Chapter 12 Efficient Markets: Theory And Evidence

Efficient Market Assumptions Large number of analysts assessing The true value of the firm Analysts look for mispriced securities Buy or sell them Driving the market price towards true value Competition pushes prices to true value Stock prices reflect new information

Is The Market Efficient? Requires Testing for Market Efficiency Requires Identifying the Appropriate Information Efficient Market Theory (EMT) Describes the impact of information on price

Forms Of EMT Weak Form Technical Analysis Prices reflect all historical information Price changes follow a random walk Semi-Strong Form Fundamental Analysis Prices reflect all public information Strong Form Insider Trading Prices reflect all public and private information

Resources Allocation Stock Prices Reflects Firm’s Prospects Acquire Information Low cost and high speed Focus on Trading Cost and Speed New Information is Worthless Price of stock is instantaneously adjusted to reflect new information 92% of Returns Depend on Allocation

5 Rules For Smart Asset Allocation Identify Your Time Horizon Assess Your Risk Tolerance Diversify, Diversify, Diversify Don’t Tinker With Your Mix Re-Balance Your Holdings Once a Year

Is There A Contradiction Between EMT and Portfolio Selection? Yes Yes

Passive Investment Strategy Adhering to desired investment proportion Index funds do not change Active Investment Strategy Change investment proportion according to market prediction

Strategy In Inefficient Markets Fundamental Analysis Believe in weak form EMT Fundamental and Technical Analysis Believe market is inefficient No Strategy Believe in strong form EMT

Fama’s Classification For EMT Tests for Return Predictability Event Studies Test for Private Information

Testing Weak Form EMT Analysis of Technical Trading Rules of Abnormal Rates of Return Statistical Tests on Historical Data for Significant Patterns

Testing For Semi-Strong Form EMT Can Fundamental Analysis Earn Abnormal Returns? Surprise Factor Connecting Theory To Practice 12.3

Testing Strong Form EMT Insiders Can Generate Abnormal Profits Illegal Strong Form Is Not Supported Getting the Information FIRST Before the market reacts

Market Anomalies Firm Seasonal Event Accounting

Firm Anomalies Size Closed-End Mutual Funds Neglect Institutional Holdings

Seasonal Anomalies Week-End Time of Day End of Month Seasonal Holidays

Event Anomalies Analysis’ Recommendations Insider Trading Listing Value Line Rating Change

Accounting Anomalies P/E Ratio Earnings Surprises Price/Sales Ratio Price/Book Ratio Dividend Yield Earnings Momentum