1. How Efficient Is the Market?
Efficient Market Hypothesis (EMH)
Random Walk Hypothesis
Forms of EMH
Implications of EMH
Predictability
Anomalies
Professional Management

2. Efficient Market Hypothesis
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Efficient Market Hypothesis
Definition
Prices of securities fully reflect all available information about these securities
Question
Is a $20 bill you find while walking down a busy street worth $20?
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3. Random Walk Hypothesis
Tracing the evolution of several economic variables  predict stock prices?
Kendall (1953)  no predictable patterns
Random Walk
Stock prices are random
More precisely
Expected return is positive over time
Positive trend and random around the trend
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4. Random Walk Hypothesis
Positive Trend with random fluctuation
Security
Prices
Time
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5. Efficient Markets and Random Walk
Stock prices fully and immediately reflect all available information
Once information becomes available, market participants analyze it
Competition assures that prices reflect all available information
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6. Forms of EMH Meaning of all available information Weak Form
Information contained in market trading data
Past prices, volumes, interest rate, CPI, etc.
Technical analysis (e.g. trend-chasing or “charting”) is irrelevant
Semi-strong Form
All publicly available information
All earnings forecasts, accounting information
Fundamental analysis is irrelevant
Strong Form
All information relevant to the firm including insider information
Insider Trading
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7. More on Fundamental Analysis
Stock price should be equal to discounted value of expected future cash flow!
Information used
Earnings and dividend forecasts
Future interest rate forecasts
Firm risk evaluation
Process
Step 1: examine past earnings and company balance sheets
Step 2: evaluation of quality of the firm’s management, firm’s standing in its industry, and prospects of the industry
Step 3: determine the present discounted value of all the payments to a shareholder
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8. Forms of EMH Strong Form Set Semi-strong Form Set Weak Form Set
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9. Fundamental vs. Technical Analysis
Is it like
astronomy vs. astrology?
Depends if you believe in EMH...
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10. Implications of EMH Active Management (against EMH?)
Stock picking (security analysis)
Market Timing
Economically feasible only for managers of large portfolios
Do even large mutual funds have the ability to uncover mispriced securities?
Passive Management (for EMH?)
A well-diversified portfolio
Buy and hold strategy
Index Funds
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11. Implications of EMH Role of Portfolio Management
Diversification
Idiosyncratic risk should be diversified away at a minimal cost
Appropriate risk level
Provide the systematic risk level that investors can tolerate
Tax considerations
Growth vs Income stocks, munis vs Treasuries
Other considerations
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12. Are Markets Efficient? EMH implies Empirical tests of the hypothesis
A great deal of portfolio managers’ activities (the search for mispriced securities) is wasted effort
Active management may hurt clients because of costs and imperfectly diversified portfolios
Not hailed by professional portfolio managers
Empirical tests of the hypothesis
Tests of predictability in stock returns (weak EMH)
Testing some trading rules (weak EMH)
Event studies (semi-strong EMH)
Studying insider trades (strong EMH)
Assessing performance of professional managers
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13. Predictability – Short-Term
Auto (serial) correlation
Return correlation of two consecutive periods
Returns over short horizons (monthly or less)
Lo, Mamaysky and Wang (2000, JF)
Technical trading offers excess return
Lehman (1990, QJE), Conrad and Kaul (1988, JB), Lo and MacKinlay (1988, RFS)
Positive short-term correlation
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14. Predictability – Intermediate-Term
Returns over intermediate horizons (3-12 mon)
Jagadeesh and Titman (1993, JF)
Stocks exhibit a momentum property in which good or bad recent performance continues
Performance of individual stocks
Highly unpredictable
Portfolios of the past winners appear to outperform portfolios of the past losers.
Momentum strategy:
Long on winners and short on losers (still works)
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15. Predictability – Long-Term
Returns over long horizons (multi-years)
DeBondt and Thaler (1985, JF)
Negative long-term serial correlation over long horizons (5-year prediction, 3-year estimation)
Stocks exhibit a price-reversal property in which good or bad recent performance reverses
Fama and French (1988, JF)
Contrarian profits reflect time-varying risk premium
Contrarian strategy:
Long on losers and short on winners
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16. Anomalies Small-firm-in-January effect
Stocks of small firms have earned abnormal returns, primarily in the month of January
Neglected-firm effect and liquidity effects
The tendency of investments in stock of less well-known firms to generate abnormal returns
Book-to-market ratios
The higher the book-to-market ratio, the higher returns
P/E effect
Portfolios of low P/E stocks exhibit higher average risk-adjusted returns than high P/E stocks
Closed-end fund puzzle: Price < NAV
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17. Royal Dutch vs. Shell – Where Is Arbitrage?
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18. Why Do Anomalies Happen?
Limits to arbitrage
Fundamental risk in exploiting arbitrage opportunities
Implementation costs
Models risk (i.e. a model not properly accounting for risk)
Liquidity issues and non-traded assets
Behavioral effects
Overconfidence
Mental accounting
Prospect theory
etc…
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19. Event Studies Cumulative Abnormal Return (CAR) Market Model approach
Non-event time: run rit = ai + bi rmt + eit
Event time:
Excess Return = (Actual - Expected)
eit = Actual - (ai + bi rmt)
CARt = e-T+ e-T+1 +…+et
CAR -T t +T
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20. Event Studies – CAR for Target Companies before Takeover Attempts
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21. Anomalies after Earnings Announcements
Foster, Olsen, and Shevlin (1984, Accounting Review)
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22. Professional Management
Some evidence of persistent positive and negative performances
Potential measurement error for benchmark returns
Style changes
Risk premiums
Superstar phenomenon
or statistical outliers?..
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23. Persistence of Mutual Fund Performance
Carhart (1997, JF) - not much of a long term persistence!
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24. Wrap-up What is an efficient market? What is the weak form of EMH?
What is the semi-strong form of EMH?
What is the strong form of EMH?
What is the evidence of predictability?
What is the relationship between an anomaly and EMH?
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