1. 1 Efficient Market Theory Dr. Rana Singh Associate Professor www.ranasingh.org

2. 2 Efficient Capital Markets n In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security n Whether markets are efficient has been extensively researched and remains controversial

3. 3 Why Should Capital Markets Be Efficient? The premises of an efficient market A large number of profit-maximizing participants analyze and value securities New information regarding securities comes to the market in a random fashion Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information Conclusion: the current price of a security should reflect its risk

4. 4 Alternative Efficient Market Hypotheses n Weak-form efficient market hypothesis n Semistrong-form EMH n Strong-form EMH

5. 5 Weak-Form EMH n Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market- generated information n This implies that past rates of return and other market data should have no relationship with future rates of return

6. 6 Semistrong-Form EMH n Current security prices reflect all public information, including market and non- market information n This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions

7. 7 Strong-Form EMH n Stock prices fully reflect all information from public and private sources n This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return n This assumes perfect markets in which all information is cost-free and available to everyone at the same time

8. 8 Tests and Results of Weak-Form EMH n Statistical tests of independence between rates of return Autocorrelation tests have mixed results Runs tests indicate randomness in prices

9. 9 Tests and Results of Weak-Form EMH n Comparison of trading rules to a buy- and-hold policy is difficult because trading rules can be complex and there are too many to test them all Filter rules yield above-average profits with small filters, but only before taking into account transactions costs Trading rule results have been mixed, and most have not been able to beat a buy- and-hold policy

10. 10 Tests and Results of Weak-Form EMH n Testing constraints Use only publicly available data Include all transactions costs Adjust the results for risk

11. 11 Tests and Results of Weak-Form EMH n Results generally support the weak- form EMH, but results are not unanimous

12. 12 Tests and Results of Semistrong-Form EMH n Studies to predict future rates of return using public information beyond market information Time series analysis Cross-section distribution n Event studies examine how fast stock prices adjust to significant economic events

13. 13 Tests and Results of Semistrong-Form EMH n Test results should adjusted a security’s rate of return for the rates of return of the overall market during the period considered Ar it = R it - R mt where: Ar it = abnormal rate of return on security i during period t R it = rate of return on security i during period t R mt =rate of return on a market index during period t

14. 14 Tests and Results of Semistrong-Form EMH Ar it = R it - E(R it ) where: E(R it ) = the expected rate of return for stock I during period t based on the market rate of return and the stock’s normal relationship with the market (its beta)

15. 15 Tests and Results of Semistrong-Form EMH n Time series tests for abnormal rates of return short-horizon returns have limited results long-horizon returns analysis has been successful based on –dividend yield (D/P) –default spread –term structure spread Quarterly earnings reports may yield abnormal returns due to –unanticipated earnings change

16. 16 Tests and Results of Semistrong-Form EMH Tests of standardized unexpected earnings (SUE) normalize the difference in actual and expected earnings by the standard error of estimate from the regression used to derive the expected earnings figure SUE = Reported EPS t - Predicted EPS t Standard Error of Estimate for the Estimating Regression Equation

17. 17 Tests and Results of Semistrong-Form EMH n Large SUEs result in abnormal stock price changes, with over 50% after the announcement n Unexpected earnings can explain up to 80% of stock drift over a time period n These are evidence against the EMH n Additional tests include calendar studies

18. 18 Tests and Results of Semistrong-Form EMH n The January Anomaly Stocks with negative returns during the prior year had higher returns right after the first of the year - studies indicate an excess return on AMEX but not on NYSE

19. 19 Tests and Results of Semistrong-Form EMH n Other calendar effects All the market’s cumulative advance occurs during the first half of trading months Monday/weekend returns were significantly negative

20. 20 Tests and Results of Semistrong-Form EMH n Predicting cross-sectional returns All securities should have equal risk-adjusted returns n Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns These tests include a joint hypothesis and are dependent both on market efficiency and the asset pricing model used

21. 21 Tests and Results of Semistrong-Form EMH n Price-earnings ratios and returns Examine historical P/E ratios and returns Stocks are divided into five P/E classes Low P/E stocks had higher returns and had lower risk Publicly available P/E ratios could be used for abnormal returns This is inconsistent with semistrong efficiency

22. 22 Tests and Results of Semistrong-Form EMH n The size effect (total market value) All stocks on NYSE and AMEX were ranked by market value and divided into ten equally weighted portfolios The risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms Could this have caused the P/E results previously studied?

23. 23 Tests and Results of Semistrong-Form EMH n The P/E studies and size studies are dual tests of the EMH and the CAPM n Abnormal returns could occur because either markets are inefficient or market model is not properly specified and provides incorrect estimates of risk and expected returns

24. 24 Tests and Results of Semistrong-Form EMH n Adjustments for riskiness of small firms did not explain the large differences in rate of return n The impact of transactions costs of investing in small firms depends on frequency of trading Daily trading reverses small firm gains n The small-firm effect is not stable from year to year

25. 25 Tests and Results of Semistrong-Form EMH n Neglected Firms Firms divided by number of analysts following a stock Neglected firm effect caused by lack of information, crosses size classes Contradictory results from another study n Trading volume Studied relationship between returns, market value, and trading activity

26. 26 Tests and Results of Semistrong-Form EMH n Firm size has emerged as a major predictor of future returns n This is an anomaly in the efficient markets literature n Attempts to explain the size anomaly in terms of superior risk measurements, transactions costs, analysts attention, trading activity, and differential information have not succeeded

