The Efficient Market Hypothesis Chapter 8

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

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?

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.

Stock Price Reaction to CNBC Reports

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?

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

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

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.

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

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

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

Types of Efficient Markets Strong Semi-Strong Weak

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

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

Head and Shoulders

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

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

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.

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.

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

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

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

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

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

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

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

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

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).

CARs Around Earnings Announcements

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.

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.

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

Figure 8.8 Persistence of Mutual Fund Performance

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

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

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

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

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

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.