1. The Efficient Market Hypothesis
Chapter 8
The Efficient Market Hypothesis
Describes the financial instruments traded in primary and secondary markets.
Discusses Market indexes. Discusses options and futures.
McGraw-Hill/Irwin
Copyright © by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. 8.1 Random Walks and the Efficient Market Hypothesis
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3. Efficient Market Hypothesis (EMH)
Do security prices accurately reflect information?
Informational Efficiency
_____________________________________
Allocational Efficiency
Gold and the _______________________.
Huge implications concerning the answers to these questions.
Are price changes consistently predictable?
accurately
reflect the cash flows
Are prices correct in that they ____________ ________________________ associated with the security?
Efficiency centers on the idea that stock prices always reflect information.
If stock prices don’t fairly represent firm value this can lead to a mistrust of corporations and their management.
Efficient markets help investors to feel confident about the accuracy of stock prices, and that stocks are fairly prices.
Why does gold have value? It provides no cash flow, so what is its value based on? It is a hedge against uncertainty and inflation but it provides no tangible benefit. The ‘greater fool’ theory maintains that you buy gold and hold it until you find a greater fool to buy it from you.
greater fool theory
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4. Implications of Efficiency
Allocational efficiency
If markets are not allocationally efficient then perhaps there is a ________________________ ___________ in capital markets.
role for greater government
intervention
Possible rules changes to attempt to improve allocational efficiency
Tax on trading activity
More taxes on short holding period returns
Changes in corporate compensation
Still debatable whether government can make it better because they are so inefficient. I am NOT advocating greater government intervention in the markets. Rather we need to understand what is implied by what I think is some sloppy thinking about the implications that follow if we blithely conclude that markets are not efficient.
Direct government involvement in capital allocation: Industrial Policy
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5. Implications of Efficiency
Informational efficiency
If markets are not informationally efficient
Investors may not be able to trust that market prices are up to date and investors should then conduct their own research (or hire a researcher) to validate the price.
Privileged groups of investors will be able to consistently take advantage of the general public.
Active strategies should outperform passive strategies.
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6. Implications of Efficiency
Informational efficiency
If markets are not informationally efficient
Corporations have to rethink their goals and how best to achieve them.
Maximize shareholder wealth  maximize share price, so how does one go about maximizing shareholder wealth in this case?
Lack a benchmark to evaluate corporate decisions.
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7. EMH and Competition
Competition among investors should imply that stock prices fully and accurately reflect publicly available information very quickly. Why?
Else there are unexploited profit opportunities.
Once information becomes available, market participants quickly analyze it & trade on it & frequent, low cost trading assures prices reflect information.
Competition suggests that new information is quickly analyzed and the signal associated with the information is quickly integrated into security prices.
Structural market problems refers to market imperfections such as transaction costs limiting arbitrage, constraints on short sales doing the same and recognizing that in volatile markets, most arbitrage strategies are really risky arbitrage, not riskless arbitrage. More on this later.
Questions arise about efficiency due to:
Unequal access to information
Structural market problems
Psychology of investors (Behavioralism)
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8. Random Price Changes Why are price changes random?
In very competitive markets prices should react to only NEW information
Flow of NEW information is random
Therefore, price changes are random
Idea that stock prices follow a “Random Walk”
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9. Random Walk and the EMH
Random Walk: stock price ______________________
Stock prices actually follow a ____________________
changes are unpredictable
A “pure” random walk implies informational efficiency
submartingale process
Expected price change is positive over time
But random changes are superimposed on the positive trend
E(pricej,t) > E(pricej,t-1) t = time period
EMH suggest stock prices should not be predictable. If information important to stocks arrive in a random fashion we should expect stock prices to move in a random fashion.
Since we have a positive risk premium we expect stocks to have a positive trend upward.
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10. Random Walk with Positive Trend
Security
Prices
Evidence on Random Walk idea later.
Deviations from the trend should be unpredictable.
the + trend line is there because firms invest in + NPV projects on average
Time
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11. Forms of the EMH Prices reflect all relevant information
Vary the ________________
Weak
information set
The relevant information is historical prices and other trading data such as trading volume.
