CHAPTER 11

THE EFFICIENT MARKET HYPOTHESIS

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Outline of the Chapter

What is the Efficient Market Hypothesis? Versions of the EMH Methods employed to identify underpriced securities Event studies Empirical Tests of EMH
Weak-form Semistrong-form

Mutual fund and analyst performance

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Random Walks and the Efficient Market Hypothesis

Efficient Market Hypothesis (EMH): stock prices already reflect all the available information
Stock prices should follow a random walk Price changes should be random and unpredictable
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Random Walks and the Efficient Market Hypothesis (Continued)

Stock prices fully and accurately reflect publicly available information. Once information becomes available, market participants analyze it. Competition assures prices reflect information. Degree of efficiency differs across various markets.
Emerging markets, and small stocks are less intensively analysed so the stocks in emerging markets and the small stocks may be less efficiently priced.
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Random Walks and the Efficient Market Hypothesis (Continued)

There are three forms of efficiency which differ by their notions of what is meant by the term all available information.
Weak-form efficiency indicates that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices and trading volume.
In a weak-form efficient markets if historical data such as past prices conveys an information related to the future it has to be known by the all investors and caused an immediate change in the stock prices.
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Random Walks and the Efficient Market Hypothesis (Continued)

Semistrong-form efficiency indicates that all publicly available information regarding the prospects of a firm must be already reflected in the stock price.
Information includes past prices, fundamental data on the firms product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices.

Strong-form efficiency states that stock prices reflect all information relevant to the firm, even including information available only to company insiders.
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Random Walks and the Efficient Market Hypothesis (Continued)

If an investor earns abnormal returns by using historical data then the market is _______ If an investor earns abnormal returns by using publicly available information then the market is_________.
If an investor earns abnormal returns by using private information (inside information) then the market is ____________.
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Implications of the EMH

Technical Analysis:
Search for repeating and predictable patterns in stock prices. Technical analysts study records or charts of past stock prices to find patterns they can exploit to make profit. Key assumption is that stock prices respond slowly to the changes in the supply and demand factors.
Prices of stocks do not change that quickly

Using stock prices and volume information to predict future prices Technical analysis should not work even in a _________

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Implications of the EMH (Continued)

Technical Analysis (Continued)
Trends and Corrections
Trying to find the trends in stock prices. Searching for the momentum, tendency for rising asset prices to raise further. Methods employed:
Dow Theory, Moving Averages, Breadth

Sentiment Indicators
Methods employed:
Trin Statistic, Confidence Index, Put/Call Ratio

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Implications of the EMH (Continued)

Dow Theory

Three factors affect the stock prices according to this theory.

Primary trend: long-term movement of prices Secondary (intermediate) trends: short-term deviations of prices from the underlying trend Tertiary (minor) trends: daily fluctuations

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Implications of the EMH (Continued)

Dow Theory (Continued)
Efficient Market Hypothesis says that if there is a pattern investors would try to use this and make profit

Moving Averages
Average level of the index (stock price) over a given interval of time (e.g. 52 weeks)

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Implications of the EMH (Continued)

Moving Averages (Continued)
When moving average line cuts the stock prices line from below it is time to _________. When moving average line cuts the stock prices line from above it is time to ___________.

Breadth
A measure of the extens to which movement in a market index is reflected in the price movements of all the stocks in the market. Spread=number of stocks those prices increased-number of stocks those prices decreased
If advances are larger than declines then the market is stronger

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Implications of the EMH (Continued)

Trin Statistic
The more investors participate in market advance or retreat (transactions) the more the significance of the movement. The increase in the market index is a better signal for continuing price increases if complimanted by increase in a trading volume. The decrease in the market index is considered more bearish when associated with higher volume. Trin statistic=[volume declining/number declining]/[volume advancing/number advancing] If trin statistis>1 then the market is considered ________
Shows _______ pressure

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Implications of the EMH (Continued)

Confidence Index
Assumption: actions of the bond traders will be followed by the stock market traders. The average yield on 10 top-rated corporate bonds/the average yield on 10 intermediate-grade corporate bonds When bond traders are optimistic they require smaller default premiums on the lower graded bonds thus the yield spread narrows. The confidence index approaches to ________. Higher values of confidence index is a sign for _______.

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Implications of the EMH (Continued)

Put/Call Ratio
Outstanding put options/outstanding call options Call option: give investor the right to buy a stock at a fixed price. Exercised when prices increase Put option: give investor right to sell a stock at a fixed price. Exercised when prices decrease

If the put/call ratio increases above a historical average then it is accepted as a signal for ________.

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Implications of the EMH (Continued)

Fundamental Analysis
Uses earnings and dividend prospects of the

firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The fundamental analyst tries to determine the present discounted value of all the payments a stockholder will receive from each share of stock. Then the analyst compare the fair price he computed with the market price and if the market price is lower then he recommend to _____ the shares since they are __________.
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Implications of the EMH (Continued)

However if the market is semistrong-form efficient then the stock prices should already reflect all the information employed by the analyst to value the stock. Thus the analyst has to find the firms that are better than everyone elses estimate in order fundamental analysis to work. The analysts can make money only if his analysis is better than that of his competitors since the market price already reflect all commonly available information.
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Implications of the EMH (Continued)

The Efficient Market Hypothesis implies passive investment strategy.
Passive investment strategy makes no attempt to outsmart the market. It aims to find a well-diversified portfolio and buyand-hold this portfolio. The stock prices are at fair levels with given information, they reflect all the information available. So, there is no need to try to find overunderpriced stocks, no need to buy and sell securities frequently and generate large brokerage fees.
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Implications of the EMH (Continued)

Even if the market is efficient a role exists for portfolio management:
Role of diversification: Portfolio managers can select securities that diversifies the unsystematic risk of the portfolio and provide the systematic risk level that the investor asks for. Tax considerations: High-tax bracket investors generally will not want the same securities that low-bracket investors find favorable. Other considerations:
Different risk profiles of investors.

