The Efficient Market Hypothesis CHAPTER 11

Efficient Market Hypothesis (EMH) Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment

Figure 11.1 Cumulative Abnormal Returns Before Takeover Attempts: Target Companies

Figure 11.2 Stock Price Reaction to CNBC Reports

EMH and Competition Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information

The market price is more informative (accurate) than individual value estimates V = the true fundamental value, P = the market price, vi = value estimate of trader i; vi = V + ei, where E(ei) = 0, Di = trader i’s desired position in the security; Di = a(vi – P), where a is a constant. From ∑ Di = ∑ a(vi – P) = 0 (i.e., zero net supply), we have ∑ a(vi – P) = 0 → a∑(vi – P) = 0 → ∑(vi – P) = 0 → ∑vi – ∑P = 0 → ∑vi = ∑P = N * P → P = (1/N) ∑vi P = (1/N) ∑vi = (1/N) ∑(V + ei) = V + eM, where eM = (1/N) ∑ei ≈ 0.

Versions of the EMH Weak Semi-strong Strong

Types of Stock Analysis Technical Analysis - using prices and volume information to predict future prices Weak form efficiency & technical analysis Fundamental Analysis - using economic and accounting information to predict stock prices Semi strong form efficiency & fundamental analysis

Active or Passive Management Active Management Security analysis Timing Passive Management Buy and Hold Index Funds

Market Efficiency & Portfolio Management Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations

Event Studies Empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price Abnormal return due to the event is estimated as the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event

How Tests Are Structured Returns are adjusted to determine if they are abnormal Market Model approach a. rt = at + brmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = rt - (a + brMt)

Are Markets Efficient Magnitude Issue Selection Bias Issue Lucky Event Issue

Weak-Form Tests Returns over the Short Horizon Momentum Returns over Long Horizons

Predictors of Broad Market Returns Fama and French Aggregate returns are higher with higher dividend ratios Campbell and Shiller Earnings yield can predict market returns Keim and Stambaugh Bond spreads can predict market returns

Semistrong Tests: Anomalies P/E Effect Small Firm Effect (January Effect) Neglected Firm Effect and Liquidity Effects Book-to-Market Ratios Post-Earnings Announcement Price Drift

Figure 11.3 Average Annual Return for 10 Size-Based Portfolios, 1926 – 2006

Figure 11.4 Average Return as a Function of Book-To-Market Ratio, 1926–2006

Figure 11.5 Cumulative Abnormal Returns in Response to Earnings Announcements

Strong-Form Tests: Inside Information The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon SEC requires all insiders to register their trading activity

Interpreting the Evidence Risk Premiums or market inefficiencies—disagreement here Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets

Interpreting the Evidence Continued Anomalies or Data Mining The noisy market hypothesis Fundamental indexing

Stock Market Analysts Do Analysts Add Value Mixed evidence Ambiguity in results

Mutual Fund Performance Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns Style changes May be risk premiums Hot hands phenomenon

Figure 11.7 Estimates of Individual Mutual Fund Alphas, 1972 - 1991

Table 11.1 Performance of Mutual Funds Based on Three-Index Model

Figure 11.8 Persistence of Mutual Fund Performance

Table 11.2 Two-Way Table of Managers Classified by Risk-Adjusted Returns over Successive Intervals