If the markets are weak form efficient, use of such information provides no benefit “at the margin.”
Explain, at the margin, means after cost of obtaining and using the information.
Weak- Prices reflect all information that can be derived from trading data such as prices and volume.
Semi-Strong: Prices reflect all publicly available information regarding the firm’s prospects. Financial Data, information about the industry, the firm management, etc.
Strong- Stock prices reflect all information both public and private. (inside information).
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12. Forms of the EMH Prices reflect all relevant information
Vary the information set:
Semi-strong
The relevant information is "all publicly available information, including past price and volume data."
If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin.
Weak- Prices reflect all information that can be derived from trading data such as prices and volume.
Semi-Strong: Prices reflect all publicly available information regarding the firm’s prospects. Financial Data, information about the industry, the firm management, etc.
Strong- Stock prices reflect all information both public and private. (inside information).
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13. Forms of the EMH Prices reflect all relevant information
Vary the information set:
Strong
The relevant information is “all information” both public and private or “inside” information.
If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin.
Weak- Prices reflect all information that can be derived from trading data such as prices and volume.
Semi-Strong: Prices reflect all publicly available information regarding the firm’s prospects. Financial Data, information about the industry, the firm management, etc.
Strong- Stock prices reflect all information both public and private. (inside information).
SEC Rule 10b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported.
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14. Relationships between forms of the EMH
Notice that _______________________________ __________________ (but ________________)
Strong form efficiency would imply that __________________________________________.
semi-strong efficiency implies weak
form efficiency holds
NOT vice versa
Weak- Prices reflect all information that can be derived from trading data such as prices and volume.
Semi-Strong: Prices reflect all publicly available information regarding the firm’s prospects. Financial Data, information about the industry, the firm management, etc.
Strong- Stock prices reflect all information both public and private. (inside information).
both semi-strong and weak form efficiency hold
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15. 8.2 Implications of the EMH (for Security Analysis)
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16. Types of Stock Analysis & Relationship to the EMH
Technical Analysis:
If the markets are weak form efficient or semi-strong form efficient or strong form efficient will technical analysis be able to consistently predict price changes?
Technical Analysis or TA is using prices and volume information to predict future price changes
TA assumes prices follow predictable trends
Chartists, by definition, don’t believe in efficient markets. They are using historical price and volume data to attempt to reap excess returns.
Fundamental Analysis: Understanding the economic fundamentals of the firm, its industry and the economy. A semi-strong efficient market suggests fundamental analysis would not aid in stock picking. NO
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17. Basic Types of Technical Analysis
Identifying common price patterns
One on the left is real, the one on the right is simulated.
One of these patterns is real and one of these is computer simulated with random price changes. Can you tell which is which?
Point?
Less than meets the eye
Data mining
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18. Basic Types of Technical Analysis
Support and resistance levels
Support level:
A price level below which it is supposedly unlikely for a stock or stock index to fall.
Resistance level:
A price level above which it is supposedly unlikely for a stock or stock index to rise.
A resistance level may arise at say $31.25 if a stock repeatedly rises to $31.25 and then declines, indicating that investors are reluctant to pay more than this price for the stock.
A stock price above $31.25 would then indicate a 'breakout' which would be a bullish signal.
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19. Types of Stock Analysis & Relationship to the EMH
Fundamental Analysis:
If the markets are weak form efficient or semi-strong form efficient or strong form efficient will fundamental analysis be able to consistently predict price changes?
using economic and accounting information to predict stock price changes
If the markets are only weak form efficient?
Fundamental Analysis CAN predict price changes
If the markets are semi-strong or strong form efficient?
Fundamental Analysis CANNOT predict price changes
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20. Fundamental Analysis
Fundamental analysis assumes that stock prices should be equal to
Fundamental analysis is thus the
the discounted value of the expected future cash flows the stock is expected to provide to investors.
“art” of identifying over- and undervalued securities based on an analysis of the firm's financial statements and future prospects.
