic changes on a day.

– Leakage of information: Information regarding a

relevant event is released to a small group of

investors before official public release.

• In this case the stock prices may start to react the

event before the official announcement date.

• So, the abnormal return on the official announcement

date may not be a good indicator to analyse the effects

of the event on the stock prices.

11-25


• In order to overcome leakage problem cumulative

abnormal returns are employed as proxies to examine

the effects of events on the stock prices.

• Cumulative abnormal return is the sum of all abnormal

returns over the time period of interest.

• Cumulative abnormal returns captures the total firm-

specific stock movement for an entire period when the

market is repsonding to the news.

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• Figure 11.1 shows an example

for an effect of good event on the

stock returns.• The huge jump of the CAR on

the event date (day 0).

• After the announcement date

CAR no longer increases or

decreases.

• The CAR starts to increase 30

days in advance of the

announcement date.

• Leakage

• Buying large blocks of stock

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• Magnitude Issue

– Stock prices might be very close to fair values

so only managers of large portfolios can earn

enough trading profits to worth the effort.

• Selection Bias Issue

– The outcomes we are able to observe have

been preselected in favor of failed attempts.

– If an investor finds a way to beat the market,

make money then usually (s)he will not

publish it.

Are Markets Efficient?

11-28

Are Markets Efficient?(Continued)

• Lucy Event Issue

– From time to time there might be some

successful portfolio managers.

– The important point is whether the successful

portfolio manager can repeat his/her

performance in another period.

11-29

Are Markets Efficient? (Continued)

• Empirical tests for three different forms of the

EMH:

– Weak-Form Tests

• Could speculators find trends in past prices that

would enable them to earn abnormal profits?

• Do technical analysis really work?


– Measuring the serial correlation of stock market

returns.

» Serial correlation: tendency for stock returns to

be related to past returns.

» Positive serial correlation: positive returns tend

to follow positive returns (momentum type

property)

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» Negative serial correlation: positive returns tend to be followed by negative returns or vice versa.

• Empirical findings

– Positive serial correlation (momentum) in stock market prices is detected in short-to-intermediate horizon.

– Negative serial correlation in market prices is detected in long-horizon (multiyear periods).

– Stock markets may overreact to some news and present positive serial correlation among prices in the short horizon. However the stock markets correct this overreaction in the long time horizon so presents negative serial correlation.

– Stock market prices fluctuate around their fair values.

11-31


–Variables to predict market returns:

»The dividend/price ratio (Fama and

French, 1988)

»The earnings yield (Campell and Shiller,

1988)

»The spread between yields on high-and

low-grade corporate bonds (Keim and

Stambaugh, 1986)

–Does this show market inefficiency?

11-32


– Semistrong-form Tests

• In general, these are the tests employed to

examine whether the fundamental analysis

help to improve investment performance.

• Efficient market anomalies

• Problems:

–Joint tests of efficient market hypothesis

and the risk adjustment procedure.

11-33


• Examples of anomalies:

– Price/earnings effect

» Basu (1977, 1983) shows that low price to

earnings ratio portfolios have provided higher

returns than high P/E portfolios.

» The returns are adjusted for the portfolio beta

– Small-firm effect (size effect)

» Banz (1981) presents that small –firm portfolios

have higher returns even when returns are

adjusted for risk using CAPM.

» Keim (1983), Reinganum (1983), Blume and

Stambaugh (1983) find that small-firm effect

holds in January (first 2 weeks of January).

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» Neglected-firm effect : Arbel and Strebel (1983)

show that because small-firms are neglected by

big institutional traders information about them

are less available. This information deficiency

makes these small firms riskier thus they should

ask for more return.

» Liquidity effect: Amihud and Mendelson (1986,

1991) present that small and neglected firms

are less liquid and have higher trading costs, so

these firms’ stocks have tendency to exhibit

high risk-adjusted rates of return, which in

reality is higher risk premium for being illiquid.

11-35


– Book-to-market ratio

» Fama and French (1992) also find an anomaly

and show that higher book-to market portfolios

(portfolios composed of high book value of

equity to market value of equity ratio) have

higher average monthly rate of returns.

– Post-earnings-announcement price drift

» Ball and Brown (1986) show that contrary to

EMH, stock prices do not react to the

announcements as quick as they should.

» Rendlemen, Jones and Latane (1982) find that

if the firms announce good (bad) news then

there is a positive (negative) abnormal return in

the announcement day.

11-36


» However, the cumulative abnormal returns of

positive surprise rise even after the

announcement date (momentum) and the

negative-surprise firms continue to suffer

negative abnormal returns.

– Strong-form Tests

• We do not expect markets to be strong-form

efficient.

• If insiders trade then they can have abnormal

profits because of their superior information.

• Jaffe (1974) shows that the stock prices tend to

increase (decrease) after insiders intensively

bought (sold) shares.

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– How are these anomalies interpreted in the

finance literature?

• Fama and French (1993) argue that size and book-

to-market ratios are risk factors as CAPM beta.

Thus it is not against the efficieny hypothesis that

these factors are significant when explaining the

abnormal returns in the market

• On the other hand, Lakonishok, Shleifer, and

Vishney (1995) argue that security analysts

overprice firms with recent good performance and

underprice firms with recent poor performance.

11-38


• Noisy market hypothesis:

– The market prices may contain pricing errors

(“noises”) relative to their intrinsic (“true”) values.

– On average the prices may be correct but at any

time some stocks may be overpriced and inflate

market returns relative to the true values.

– Since indexed portfolios invest in securities in

proportion to their market capitalization (stock price

times number of shares), there portfolios invest

more in overpriced securities.

– Thus, this capitalization-weighted investment

strategy is overweight the firms with the worst

return prospects.

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– The advocates of noisy market hypothesis suggest

to employ fundamental index portfolios to invest.

– Fundamental index portfolios are formed by

investing in securities in proportion to their intrinsic

values.

» Problem: true intrinsic values

11-40

Mutual Fund and Analyst Performance

• Can the skilled investors make consistent abnormal

profits?

– Looking at the performance of market professionals

(stock market analysts and mutual fund managers)

– Can they generate performance superior to that of a

passive index fund?

– The research related to mutual fund managers

indicate that the performance of the professional

managers is consistent with the market efficiency.

– There are not that many performances that is superior

to the passive strategies.

• Studies of mutual fund performance can be

affected by survivorship bias.

11-41

Mutual Fund and Analyst Performance

(Continued)

• Survivorship Bias

– The tendency for the less successful funds to go out

of business over time and leave the sample.

– It looks like there is persistency in the performance

even if there is none in reality.

– Only the successful funds stayed in the sample so

they look persistently outperforming the market since

the rest, unsuccessful ones, have already left the

stage

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