1. Chapter 10
Market Efficiency

2. Learning Objectives Explain the concept of efficient markets.
Describe the three forms of market efficiency – weak, semi-strong, and strong
Discuss the evidence regarding the Efficient Market Hypothesis.
State the implications of market efficiency for investors.
Outline major exceptions to the Efficient Market Hypothesis. 2

3. Efficient Markets How well do markets respond to new information?
Should it be possible to decide between a profitable and unprofitable investment given current information?
Efficient Markets
The prices of all securities quickly and fully reflect all available information 2

4. Conditions for an Efficient Market
Large number of rational, profit-maximizing investors
Actively participate in the market
Individuals cannot affect market prices
Information is costless, widely available
Information is generated in a random fashion
Investors react quickly and fully to new information 3

5. Consequences of Efficient Market
Quick price adjustment in response to the arrival of random information makes the reward for analysis low
Prices reflect all available information
Price changes are independent of one another and move in a random fashion
New information is independent of past 4

6. Market Efficiency Forms
Efficient market hypothesis
To what extent do securities markets quickly and fully reflect different available information?
Three levels of Market Efficiency
Weak form - market level data
Semi-strong form - all public information
Strong form - all information, both public and private 5

7. Cumulative Levels of Market Efficiency and the Information Associated with Each
Strong Form
All Information
Semi-Strong Form
Public Information
Weak Form
Market Data

8. Weak Form Prices reflect all past price and volume data
Technical analysis, which relies on the past history of prices, is of little or no value in assessing future changes in price
Market adjusts or incorporates this information quickly and fully 6

9. Semi-Strong Form Prices reflect all publicly available information
Investors cannot act on new public information after its announcement and expect to earn above-average, risk-adjusted returns
Encompasses weak form as a subset 7

10. Strong Form Prices reflect all information, public and private
No group of investors should be able to earn abnormal rates of return by using publicly and privately available information
Encompasses weak and semi-strong forms as subsets 8

11. Evidence on Market Efficiency
Keys:
Consistency of returns in excess of risk
Length of time over which returns are earned
Economically efficient markets
Assets are priced so that investors cannot exploit any discrepancies and earn unusual returns
Transaction costs matter 9

12. Weak-Form Evidence
Test for independence (randomness) of stock price changes
If independent, trends in price changes do not exist
Overreaction hypothesis and evidence
Test for profitability of trading rules after brokerage costs
Simple buy-and-hold better 10

13. Weak-Form EMH Mostly supportive of weak-form EMH
E.g. technical trading rules have not consistently outperformed the market on average
Runs tests
looking for patterns in signs of returns
i.e
Filter rules
sell after falls a certain % or buy after rises a certain %

14. Two Apparent Contradictions to the Weak-Form EMH
Momentum or persistence in stock returns
tendency of stocks that have done well over the past 6 to 12 months to continue to do well over the next 6 to 12 months
“Contrarian” Strategies
stocks that have done well over the past 3-5 year period, will do poorly over the subsequent 3-5 year period

15. Semi-Strong-Form Evidence
Event studies
Empirical analysis of stock price behaviour surrounding a particular event
Examine company unique returns
The residual error between the security’s actual return and that given by the index model
Abnormal return (Arit) = Rit - E(Rit) n
Cumulative abnormal return (CAR) = Σ Arit
t=1 11

16. Semi-Strong-Form Evidence
Stock splits
Implications of split reflected in price immediately following the announcement
Accounting changes
Quick reaction to real change in value
Initial public offerings
Only issues purchased at offer price yield abnormal returns
Announcements and news
Little impact on price after release 12

17. Professional Portfolio Manager Performance
Substantial evidence that they do not outperform the market (or earn abnormal risk-adjusted returns) over the long run
Based on fund averages
Based on persistence in manager performance (evidence on this point is weaker)

18. Strong-Form Evidence
Test performance of groups which have access to nonpublic information
Corporate insiders have valuable private information
Evidence that many have consistently earned abnormal returns on their stock transactions
Insider transactions must be publicly reported 13

19. Implications of Efficient Market Hypothesis
What should investors do if markets are efficient?
Technical analysis
Not valuable if weak-form holds
Fundamental analysis of intrinsic value
Not valuable if semi-strong-form holds
Experience average results 14

20. Implications of Efficient Market Hypothesis
For professional money managers
Less time spent on individual securities
Passive investing favoured
Otherwise, must believe in superior insight
Tasks if markets informationally efficient
Maintain correct diversification
Achieve and maintain desired portfolio risk
Manage tax burden
Control transaction costs 15

21. Market Anomalies
Exceptions that appear to be contrary to market efficiency
Earnings announcements affect stock prices
Adjustment occurs before announcement, but also significant amount after
Contrary to efficient market hypothesis because the lag should not exist 16

22. Market Anomalies
Low P/E ratio stocks tend to outperform high P/E ratio stocks
Low P/E stocks generally have higher risk-adjusted returns
But P/E ratio is public information
Should portfolio be based on P/E ratios?
Could result in an undiversified portfolio 17

23. Market Anomalies Size effect January effect
Tendency for small firms to have higher risk-adjusted returns than large firms
January effect
Tendency for small firm stock returns to be higher in January
Of 30.5% small-size premium, half of the effect occurs in January 18

24. Market Anomalies Value Line Ranking System
Advisory service that ranks 1,700 stocks from best (1) to worst (5)
Probable price performance in next 12 months
, Group 1 stocks had annualized return of 19.3%
Best investment letter performance overall
Transaction costs may offset returns 19

25. Conclusions about Market Efficiency
Support for market efficiency is persuasive
Much research using different methods
Also many anomalies that cannot be explained satisfactorily
Markets very efficient, but not totally
To outperform the market, fundamental analysis beyond the norm must be done 20

26. Conclusions about Market Efficiency
If markets operationally efficient, some investors with the skill to detect a divergence between price and semi-strong value earn profits
Excludes the majority of investors
Anomalies offer opportunities
Controversy about the degree of market efficiency still remains 21