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21. Fundamental Analysis
Fundamental analysis varies in technique but generally focuses on
forecasting the firm's future dividends or earnings,
discounting those future cash flows by the required rate of return (usually obtained from the CAPM),
and comparing the resulting estimated price with the current stock price.
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22. Fundamental Analysis greater
If the estimated price is ______ than the current price an investor should ___ the stock since it is ___________ and since its price should ________ to the "true" or "fundamental" value uncovered by the analyst.
If the estimated price is ____ than the current price the stock should be ____ because the stock is currently __________ by the market.
In either case if the analyst is correct the investor should receive an ________________.
buy
greater
undervalued
increase
less
sold
overvalued
“abnormal return”
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23. Fundamental Analysis
Forecasts already exist and for FA to add value, your forecast must be better than the consensus forecast.
Not enough to find a good company, you must find a company that is better than others believe, i.e., mispriced.
Both of these are key points the students need to understand
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24. Implications of Efficiency for Active or Passive Management
Assumes inefficiency, use technical and/or fundamental analysis to pick securities
Active Management
Passive Management
Security analysis
Timing strategies
Investment Newsletters
Consistent with semi-strong efficiency
Active management assumes markets are inefficient. Use either technical or fundamental analysis to pick stocks.
Passive management tends to be the management style that fits the EMH. No reason to spend any money or make any effort to pick “winners.”
Buy and Hold portfolios
Index Funds
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25. Market Efficiency and Portfolio Management
Even if the market is efficient a role exists for portfolio management
Identify risk & choose appropriate risk level
Tax considerations
Other considerations such as liquidity needs or diversify away from the client’s industry.
We talked about investor preferences due to level of risk aversion. Risk tolerance can change as you age!
Highly taxed investors may dislike investments with large dividends. People may desire selling losers and winners together to minimize taxes.
Other. Talk about a large manager at a Firm like GM. Would not want to hold more auto industry stock, due to his overweighting of wealth tied up in the auto industry.
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26. 8.3 Are Markets Efficient?
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27. Empirical Tests of Informational Efficiency
Recall that over time stock prices tend to follow a ____________________
This has nothing to do with efficiency, per se. It does however have serious implications for ________________.
In words this says that a _________________ ______________________________________ _____________.
submartingale process
tests of efficiency
Event Studies look at how quickly information is integrated into prices around an informational event. EMH suggests quick assimilation of information into prices.
Do professional managers, use their resources and tools to outperform the market? EMH suggests professionals will not outperform the market.
Are there specific trading rules that could make money? Use filter rules (ex. Buy after 20% price drop, sell after 20% gain)
randomly chosen
portfolio of stocks can be expected to have a positive return
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28. Empirical Tests of Informational Efficiency
In practice this means that when trying to figure out if some portfolio manager is earning abnormal returns we must ____________________________ _______________________.
I.E. they must ____________________________, or in practice they must beat ____________________ ________.
compare their performance to a
randomly chosen portfolio
outperform the random portfolio
some benchmark rate
of return
Event Studies look at how quickly information is integrated into prices around an informational event. EMH suggests quick assimilation of information into prices.
Do professional managers, use their resources and tools to outperform the market? EMH suggests professionals will not outperform the market.
Are there specific trading rules that could make money? Use filter rules (ex. Buy after 20% price drop, sell after 20% gain)
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29. Empirical Tests of Informational Efficiency
Can anyone consistently earn an abnormal return?
Do investors systematically misinterpret information?
This says that investors do not repeat the same mistakes over and over in an irrational fashion.
For example, sometimes they may overestimate the impact on earnings of some event and sometimes they underestimate the impact on earnings but on average the estimates are unbiased.
Event Studies look at how quickly information is integrated into prices around an informational event. EMH suggests quick assimilation of information into prices.
Do professional managers, use their resources and tools to outperform the market? EMH suggests professionals will not outperform the market.
Are there specific trading rules that could make money? Use filter rules (ex. Buy after 20% price drop, sell after 20% gain)
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30. Empirical Tests of Inform. Efficiency
Event studies
Assessing performance of professional managers
Testing a trading rule
Examine how quickly information is integrated into prices around an informational event.
EMH suggests rapid assimilation of information into prices.
Can professional managers, using their resources and tools, “beat” the market after considering risk?
EMH suggests professionals will not outperform the market.
Event Studies look at how quickly information is integrated into prices around an informational event. EMH suggests quick assimilation of information into prices.
Do professional managers, use their resources and tools to outperform the market? EMH suggests professionals will not outperform the market.
Are there specific trading rules that could make money? Use filter rules (ex. Buy after 20% price drop, sell after 20% gain)
Testing whether a rule that uses available information can earn abnormal returns after considering the risk and cost of using the rule.
EMH suggests that such rules will not work.
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31. How Tests Are Structured
1. Examine prices and returns around some material announcement
With event studies we must examine prices and returns around the event date.
For analysis of money manager performance we can compare returns to diversified index returns.
For filter rules we can also compare the returns over time with market returns.
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32. -t +t Announcement Date
Individual Abnormal Returns Surrounding the Event in an _______________
Efficient Market
= abnormal return -t +t
Announcement Date
This might be an example of an event where the returns directly following the event are above zero; a good news event.
Any type of event that has abnormal returns after the event should not be predictable.
Earnings above forecast for example
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33. Earnings above forecast for example
Individual Abnormal Returns Surrounding the Event in an _______________
Inefficient Market
= abnormal return -t +t
Announcement Date
Earnings above forecast for example
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34. How Tests Are Structured (cont.)
How do we determine if the returns are abnormal?
Market Model approach a. b.
rt = a + b(rindex,t) + et
Estimate a and b coefficients
Abnormal Return or AR = (Actual - Expected)
ARt = et = Actual return – [a + b(rindex,t)]
Question: How do we determine if the returns are abnormal?
Returns at any time t should be a function of the market returns the risk free rate and the market returns that occur during the same period.
Abnormal returns are excess (unexpected returns)
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35. How Tests Are Structured (cont.)
2. continued:
c. Cumulate the abnormal returns over time:
Add up the ARs over time +t -t
Cumulating the excess returns over time we can see if information is integrated into prices before or after the event. Here it appears to have some information leaking into the price prior to the event date. See p. 285 for cumulative abnormal returns and earnings announcements. (Post-Earning announcement drift)
In this case there appears to be information leakage before the announcement date (day 0), but markets adjust quickly to new information.
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36. Cumulative Abnormal Returns before Takeover Attempts: Target Companies
In this case there appears to be information leakage before the announcement date (day 0), but markets adjust quickly.
Keown & Pinkerton
Big jump on Day 0, but no further drift up. Consistent with efficient markets
Study is 1981
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37. Stock Price Reaction to CNBC Midday Reports
Patell & Wolfson
The leveling off point indicates when the market had fully digested the news. Note that for the positive report the news is fully digested in about 5 minutes. It took a little longer for the negative news to be fully reflected in market prices, that took about 12 minutes (Busse and Green, 2002, JFE 65)
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38. Issues in Examining the Results
Magnitude Issue
Even _____________________________ may be worthwhile for managers of large investments.
Eg.
The problem is that these __________________________ would be _________________ to measure since the standard deviation of many portfolios ______________.
small changes in performance
$5 billion dollar portfolio. Use research to improve results by 1/10 of a percent per year = $5 million in value.
Magnitude- Even small changes in performance may be worthwhile for managers of large investments. Eg. $5 billion dollar portfolio. Use research to improve results by 1/10 of a percent per year = $5 million dollars in value. Problem is that these small changes in performance would be virtually impossible to measure since the standard deviation of portfolios like S&P 500 is 20% per year. “Large portfolios may have more benefit to research”.
Selection Bias: Would anyone publish a money making scheme. The literature only sees the schemes that don’t work.
Lucky event: 10,000 people to flip coins 50 times. 2 people would likely flip 75% or more heads.
Model misspecification: When we do risk adjustments. Who says we have the correct risk model.
small changes in performance
virtually impossible
is 20% or more
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39. Issues in Examining the Results
Selection Bias Issue
Lucky Event Issue
“I have this foolproof new trading scheme that will make me millions. I want to tell everyone about it.”
We only learn about the schemes that don’t really work, or only worked in the past.
Magnitude- Even small changes in performance may be worthwhile for managers of large investments. Eg. $5 billion dollar portfolio. Use research to improve results by 1/10 of a percent per year = $5 million dollars in value. Problem is that these small changes in performance would be virtually impossible to measure since the standard deviation of portfolios like S&P 500 is 20% per year. “Large portfolios may have more benefit to research”.
Selection Bias: Would anyone publish a money making scheme. The literature only sees the schemes that don’t work.
Lucky event: 10,000 people to flip coins 50 times. 2 people would likely flip 75% or more heads.
Model misspecification: When we do risk adjustments. Who says we have the correct risk model.
If 10,000 people flip fair coins 50 times we can expect 2 people to flip 75% or more heads.
In a large group of stock analysts, some will be correct most of the time in their picks, and they will look very smart even though their results are due to pure chance!
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40. Issues in Examining the Results
Possible Model Misspecification
Results have to be adjusted for the risk of the given stock or strategy.
This means that tests of efficiency are necessarily joint tests of the model used to measure risk and market efficiency.
Results counter to efficiency may just be saying researchers aren’t using the right model to measure risk and hence the expected return.
Magnitude- Even small changes in performance may be worthwhile for managers of large investments. Eg. $5 billion dollar portfolio. Use research to improve results by 1/10 of a percent per year = $5 million dollars in value. Problem is that these small changes in performance would be virtually impossible to measure since the standard deviation of portfolios like S&P 500 is 20% per year. “Large portfolios may have more benefit to research”.
Selection Bias: Would anyone publish a money making scheme. The literature only sees the schemes that don’t work.
Lucky event: 10,000 people to flip coins 50 times. 2 people would likely flip 75% or more heads.
Model misspecification: When we do risk adjustments. Who says we have the correct risk model.
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41. Counter Evidence: Some Apparent Predictors of Broad Market Returns
Fama and French
Campbell and Shiller
Keim and Stambaugh
Aggregate returns tend to be higher for firms with higher dividend yields
Aggregate returns tend to be higher for firms with higher earnings yields
Changes in bond credit spreads can predict market returns
Each of these may also be consistent with changing risk premiums and may have nothing to say about market efficiency.
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42. Average Annual Returns for 10 size-based portfolios, 1926-2007
Results are driven by returns in the first two weeks of January
May be related to higher ESTIMATION risk of smaller firms
Extra return may be more apparent than real due to higher trading costs and illiquidity
NYSE stocks broken up into size deciles. This is driven by January returns! (The first two weeks). Arbel and Strebel claim this size effect is a neglected firm effect and is hence due to higher risk, not fully captured by the CAPM. Brooks and others have shown that these returns are hard to capture due to high trading costs and lower liquidity of small firms.
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43. Average Returns as a Function of the Book-To Market Ratio, 1926 to 2007
Value Stock premium return
Distressed and out of favor stocks?
High book to market ratio may indicate the stock is out of favor (a value stock) and hence a good buy. It may also contain more financially distressed firms which would explain the higher return. FF find that using this factor, the traditional beta becomes insignificant. This may imply inefficient pricing or it may indicate that this variable is proxying for a risk premium factor.
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44. Cumulative Abnormal Returns in Response to Earnings Announcements
Short term momentum effect that is counter to efficiency.
Rendleman, Jones and Latane’ results. These have been updated many times. Note the continual drift up after the earnings announcement date for the firms with the highest earnings surprises and the continual drift down for the firms with poor earnings surprises. This is termed the short term momentum effect and is counter to market efficiency. You apparently CAN earn +ARs from this one, although logically this seems unlikely.
Rendleman, Jones & Latane
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45. Bubbles and Market Efficiency
Periodically stock prices appear to undergo a ‘speculative bubble.’
A speculative bubble is said to occur if prices do not equal the intrinsic value of the security.
Does this imply that markets are not efficient?
Very difficult to predict if you are in a bubble and when the bubble will burst.
Stock prices are estimates of future economic performance of the firm and these estimates can change rapidly.
Risk premiums can change rapidly and dramatically.
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46. Bubbles and Market Efficiency
With hindsight there appear to be times when stock prices decouple from intrinsic or fundamental value, sometimes for years.
Prices eventually conform to intrinsic value.
Brings into question the allocational efficiency of the markets more than the informational efficiency.
What capital allocation mechanism is likely to perform better than the market based system?
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47. 8.4 Mutual Fund and Analyst Performance
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48. Returns to Style Portfolio as a Predictor of GDP Growth
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49. Estimates of Individual Mutual Fund Alphas, 1972 - 1991
The mean alpha is statistically equal to zero. This is Malkeils’ work and it uses the S&P500 as a benchmark which is probably the wrong benchmark given that many funds hold small stocks.
Mutual fund returns versus the S&P500 index; Mean alpha = 0
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50. Performance of Mutual Funds Based on a Four Factor Model
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51. Persistence of Mutual Fund Performance
Belaboring the point? Not much persistence in performance over time.
Carhart 1997, JOF
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52. Mutual Fund and Professional Manager Performance
Superstar phenomenon
John Templeton (Templeton Funds)
Warren Buffet (Berkshire Hathaway)
Peter Lynch (Fidelity Magellan)
Bill Miller (Legg Mason)
Jon Neff (Vanguard’s Windsor Fund)
Generally the passive portfolios outdo the managed portfolios.
Most performance differences between managers appears to be related to trading turnover and high fees.
What is the correct benchmark. Is the S&P 500 a broad enough benchmark portfolio.
Style changes. For years small stocks under-performed and than over over performed the s&P. If funds held a lot of small stocks and benchmark was S&P could lead to strange results.
Peter Lynch, Warren Buffet, John Templeton, and George Soros, appear even beyond the lucky event phenomenon.
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53. Summary: What Does the Evidence Show?
Technical Analysis (TA)
Stocks do not follow a pure random walk, so there is hope for technical trading strategies.
Most TA rules utilize short term trading strategies that generate excessive transaction costs and are not profitable.
There appears to be some long term trend reversals.
Most of the findings suggest that the markets are fairly efficient, and technical analysis or fundamental analysis do not generally reap excess rewards.
In technical analysis items like filter rules don’t appear to make excess returns that outweigh the extra transaction costs.
Jagadeesh and Titman (1993) find a momentum property (3-12 months) suggesting good and bad times persist, and profits could be made. (questionable)
For fundamental analysis people question if the different ratios are just capturing returns associated with misspecified risk measurement.
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54. Summary: What Does the Evidence Show?
Fundamental Analysis
Appears to be difficult to consistently generate abnormal returns using fundamental analysis.
This is because the analysis/investment industry is so competitive and volatility is high.
May help you avoid seriously overvalued investments.
Most of the findings suggest that the markets are fairly efficient, and technical analysis or fundamental analysis do not generally reap excess rewards.
In technical analysis items like filter rules don’t appear to make excess returns that outweigh the extra transaction costs.
Jagadeesh and Titman (1993) find a momentum property (3-12 months) suggesting good and bad times persist, and profits could be made. (questionable)
For fundamental analysis people question if the different ratios are just capturing returns associated with miss-specified risk measurement.
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55. Summary: What Does the Evidence Show?
Fundamental Analysis
The Conundrum:
Without fundamental analysis the markets would surely be inefficient, &
Abnormal profit opportunities would exist,
Leading to profitable fundamental analysis
Most of the findings suggest that the markets are fairly efficient, and technical analysis or fundamental analysis do not generally reap excess rewards.
In technical analysis items like filter rules don’t appear to make excess returns that outweigh the extra transaction costs.
