1. Market Efficiency
Chapter 9

2. Recapping MPT
Modern portfolio theory (MPT) is based on the logic that all investors are risk-averse.
Investors desire a sure thing over uncertainty.
From a practical standpoint – investors who believe in MPT and the efficient market hypothesis generally invest their assets in a diversified portfolio of securities (index mutual funds/ETFs) and the risk-free rate (cash/money markets).

3. Opponents of MPT Not every investor believes in an efficient market.
Investors frequently site examples where their “method” of investing “beat the market”.
For accusations like these – the EMH practitioner would likely respond with two simple statements: 1) risk and 2) luck.

4. Risk and luck
EMH investors readily agree that the “market” can be beaten by taking on more risk.
EMH investors also think that literally “anyone” has the opportunity to “beat the market” on average 50% of the time (just by sheer luck).
However – the EMH investor believes you have an equal chance of falling below the market.

5. Introduction to market efficiency
Market efficiency is the most controversial (and intriguing) issue in investments.
Analysts have been debating it for years, and will continue…
The central issue to market efficiency is:
Can you (or anyone else) consistently “beat the market”?

6. Foundations of market efficiency
Three economic forces lead to market efficiency:
Investor rationality
Independent deviations from rationality
Arbitrage

7. Investor rationality
“Rational” means that investors do not systematically overvalue or undervalue financial assets in light of the information they possess.
If every investor makes rational investment decisions, earning an excess return would be difficult (or impossible).
If everyone is rational, no bargains would be there to be had, because relative prices would all be correct.

8. What if all investors are not rational?
The market would still be efficient (or at least mostly efficient).
Suppose some investors are irrational – if that is the case then some will be optimistic and some will be pessimistic, therefore the net effect might be canceled out.
Therefore “independent deviations from rationality” still imply an efficient market.

9. What if many investors are irrational?
The market would still be efficient (or at least mostly efficient).
If there are many irrational investors, then observed market prices could be too high or too low relative to risk, but if there are ANY rational investors, then the rational investors would recognize the arbitrage opportunities and capitalize on them – and dominate them.
As long as some rational investors are faster than you, then you have little opportunity to beat the market.

10. Forms of market efficiency
A market is efficient with respect to some particular information.
Will knowledge of baseball stats be of use to you in beating the market?
If not, then the market is efficient when it comes to baseball stats.
Will knowledge of an impending corporate takeover be of use to you in beating the market?
If so, then the market is not efficient when it comes to this knowledge.

11. The three forms of market efficiency
Three general types of market efficiency.
Notice the three forms of market efficiency are nested – that is the information in the strong form includes the information in the semi-strong form – and so on.

12. The weak form
The weak form of market efficiency states that information reflected in past prices and volume figures is of no value in beating the market.
If you believe the market is weak form efficient, then technical analysis (charting) is of no use whatsoever.

13. The semi-strong form
The semi-strong form of market efficiency states that publicly available information of any and all kinds is of no use in beating the market.
If you believe in the semi-strong from then fundamental analysis (studying past price and volume data & studying earnings and growth forecasts) is useless.

14. The strong form
The strong form of market efficiency states that no information of any kind, public or private is useful in beating the market.
If you believe in strong form efficiency, then ignoring the issue of legality, possessing non-public inside information is useless when it comes to beating the market.
Clearly – the market is not strong form efficient. The debate is over weak and semi-strong form efficiency.

15. Why would markets be efficient?
Competition and the motive to earn profits.
Using the most advanced information possible, investors constantly try to identify superior- performing investments.
This constant appraisal and subsequent trading activity (as well as the research behind these activities) act to ensure that prices never differ much from their efficient market price.

16. The incentive to identify superior performance
Consider the Growth Fund of America from American Funds:
Approximately $150 billion under management.
Suppose American Funds (through its research) could improve the performance of the fund by 10 basis points for one year.
A basis point equals 1 percent of 1 percent – so we are talking about X $150,000,000,000 or $150 million.
Thus, American Funds would be willing to spend up to $150 million to boost performance by 10 bps.
There is tremendous incentive...