27. 27 Tests and Results of Semistrong-Form EMH n Book value-market value ratio As a predictor of stock returns Significant positive relationship between the current values for this ratio and future stock returns are evidence against EMH n Size and BV/MV dominate other ratios such as E/P ratio or leverage n This combination only works during expansive monetary policy

28. 28 Tests and Results of Semistrong-Form EMH n Event studies Stock split studies show that splits do not result in abnormal gains after the split announcement, but before Initial public offerings seems to be underpriced by about 15%, but that varies over time, and the price is adjusted within one day after the offering Being listed on an exchange may offer some short term profit opportunities

29. 29 Tests and Results of Semistrong-Form EMH n Event studies (continued) Unexpected world events and economic news are quickly adjusted to and do not provide opportunities Announcements of accounting changes are quickly adjusted for and do not seem to provide opportunities Corporate events such as mergers and offerings are adjusted to within a few days

30. 30 Summary on the Semistrong-Form EMH n Evidence is mixed

31. 31 Summary on the Semistrong-Form EMH n Evidence is mixed n Strong support from numerous event studies with the exception of exchange listing studies

32. 32 Summary on the Semistrong-Form EMH n Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient

33. 33 Summary on the Semistrong-Form EMH n Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient Dividend yields

34. 34 Summary on the Semistrong-Form EMH n Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient Dividend yields, risk premiums

35. 35 Summary on the Semistrong-Form EMH n Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient Dividend yields, risk premiums, calendar patterns

36. 36 Summary on the Semistrong-Form EMH n Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient Dividend yields, risk premiums, calendar patterns, and earnings surprises

37. 37 Summary on the Semistrong-Form EMH n Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient Dividend yields, risk premiums, calendar patterns, and earnings surprises n This also included cross-sectional predictors such as size, the BV/MV ratio (when there is expansive monetary policy), E/P ratios, and neglected firms.

38. 38 Tests and Results of Strong-Form EMH n Strong-form EMH contends that stock prices fully reflect all information, both public and private n This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits

39. 39 Testing Groups of Investors n Corporate insiders

40. 40 Testing Groups of Investors n Corporate insiders n Stock exchange specialists

41. 41 Testing Groups of Investors n Corporate insiders n Stock exchange specialists n Security analysts

42. 42 Testing Groups of Investors n Corporate insiders n Stock exchange specialists n Security analysts n Professional money managers

43. 43 Corporate Insider Trading n Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities

44. 44 Corporate Insider Trading n Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities n Insiders must report to the SEC each month on their transactions as insiders

45. 45 Corporate Insider Trading n Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities n Insiders must report to the SEC each month on their transactions as insiders n These insider trades are made public about six weeks later and allow for study

46. 46 Corporate Insider Trading n Corporate insiders generally experience above-average profits especially on purchase transaction

47. 47 Corporate Insider Trading n Corporate insiders generally experience above-average profits especially on purchase transaction n This implies that many insiders had private information from which they derived above-average returns on their company stock

48. 48 Corporate Insider Trading n Studies showed that public investors who traded with the insiders based on announced transactions would have enjoyed excess risk-adjusted returns, but the markets now seem to have eliminated this inefficiency (soon after it was discovered)

49. 49 Corporate Insider Trading n Other studies indicate that you can increase returns from using insider trading information by combining it with key financial ratios and considering what group of insiders is doing the buying and selling

50. 50 Stock Exchange Specialists n Specialists have monopolistic access to information about unfilled limit orders

51. 51 Stock Exchange Specialists n Specialists have monopolistic access to information about unfilled limit orders n You would expect specialists to derive above-average returns from this

52. 52 Stock Exchange Specialists n Specialists have monopolistic access to information about unfilled limit orders n You would expect specialists to derive above-average returns from this n The data generally supports this

53. 53 Security Analysts n Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks

54. 54 Security Analysts n Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks n This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendation

55. 55 The Value Line enigma n Value Line (VL) publishes financial information on about 1,700 stocks

56. 56 The Value Line enigma n Value Line (VL) publishes financial information on about 1,700 stocks n The report includes a timing rank from 1 down to 5

57. 57 The Value Line enigma n Value Line (VL) publishes financial information on about 1,700 stocks n The report includes a timing rank from 1 down to 5 n Firms ranked 1 substantially outperform the market

58. 58 The Value Line Enigma n Value Line (VL) publishes financial information on about 1,700 stocks n The report includes a timing rank from 1 down to 5 n Firms ranked 1 substantially outperform the market n Firms ranked 5 substantially underperform the market

59. 59 The Value Line Enigma n Changes in rankings are quickly price adjusted into the market

60. 60 The Value Line Enigma n Changes in rankings are quickly price adjusted into the market n Some content that the Value Line effect is merely the unexpected earnings anomaly due to changes in rankings from unexpected earnings

61. 61 Security Analysts n There is evidence in favor of existence of superior analysts who apparently posses private information

62. 62 Efficient Markets and Technical Analysis n Technical analysts develop systems to detect movement to a new equilibrium (breakout) and trade based on that n Contradicts EMH rapid price adjustments n If the capital market is weak-form efficient, a trading system that depends on past trading data can have no value

63. 63 Efficiency in European Equity Markets n Hawawini study indicates behavior of European stock prices is similar to U.S. common stocks

64. 64 Future topics Chapter 9 n Analysis of Financial Statements n Financial Ratios n Evaluating Performance

65. 65