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. 4

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

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? 6

Why are price changes random? Prices react to unexpected information Unexpected information arrives randomly  If there was a pattern it would be anticipated information The random arrival of unexpected information causes prices to move randomly

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

10 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

11 Types of Efficient Markets Weak Semi-Strong Strong

12 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

13 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

14 Head and Shoulders

Why Technical Analysis Fails -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 Stock Price Time Sell Buy

17 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.

20 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 21

Who can earn abnormal returns, if the market is ____ Efficient? WeakSemi-StrongStrong Chartist Fundamental Analyst Insiders

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 Active Management: Believes the market is not perfectly efficient → Hunts for mispricing  An expensive strategy  Suitable only for very large portfolios Efficient Markets imply that Active cannot dominate Passive

11-24 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

25 Event Studies: Dividend Omissions Efficient market response to “bad news”

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.

27 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

28 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

There are Some Anomalies The most puzzling anomalies are price-earnings, small-firm, market-to-book, momentum, and long- term reversal.  Fama and French argue these are due to risk  Lakonishok, Shleifer, and Vishney argue evidence of inefficiency Anomalies or data mining?  Some 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.

Efficient Markets & Portfolio Management Regardless of your view on EMH there is a role for portfolio management:  Diversification  Appropriate risk level  Tax considerations  Picking stocks (if markets are inefficient)

32 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.