McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets Hypothesis 1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is efficient if prices “fully reflect” available information and adjust rapidly to new information. 2

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Market prices are determined by the actions of buyers and sellers.  In an efficient market, security prices fairly reflect all that is known by investors. 3

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  An efficient market is a “fair game” as long as information is equally available. Public info cannot be used to “beat the market.” 4

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Random: without definite aim, direction, rule or method. If something is random, it cannot be explained or predicted.  If a market is efficient, price levels are not random ; price changes are random (cannot be predicted). 5

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Random Walk Hypothesis of stock prices:  Expected price change is positive  Price changes about the trend are random 6

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. SecurityPrices Time Random Walk with Positive Trend 7

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why would price changes be random?  Prices react to new information  Information is new only if it is not expected  Flow of information is random  Therefore, price changes are random 8

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1. Weak form 2. Semi-strong form 3. Strong form  These vary with respect to the set of information 9

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is weak-form efficient if prices fully reflect market data. 10

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Technical Analysis –using patterns in market data to predict price changes.  If the stock market is weak-form efficient, can technical analysis benefit investors? 11

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is semistrong efficient if prices fully reflect all public information. 12

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Fundamental Analysis –using economic and accounting information to evaluate a security.  If the stock market is semistrong form efficient, can fundamental analysis benefit investors? 13

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is strong form efficient if: prices fully reflect all information, public and private. 14

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  If the stock market is strong form efficient, do insiders have an advantage over other investors? 15

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are efficient: Diversify broadly Match portfolio risk to your risk tolerance Buy & hold 16

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are inefficient:, try to beat the market by identifying undervalued securities or sectors (by using either fundamental analysis or technical analysis) & overweighting. 17

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  The evidence is generally consistent with weak form efficiency in securities markets. Most, but not all, studies conclude that technical analysis is not profitable. 18

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  The empirical evidence is generally consistent with semistrong efficiency: security prices tend to adjust very rapidly to new information. 19

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 20

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  While most evidence supports semistrong efficiency, several price patterns are inconsistent with semistrong efficiency, however (“anomalies”).  An “anomaly” is something that deviates from what is believed to be true. 21

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Small firm/January effect  Book-to-Market ratios  Post-earnings announcement drift 22

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 23

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 24

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 25

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Risk Premiums or market inefficiencies?  Anomalies or data mining? 26