1. The Efficient Market Hypothesis
Chapter 8
The Efficient Market Hypothesis
McGraw-Hill/Irwin
Copyright © by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. 8.1 Random Walks and the Efficient Market Hypothesis

3. Efficient Market Hypothesis (EMH)
Do security prices accurately reflect information?
Informational Efficiency
_____________________________________
Allocational Efficiency
Gold and the _______________________.
Huge implications concerning the answers to these questions.
Are price changes consistently predictable?
accurately
reflect the cash flows
Are prices correct in that they ____________ ________________________ associated with the security?
greater fool theory

4. Implications of Efficiency
Allocational efficiency
If markets are not allocationally efficient then perhaps there is a ________________________ ___________ in capital markets.
role for greater government
intervention
Possible rules changes to attempt to improve allocational efficiency
Tax on trading activity
More taxes on short holding period returns
Changes in corporate compensation

5. Implications of Efficiency
Informational efficiency
If markets are not informationally efficient
Investors may not be able to trust that market prices are up to date and investors should then conduct their own research (or hire a researcher) to validate the price.
Privileged groups of investors will be able to consistently take advantage of the general public.
Active strategies should outperform passive strategies.

6. Implications of Efficiency
Informational efficiency
If markets are not informationally efficient
Corporations have to rethink their goals and how best to achieve them.
Maximize shareholder wealth  maximize share price, so how does one go about maximizing shareholder wealth in this case?
Lack a benchmark to evaluate corporate decisions.

7. EMH and Competition
Competition among investors should imply that stock prices fully and accurately reflect publicly available information very quickly. Why?
Once information becomes available, market participants quickly analyze it & trade on it & frequent, low cost trading assures prices reflect information.
Questions arise about efficiency due to:
Unequal access to information
Structural market problems
Psychology of investors (Behavioralism)

8. Random Price Changes Why are price changes random?
In very competitive markets prices should react to only NEW information
Flow of NEW information is random
Therefore, price changes are random
Idea that stock prices follow a “Random Walk”

9. Random Walk and the EMH
Random Walk: stock price ______________________
Stock prices actually follow a ____________________
changes are unpredictable
A “pure” random walk implies informational efficiency
submartingale process
Expected price change is positive over time
But random changes are superimposed on the positive trend
E(pricej,t) > E(pricej,t-1) t = time period

10. Random Walk with Positive Trend
Security
Prices
Evidence on Random Walk idea
Time

11. Forms of the EMH Prices reflect all relevant information
Vary the ________________
Weak
information set
The relevant information is historical prices and other trading data such as trading volume.
If the markets are weak form efficient, use of such information provides no benefit “at the margin.”

12. Forms of the EMH Prices reflect all relevant information
Vary the information set:
Semi-strong
The relevant information is "all publicly available information, including past price and volume data."
If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin.

13. Forms of the EMH Prices reflect all relevant information
Vary the information set:
Strong
The relevant information is “all information” both public and private or “inside” information.
If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin.
SEC Rule 10b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported.

14. Relationships between forms of the EMH
Notice that _______________________________ __________________ (but ________________)
Strong form efficiency would imply that __________________________________________.
semi-strong efficiency implies weak
form efficiency holds
NOT vice versa
both semi-strong and weak form efficiency hold

15. 8.2 Implications of the EMH (for Security Analysis)

16. Types of Stock Analysis & Relationship to the EMH
Technical Analysis:
If the markets are weak form efficient or semi-strong form efficient or strong form efficient will technical analysis be able to consistently predict price changes?
Technical Analysis or TA is using prices and volume information to predict future price changes
TA assumes prices follow predictable trends

17. Basic Types of Technical Analysis
Support and resistance levels
Support level:
A price level below which it is supposedly unlikely for a stock or stock index to fall.
Resistance level:
A price level above which it is supposedly unlikely for a stock or stock index to rise.
A resistance level may arise at say $31.25 if a stock repeatedly rises to $31.25 and then declines, indicating that investors are reluctant to pay more than this price for the stock.
A stock price above $31.25 would then indicate a 'breakout' which would be a bullish signal.

18. Types of Stock Analysis & Relationship to the EMH
Fundamental Analysis:
If the markets are weak form efficient or semi-strong form efficient or strong form efficient will fundamental analysis be able to consistently predict price changes?
using economic and accounting information to predict stock price changes

19. Fundamental Analysis
Fundamental analysis assumes that stock prices should be equal to
Fundamental analysis is thus the
the discounted value of the expected future cash flows the stock is expected to provide to investors.
“art” of identifying over- and undervalued securities based on an analysis of the firm's financial statements and future prospects.

20. Fundamental Analysis
Fundamental analysis varies in technique but generally focuses on
forecasting the firm's future dividends or earnings,
discounting those future cash flows by the required rate of return (usually obtained from the CAPM),
and comparing the resulting estimated price with the current stock price.

21. Fundamental Analysis greater
If the estimated price is ______ than the current price an investor should ___ the stock since it is ___________ and since its price should ________ to the "true" or "fundamental" value uncovered by the analyst.
If the estimated price is ____ than the current price the stock should be ____ because the stock is currently __________ by the market.
In either case if the analyst is correct the investor should receive an ________________.
buy
greater
undervalued
increase
less
sold
overvalued
“abnormal return”

22. Fundamental Analysis
Forecasts already exist and for FA to add value, your forecast must be better than the consensus forecast.
Not enough to find a good company, you must find a company that is better than others believe, i.e., mispriced.

