1. The Efficient Market Hypothesis
Chapter 8

2. Learning Objectives Understand the concept of market efficiency
Understand the investment implications of the various levels of market efficiency
Develop a thorough understanding of the tests of market efficiency and observed market anomalies

3. Market Efficiency
A market is efficient when it uses all available information is quickly incorporated into prices.
Efficiency is the degree to which prices reflect available information.
If prices reflect all available information then what causes prices to move?

4. New Information
When information is released it contains two components
Anticipated: Information already included in the price
Unexpected: New information that is not currently priced
The market prices assets based on what is expected to happen (Anticipated Information)
Unexpected information causes the market to change its expectations → Moving prices
Result: Prices change until expected returns are exactly commensurate with risk.

5. Stock Price Reaction to CNBC Reports

6. A Random Walk Unexpected information arrives RANDOMLY
Therefore price changes will be random
Price tomorrow = today’s price + random (+/-)
If price changes are random does that mean they are uncaused?

7. Price: This Week & Next
Do you see a pattern?

8. Why are price changes random?
Prices react to information
Flow of information is random
Results in random price changes

9. How prices move
Stock prices are the consequence of intelligent investors competing to discover relevant information
These discoveries occur randomly
We expected returns to generally be positive over time
These two trends results in stock prices having:
→Positive trend with random movements around trend
Draw graph with price on Y-axis, Time on X-axis, and upward trend line (expected price) and random price movements around trend line.

10. Information The MOST precious commodity on Wall Street
Strong competition assures prices reflect information.
The first to learn something new will make money
The marginal return on research activity may be so small that only managers of the largest portfolios will find them worth pursuing.
Only ones with enough capital to make it worth while
Can use leverage to juice returns

11. The Value of Information: Real Ex
Pacific Century Cyberworks
Was going to be added to Hong Kong Index, in a major way
Since Index would be buying up shares, price would rise, so everyone started buying shares
One investor in Japan went to Hong Kong to get as much information about the deal as possible
Discovered the share weren’t being bought on the market
Shares would come from the founder, increasing the supply
What do the investors who bought need to do?
What does our investor do?
Short and made millions in minutes

12. Potential Causes of Efficient Markets
Investor Rationality
Everyone is rational → Everyone makes the right decision
Independent Deviation from Rationality
No one is rational → Everyone makes the wrong decision but each makes a different wrong decision
Average out the wrongness
Arbitrage
Only some people are rational → Smart money takes from less smart money

13. Types of Efficient Markets
Strong
Semi-Strong
Weak

14. Weak Form Efficiency
Prices reflect all information contained in past prices and volumes
No investor is able to form a trading strategy based on historic prices and volumes and earn an excess return

15. Disbelievers Chartists, or Technical Analysts
Analyze “charts” of a stock‘s Price and/or Volume
Chartist believe in identifiable and predictable patterns in these characteristics
Make investment decisions based on these patterns
Brokerage firms tend to love chartists

16. Head and Shoulders

18. Why Technical Analysis Fails
Stock Price
-If there is a profitable pattern, everyone would do it
-If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern
Sell
Sell
Buy
Buy
Time

19. Semi-Strong Form Efficiency
Security prices reflect all publicly available information.
Encompasses weak form efficiency
Publicly available information includes:
Historical price and volume information
Published accounting statements
Information found in the WSJ

20. Disbelievers Fundamental Analysts
Use economic and accounting information to predict stock prices
Try to find firms that are better than everyone else’s estimate.
Try to find poorly run firms that are not as bad as the market thinks.

22. Strong Form Efficiency
Strong form efficiency says that anything pertinent to the stock price and known to at least one investor is already incorporated in the security’s price.
Public & Private
Implies: Insider trading will not earn excess return
Strong form efficiency incorporates weak and semi-strong form efficiency.

23. Disbelievers Pretty much everyone
Insiders trading is generally profitable
Galleon
Raj Rajaratnam

24. EMH: Active v Passive Management
Passive Management: Believes the market is efficient → Does NOT attempt to outsmart the market
Buy well-diversified portfolios without looking for mispricing
Index Funds and ETFs
Active Management: Believes the market is not perfectly efficient → Hunts for mispricing
An expensive strategy
Suitable only for very large portfolios

25. Are Markets Efficient: Will the Debate End
Wall Street is predicated on the idea that the market is inefficient, Academics general need an efficient market
Magnitude Issue
Only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort.
Selection Bias Issue
Only unsuccessful investment schemes are made public; good schemes remain private.
Lucky Event Issue

26. Weak-Form Efficiency Tests
Look for patterns in stock returns
Returns over the Short Horizon
Momentum: Good or bad recent performance continues over short to intermediate time horizons
Returns over Long Horizons
Reversal Effect: Episodes of overshooting followed by correction

28. Semistrong Tests: Anomalies
Small Firm Effect
January Effect
Book-to-Market Ratios
Post-Earnings Announcement Price Drift

29. Average Annual Return: 10 Size-Based Portfolios, 1926-2010

30. Average Annual Return as Function of Book-to-Market Ratio, 1926-2010

31. Event Studies
Study the impact of a particular event on a firm’s stock price.
EX: Earnings or Dividend announcements
Test of the Semi-Strong EMH
Look at how quickly prices adjust to the announcement
Looking for under, over, early, delayed reactions

32. Event Studies: Dividend Omissions
Efficient market response to “bad news”
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997).

33. CARs Around Earnings Announcements

34. Interpreting the Anomalies
The most puzzling anomalies are price-earnings, small-firm, market-to-book, momentum, and long-term reversal.
Fama and French argue that these effects can be explained by risk premiums.
Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets.

35. Interpreting the Evidence
Anomalies or data mining?
Some anomalies have disappeared (e.g. size).
Book-to-market, size, and momentum may be real anomalies as they exist in many markets and asset classes around the world.

36. Mutual Funds Performance
If the market is semi-strong form efficient, then mutual fund managers, should not be able to consistently beat the average market return
When we compare the record of mutual fund performance to a market index, we see that mutual funds are not able to CONSISTENTLY beat the market.
Consistent with the market being semi-strong form efficient

37. Figure 8.8 Persistence of Mutual Fund Performance

38. Figure 8.9 Risk-Adjusted Performance in Ranking Quarter, Following Quarter

39. Mutual Fund Performance
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).

40. So, Are Markets Efficient?
The performance of professional managers is broadly consistent with market efficiency.
Most managers do not do better than the passive strategy.
There are, however, some notable superstars:
Peter Lynch, Warren Buffett, John Templeton, George Soros

41. Efficient Markets & Portfolio Management
Even if the market is efficient a role exists for portfolio management:
Diversification
Appropriate risk level
Tax considerations

42. Efficient Markets & Resource Allocation
If markets were inefficient, resources would be systematically misallocated.
Firm with overvalued securities can raise capital too cheaply.
Firm with undervalued securities may have to pass up profitable opportunities because cost of capital is too high.
Efficient market ≠ perfect foresight market

43. EMH Exercises
Indicate whether or not the EMH is contradicted, if so which form of EMH is contradicted
An investor consistently earn an abnormal return over that expected by the market by examining charts of historical prices
The acquisition of the latest annual report of a company enables an investor to earn an abnormal return.
A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows.
By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments.