1. Practical Investment Management
CHAPTER TEN
MARKET EFFICIENCY
Practical Investment Management
Robert A. Strong

2. The Efficient Market Hypothesis
Outline
The Efficient Market Hypothesis
Types of Efficiency
Degrees of Informational Efficiency
The Semi-Efficient Market Hypothesis
Security Prices and Random Walks

3. Outline Anomalies The Low PE Effect Low-Priced Stocks
The Small Firm and Neglected Firm Effects
Market Overreaction
The January Effect
The Weekend Effect
The Persistence of Technical Analysis
Final Thoughts

4. The Efficient Market Hypothesis
Types of Efficiency
Operational efficiency is a measure of how
well things function in terms of speed of execution and accuracy.
Informational efficiency is a measure of how
quickly and accurately the market reacts to new information.
The efficient market hypothesis (EMH) deals
with informational efficiency.

5. The Efficient Market Hypothesis
ASSUMPTIONS:
Investors are rational and value securities in a rational manner.
To the extent investors are not rational, they trade randomly, so irrationalities tend to cancel each other out.
To the extent that investors are not randomly irrational, they are met in the marketplace by rational arbitrageurs, who eliminate any remaining irrational pricing elements.

6. The EMH: Degrees of Informational Efficiency
Weak Form Efficiency
This least restrictive form of the
EMH states that future stock prices cannot be predicted by analyzing prices from the past.
In other words, the current stock price fully
reflects any information contained in the past series of stock prices.

7. The EMH: Degrees of Informational Efficiency
Insert Figure 10-1 here.

8. The EMH: Degrees of Informational Efficiency
Insert Figure 10-2 here.

9. Tests of Weak Form Efficiency
autocorrelation tests
filter rule tests
An autocorrelation test investigates whether
security returns are related through time. A runs test, for example, measures the likelihood that a series of two variables is a random occurrence.
A filter rule is a trading rule regarding the
actions to be taken when shares rise or fall in value by x%. Filter rules should not
work if markets are weak form efficient.

10. Tests of Weak Form Efficiency
Insert Table 10-3 here.

11. Tests of Weak Form Efficiency
Insert Table 10-4 here.

12. The EMH: Degrees of Informational Efficiency
Semistrong Form Efficiency
Semistrong form efficiency states
that security prices reflect all publicly available information.
Event studies involving phenomena
occurring at known points in time, such as a stock split or the announcement of corporate earnings, are frequently used in tests of the semistrong form of market efficiency.

13. The EMH: Degrees of Informational Efficiency
Strong Form Efficiency
This most extreme version of the
EMH states that security prices fully reflect all relevant public and private information.
Evidence does not support strong form EMH.
Insiders can make a profit on their knowledge, and people go to jail, get fined, or get suspended from trading for
doing so.

14. The Efficient Market Hypothesis
The essence of the semi-efficient market
hypothesis is the notion that some stocks are priced more efficiently than others. This idea is sometimes used in support of the thesis that the market has several tiers.
The random walk idea states that
news arrives randomly, not that stock prices move randomly.

15. Anomalies
The low PE effect : Some evidence indicates
that low PE stocks outperform higher PE stocks of similar risk.
Low-priced stocks : Many people believe that
the price of every stock has an optimum trading range.
The small firm effect : Small firms seem to
provide superior risk-adjusted returns.

16. Anomalies
The neglected firm effect : Neglected firms
seem to offer superior returns with surprising regularity.
Market Overreaction : It is observed that
the market tends to overreact to extreme news. So, systematic price reversals can sometimes be predicted.
The January effect : In January, stock returns
are inexplicably high, and small firms’ stocks do better than large firms’.

17. Anomalies
The weekend effect : It is observed that security price changes tend to be negative on Mondays and positive on the other days of the week, with Friday being the best of all.
The persistence of technical analysis : If the EMH is true, technical analysis should be useless. Each year however, an immense amount of literature based in varying degrees on the subject is printed.

18. Anomalies
From the individual investor’s perspective, the US capital markets are informationally and operationally quite efficient. Still, much is not yet known about asset pricing, resulting in a fair, but complicated financial battleground.
Final thoughts

19. The Efficient Market Hypothesis
Review
The Efficient Market Hypothesis
Types of Efficiency
Degrees of Informational Efficiency
The Semi-Efficient Market Hypothesis
Security Prices and Random Walks

20. Review Anomalies The Low PE Effect Low-Priced Stocks
The Small Firm and Neglected Firm Effects
Market Overreaction
The January Effect
The Weekend Effect
The Persistence of Technical Analysis
Final Thoughts