The Theory of Stock Market Efficiency: Accomplishments and Limitations Haoyue Guan Yulu Hou Longyu Chen Group 2 Fin 680 Introduction: Chen

Summary Market efficiency has been researched for over 50 years. Basic idea of market efficiency: competition causes information to change; reflected in stock price quickly. The research of market efficiency helped develop many financial theories, which has accomplishments and limitations. Rain

The idea that markets are “efficient” Eugene Fama defined “market efficiency” first in 1965 as: “A market where there are large numbers of rational, profit- maximizers actively competing, with each trying to predict future market value of individual securities, and where important current information is almost freely available to all participants. On the average, competition will cause the full effects of full information on intrinsic values to be reflected “instantaneously” in actual price.” Rain

Accomplishments of the theory of stock market efficiency Event time (by FFJR in 1969): stock market reaction to stock behavior. Usually, stock split is good news to investors. Studies show 72% of splitting firms announced dividend increases in the year after splitting. New public stock associated with 3% immediate drop of price. Rain

Influencing the climate for other financial economic theories Early work in market efficiency helped developed three financial theories: The Miller-Modigliani theories of corporate financial theory in 1958 CAPM in 1964 Black-Scholes option pricing model in 1973 Rain

Limitation in the theory of efficient markets Failure to explain certain aspects of share price behavior Flaw in efficiency as a model of markets Problems in testing the efficiency model Rose

Empirical Anomalies Price overreactions Excess volatility (Robert Shiller) Price underreaction to earnings The failure of CAPM to explain returns [E(R) = Rf + B (Rm - Rf)] The explanatory power of Non-CAPM factors Seasonal patterns (weekend effect) Rose

Flaw in efficiency as a model of markets Heterogeneous information and beliefs (F.A. Hayek, 1945) A brief digression on the role of security analysts Failure to consider transactions costs (Michael Jensen, 1989) Market microstructure effects Rose

Problems in testing “efficiency” as a model of stock markets E(R) = Rf + B (Rm - Rf) Change in riskless rates and risk premiums Trends in rates and market risk premiums Changes in betas Seasonal patterns in betas Chen

Is “Behavioral” finance the answer? ----- The limitations of efficient markets theory Behavioralists argue that stock price “corrections” and cycles reflect systematic biases in how investors use information. Investors are said to place too much weight on current information, focusing myopically on short-term earnings. The author doesn’t think so. The profit opportunities created by such alleged investor myopia seem grossly inconsistent with competitive markets. Behavioral finance has anomalies of its own. Chen

Concluding observations Are stock market efficient? Yes and no. The research provides insights into stock price behavior that were previously unimaginable. As research has come to show, the theory of efficient markets is, like all theories, an imperfect and limited way of viewing stock markets. The issue will be impossible to solve conclusively while there are so many binding limitations to the asset pricing models that underlie empirical tests of market efficiency. Chen