FIN 352 – Professor Dow

 Fama: Test the efficient market hypothesis using different information sets.  Three categories:  Weak  Semi-Strong  Strong  Some tests directly use this categorization, others do not.

 All past-price information is fully reflected in stock prices.  Can’t use past prices to forecast future prices.  If true, technical analysis is not useful.

 All public information is fully reflected in stock prices.  If true, fundamental analysis is not useful.

 All information is reflected in stock prices.  Implies that trading on insider information shouldn’t be profitable.  Not true  But not legal

 A) Patterns in stock prices.  B) Back-testing trading rules.  C) Do categories of stocks earn abnormal returns?  D) Event studies.  E) Do stock prices move “too much?”  F) Bubbles.  G) Do some investors outperform the market?

 Serial Correlation > 0, Momentum  Serial Correlation < 0, Mean Reversion  Serial Correlation = 0, Random Walk  Weak Form EMH predicts random walk

 See if trading rules are profitable when applied to historical stock price data.  Data Mining  In-Sample vs. Out-of-Sample

 Value stocks  Small stocks  Or is it microcap/neglected stocks?  Is it is risk premium?

 Abnormal returns: Stocks earn greater returns than they “should”: R i – E(R)  Theory implies that stocks should earn abnormal returns when news first comes out, but not afterwards (stock prices are quick to adjust to news)  Book gives example where they use excess returns (R i -R m ) to measure response to event. Response is slower than it should be.

 Increases in asset prices not justified by “fundamentals”  At some point, bubbles pop!  Shouldn’t have bubbles if markets are efficient.  Recent experience with real estate and stock price bubbles.

 Theory: Stock price is the present value of expected future dividend payments.  Stock prices shouldn’t vary more than dividends or earnings do.  But there is more variation  Similar idea to bubbles: stock prices move based on psychological reasons rather than fundamental reasons.

 Why do some investors do well?  Luck  Higher risk  Skill  Mutual funds tests

 Markets are broadly efficient, but some important exceptions.  Bubbles  Some people understand the economy better – but do you?

 Build around index funds: Well-diversified and low cost  Do bubbles imply market timing?  Do you want to engage in fundamental analysis?