23. Implications of Efficiency for Active or Passive Management
Assumes inefficiency, use technical and/or fundamental analysis to pick securities
Active Management
Passive Management
Security analysis
Timing strategies
Investment Newsletters
Consistent with semi-strong efficiency
Buy and Hold portfolios
Index Funds

24. Market Efficiency and Portfolio Management
Even if the market is efficient a role exists for portfolio management
Identify risk & choose appropriate risk level
Tax considerations
Other considerations such as liquidity needs or diversify away from the client’s industry.

25. 8.3 Are Markets Efficient?

26. Average Annual Returns for 10 size-based portfolios, 1926-2007
Results are driven by returns in the first two weeks of January
May be related to higher ESTIMATION risk of smaller firms
Extra return may be more apparent than real due to higher trading costs and illiquidity

27. Average Returns as a Function of the Book-To Market Ratio, 1926 to 2007
Value Stock premium return
Distressed and out of favor stocks?

28. Bubbles and Market Efficiency
Periodically stock prices appear to undergo a ‘speculative bubble.’
A speculative bubble is said to occur if prices do not equal the intrinsic value of the security.
Does this imply that markets are not efficient?
Very difficult to predict if you are in a bubble and when the bubble will burst.
Stock prices are estimates of future economic performance of the firm and these estimates can change rapidly.
Risk premiums can change rapidly and dramatically.

29. Summary: What Does the Evidence Show?
Technical Analysis (TA)
Stocks do not follow a pure random walk, so there is hope for technical trading strategies.
Most TA rules utilize short term trading strategies that generate excessive transaction costs and are not profitable.
There appears to be some long term trend reversals.

30. Summary: What Does the Evidence Show?
Fundamental Analysis
Appears to be difficult to consistently generate abnormal returns using fundamental analysis.
This is because the analysis/investment industry is so competitive and volatility is high.
May help you avoid seriously overvalued investments.

31. Summary: What Does the Evidence Show?
Fundamental Analysis
The Conundrum:
Without fundamental analysis the markets would surely be inefficient, &
Abnormal profit opportunities would exist,
Leading to profitable fundamental analysis
Grossman & Stiglitz AER, 1980

32. Summary: What Does the Evidence Show?
Anomalies Exist
Small Firm in January Effect
Book to Market Ratios
Long Term Reversals
Post-Earnings Announcement Drift (Momentum)

33. Behavioralism bias Motivation
Stock prices in the 1990s did not appear to match “fundamentals,” e.g., high price earnings ratios
Evidence of refusal to sell losers
Economics discipline is exploring behavioral aspects of decision making

34. What does it all mean?
It may be an item in your toolkit but be careful relying on it too much.
Technical Analysis:
Your choices
Pick stocks yourself, based on fundamental analysis, but diversify
Beat and/or avoid the competition.
Pick one or more mutual funds
Unlikely to consistently earn + abnormal returns
Pros paying attention to market and firm conditions
Index or otherwise passively diversify.

35. Selected Problems

36. Problem 1
Zero, otherwise returns from the prior period could be used to predict returns in the subsequent period.
Some positive serial correlation exists.

37. Problem 2
No. Why?
One would have to show that Intel investors earned a higher rate of return than they should have for the risk taken.
Many investors bought Intel only after its success was evident.
By chance some stocks will perform extremely well. 37

38. Problem 3
No, Why?
It does not indicate investors are failing to consider current information in the price, nor does it present an abnormal return opportunity.
It could indicate information leakage or it could indicate that splits occur during price runups. 38

39. Problem 4
No, Why?
You won’t get + abnormal returns if the economic cycle is predictable, the news will already be incorporated in the stock’s price. 39

40. Problem 5
Buy it
This is a “Value Investment” where you believe the stock will perform better than the market and if you are correct you will earn a positive abnormal return. 40

41. Problem 6 The small firm in January effect
Might work, but it might not
Doesn’t hold every year
Would lead to “underdiversification”
Higher trading costs of these stocks might wipe out any gains
Since there is no solid theoretical reasoning for this the ‘extra return’ might just be a risk premium. 41

42. Problem 7
Consistent, expect about half to outperform the market by chance
Violation, earn + AR by investing with last year’s winners
Probably consistent, but it depends. I might be able to use an option strategy to take advantage of this.
Book says consistent on c but might be able to use an option strategy to earn a + AR. 42

43. Problem 7
Violation, you have exploitable price momentum persisting into February
Violation, the reversal offers an exploitable opportunity, namely buy last week’s losers 43

44. Problem 8
The market expected earnings to increase by more than they actually did. 44

45. Problem 10 a.
The prices of growth stocks may be consistently bid too high due to investor overconfidence.
Investors/analysts may extrapolate recent earnings (and dividend) growth too far into the future and thereby inflate stock prices, forcing poor returns eventually on growth portfolios.
At any given time, historically high growth firms may revert to lower growth and value stocks may revert to higher growth, changing return patterns, this may happen over an extended time horizon. 45

46. Problem 10
Enough investors should prefer value stocks to growth stocks and bid up the prices of value stocks and drive down the prices of growth stocks until the “extra” return on the value stocks was eliminated. b. 46