Jagadeesh and Titman (1993) find a momentum property (3-12 months) suggesting good and bad times persist, and profits could be made. (questionable)
For fundamental analysis people question if the different ratios are just capturing returns associated with miss-specified risk measurement.
Grossman & Stiglitz AER, 1980
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56. Summary: What Does the Evidence Show?
Anomalies Exist
Small Firm in January Effect
Book to Market Ratios
Long Term Reversals
Post-Earnings Announcement Drift (Momentum)
Most of the findings suggest that the markets are fairly efficient, and technical analysis or fundamental analysis do not generally reap excess rewards.
But, be smart, use day of week effect small firm effect etc to your advantage.
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57. Behavioralism bias Motivation
Stock prices in the 1990s did not appear to match “fundamentals,” e.g., high price earnings ratios
Evidence of refusal to sell losers
Economics discipline is exploring behavioral aspects of decision making
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58. What does it all mean?
It may be an item in your toolkit but be careful relying on it too much.
Technical Analysis:
Your choices
Pick stocks yourself, based on fundamental analysis, but diversify
Beat and/or avoid the competition.
You could skip this, it is mostly a restatement of prior implications.
Better shot at beating the competition by staying with what you know.
Avoid the competition by finding stocks that are out of the limelight.
Pick one or more mutual funds
Unlikely to consistently earn + abnormal returns
Pros paying attention to market and firm conditions
Index or otherwise passively diversify.
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59. Selected Problems
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60. Problem 1
Zero, otherwise returns from the prior period could be used to predict returns in the subsequent period.
Some positive serial correlation exists.
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61. Problem 2
No. Why?
One would have to show that Intel investors earned a higher rate of return than they should have for the risk taken.
Many investors bought Intel only after its success was evident.
By chance some stocks will perform extremely well.
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62. Problem 3
No, Why?
It does not indicate investors are failing to consider current information in the price, nor does it present an abnormal return opportunity.
It could indicate information leakage or it could indicate that splits occur during price runups.
Splits occur when stock prices move up out of the desirable trading range, so it is not unusual that they occur in periods of + ARs.
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63. Problem 4
No, Why?
You won’t get + abnormal returns if the economic cycle is predictable, the news will already be incorporated in the stock’s price.
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64. Problem 5
Buy it
This is a “Value Investment” where you believe the stock will perform better than the market and if you are correct you will earn a positive abnormal return.
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65. Problem 6 The small firm in January effect
Might work, but it might not
Doesn’t hold every year
Would lead to “underdiversification”
Higher trading costs of these stocks might wipe out any gains
Since there is no solid theoretical reasoning for this the ‘extra return’ might just be a risk premium.
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66. Problem 7
Consistent, expect about half to outperform the market by chance
Violation, earn + AR by investing with last year’s winners
Probably consistent, but it depends. I might be able to use an option strategy to take advantage of this.
Book says consistent on c but might be able to use an option strategy to earn a + AR.
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67. Problem 7
Violation, you have exploitable price momentum persisting into February
Violation, the reversal offers an exploitable opportunity, namely buy last week’s losers
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68. Problem 8
Implicit in the dollar-cost averaging strategy is the notion that stock prices fluctuate around a “normal” level. Otherwise, there is no meaning to statements such as: “when the price is high.”
How do we know, for example, whether a price of $25 today will be viewed as high or low compared to the stock price six months from now?
Good disciplined investing, but studies show it doesn’t get you + ARs.
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69. Problem 9
The market expected earnings to increase by more than they actually did.
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70. Problem 10 a.
The prices of growth stocks may be consistently bid too high due to investor overconfidence.
Investors/analysts may extrapolate recent earnings (and dividend) growth too far into the future and thereby inflate stock prices, forcing poor returns eventually on growth portfolios.
At any given time, historically high growth firms may revert to lower growth and value stocks may revert to higher growth, changing return patterns, this may happen over an extended time horizon.
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71. Problem 10
Enough investors should prefer value stocks to growth stocks and bid up the prices of value stocks and drive down the prices of growth stocks until the “extra” return on the value stocks was eliminated. b.
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