17. Testing market efficiency (professional money managers)
The performance of professional money managers is generally quite poor relative to simply investing in a market index (S&P 500, Russell 2000, etc.).
The performance of the professionals declines the longer the investment period
The performance of professionals is especially troublesome when we consider the enormous resources at their disposal and the substantial survivorship bias that exists.

18. Testing market efficiency (event studies)
Proponents of EMH state that the reactions of traders instantaneously adjust the market to any new information.
However, a popular retort among active traders is that the market frequently over or under-reacts to new information.
This can be tested using an event study.

19. Event studies – Possible market reactions

20. Another possibility
Some event studies seem to show that prices anticipate the event. Insider trading?

21. Informed traders and “insider trading”
An “insider” is anyone who possesses material nonpublic information.
Information not known to the public – and if it were known, it would impact stock price
It is illegal when a person acts on this information in an attempt to make a profit.
The SEC prosecutes – but it is actually quite difficult for them to prove guilt.
However, they are successful from time to time.

22. Are markets efficient?
Financial markets are one of the most extensively documented human endeavors, so you would think we would know. But we don’t.
There are several factors that make testing market efficiency difficult.
The risk adjustment problem
The dumb luck problem
The data dredging (ghosts in the data) problem

23. What do we know about market efficiency?
Short-term stock price and market movements appear to be very difficult, or even impossible, to predict with any accuracy.
The market reacts quickly to new (unanticipated) information and there is very little chance that the market under reacts or overreacts in a way that can be profitably exploited.
If the stock market can be beaten, the way to do it is (at least) not obvious, so the implication is that the market is not grossly inefficient.

24. Market anomalies
The continuing effort to discover methods to take advantage of market inefficiencies has uncovered several anomalies.
Market anomalies are predictable abnormal returns and can be interpreted as known deviations of efficiency.
Anomalies shouldn’t be counted on as a trading strategy.
They are small
They are fleeting

25. The earnings announcement puzzle
Earnings announcements by companies contain info about past earnings and future earnings potential.
According to EMH, prices should then adjust very quickly to the earnings “surprise”.
However, some research shows it takes days for the market price to adjust fully.
Some research has found it is a profitable strategy to buy stocks after positive earnings surprises.

26. The day of the week effect
In the stock market, which day of the week has, on average, the biggest return?
Monday right? (24 hours of growth versus 72 hours)
Actually – Monday is the worst day & Friday is the best
Some researchers think investors are just more optimistic facing a weekend (but this should not have an impact in an efficient market).
Average daily S&P returns, by day of the week

27. Monthly returns of small stocks minus monthly returns of large
The January effect
More specifically – the “small stock in January especially around the turn of the year for losers effect” – or SSIJEATTOTYFLE.
This one is partially understood:
Tax loss selling
Institutional investors
Monthly returns of small stocks
minus monthly returns of large
stocks

28. The small size effect
Small-capitalization stocks tend to provide investors with a greater risk-adjusted return than mid-cap and large-cap stocks.
This abnormal risk-adjusted return takes into consideration the fact that small-cap stocks are naturally more volatile than larger firms, and investors should be compensated for taking on the additional risk.
What some studies have found is that investors are compensated more than they should be for the risk taken in a small-cap stock.

29. The price-earnings anomaly
The P/E ratio is widely followed by investors and used in stock valuation.
Research shows that, on average, stocks with relatively low P/E ratios outperform those with relatively high P/E ratios.
According to EMH, the P/E is publicly available and should already be worked into the stocks price; nevertheless, some research shows that buying low P/E stocks is a positive investment strategy

30. The Fama & French three factor model
The impact of size and value on investment returns was pioneered by two very well-known finance researchers, Eugene Fama and Kenneth French.
In fact, together they created a model that expands on the CAPM. They contend that by adding size and value factors to the market risk factor of the CAPM, that you greatly increase the evaluative capacity of the model.
Market risk (as measured by beta)
Company size (smaller companies tend to outperform)
P/E (lower P/E firms tend to outperform)
From a practical standpoint, the three factor model basically states that portfolios that are heavy in small-cap and/or value stocks would provide a greater risk adjusted return than other portfolios along the efficient frontier.