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Event Studies
What is an event study?
It is a technique of empirical financial research that enables an observer to assess the impact of a particular event on a firms stock price.

Relation with the EMH

If security prices reflect all currently available information, then price changes must reflect new information. We can measure the importance of an event of interest by examining price changes during the period in which the event occurs. The event can be dividend change, mergers, acquisitions, change in regulations...
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Event Studies (Continued)

How event study methodology works?
The abnormal return due to event is estimated. The abnormal return is the difference between the stocks actual return and the benchmark. The benchmark rate is what the stocks return would have been in the absence of the event.
Benchmark rate can be broad market index as in singleindex model, or rate of return computed according to CAPM or any other multifactor model such as FamaFrench three factor model.

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Event Studies (Continued)

rt=a+brMt+et
rMt: the markets rate of return et: part of a securitys return resulting from firm-specific events b: measures sensitivity to the market return a: the average rate of return the stock would realize in a period with a zero market return.

The abnormal return (firm-specific) is the unexpected return that results from the event.
We need to estimate et to determine abnormal return.

et=rt-(a+brMt)
et: measures the stocks return over and above what one would predict based on broad market movements in that period, given the stocks sensitivity to the market due to the event.
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Event Studies (Continued)

Example: An analysts estimated that a=0.05%, and b=0.8. If the market increases by 1% then what will be the expected return of the stock? If the stock actually increases for 2% what will be the abnormal return of the stock due to the firm-specific news?

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Event Studies (Continued)

Problems related to the event studies:
It is really difficult to isolate the effects of single event on the stock prices.
The stock prices are usually affected from macro and microeconomic changes on a day.

Leakage of information: Information regarding a relevant event is released to a small group of investors before official public release.
In this case the stock prices may start to react the event before the official announcement date. So, the abnormal return on the official announcement date may not be a good indicator to analyse the effects of the event on the stock prices.
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Event Studies (Continued)

In order to overcome leakage problem cumulative abnormal returns are employed as proxies to examine the effects of events on the stock prices. Cumulative abnormal return is the sum of all abnormal returns over the time period of interest. Cumulative abnormal returns captures the total firmspecific stock movement for an entire period when the market is repsonding to the news.

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Event Studies (Continued)

Figure

11.1 shows an example for an effect of good event on the stock returns.
The huge jump of the CAR on the event date (day 0). After the announcement date CAR no longer increases or decreases. The CAR starts to increase 30 days in advance of the announcement date. Leakage Buying large blocks of stock

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Are Markets Efficient?

Magnitude Issue
Stock prices might be very close to fair values so only managers of large portfolios can earn enough trading profits to worth the effort.

Selection Bias Issue

The outcomes we are able to observe have been preselected in favor of failed attempts. If an investor finds a way to beat the market, make money then usually (s)he will not publish it.
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Are Markets Efficient?(Continued)

Lucy Event Issue
From time to time there might be some successful portfolio managers. The important point is whether the successful portfolio manager can repeat his/her performance in another period.

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Are Markets Efficient? (Continued)

Empirical tests for three different forms of the EMH:
Weak-Form Tests
Could speculators find trends in past prices that would enable them to earn abnormal profits? Do technical analysis really work? Methods employed:
Measuring the serial correlation of stock market returns. Serial correlation: tendency for stock returns to be related to past returns. Positive serial correlation: positive returns tend to follow positive returns (momentum type property)

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Are Markets Efficient? (Continued)

Negative serial correlation: positive returns tend to be followed by negative returns or vice versa. Empirical findings Positive serial correlation (momentum) in stock market prices is detected in short-to-intermediate horizon. Negative serial correlation in market prices is detected in long-horizon (multiyear periods). Stock markets may overreact to some news and present positive serial correlation among prices in the short horizon. However the stock markets correct this overreaction in the long time horizon so presents negative serial correlation. Stock market prices fluctuate around their fair values.
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Are Markets Efficient? (Continued)

Variables to predict market returns: The dividend/price ratio (Fama and French, 1988) The earnings yield (Campell and Shiller, 1988) The spread between yields on high-and low-grade corporate bonds (Keim and Stambaugh, 1986) Does this show market inefficiency?

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Are Markets Efficient? (Continued)

Semistrong-form Tests In general, these are the tests employed to examine whether the fundamental analysis help to improve investment performance. Efficient market anomalies Problems: Joint tests of efficient market hypothesis and the risk adjustment procedure.

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Are Markets Efficient? (Continued)

Examples of anomalies:
Price/earnings effect Basu (1977, 1983) shows that low price to earnings ratio portfolios have provided higher returns than high P/E portfolios. The returns are adjusted for the portfolio beta Small-firm effect (size effect) Banz (1981) presents that small firm portfolios have higher returns even when returns are adjusted for risk using CAPM. Keim (1983), Reinganum (1983), Blume and Stambaugh (1983) find that small-firm effect holds in January (first 2 weeks of January).
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Are Markets Efficient? (Continued)

Neglected-firm effect : Arbel and Strebel (1983) show that because small-firms are neglected by big institutional traders information about them are less available. This information deficiency makes these small firms riskier thus they should ask for more return. Liquidity effect: Amihud and Mendelson (1986, 1991) present that small and neglected firms are less liquid and have higher trading costs, so these firms stocks have tendency to exhibit high risk-adjusted rates of return, which in reality is higher risk premium for being illiquid.

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Are Markets Efficient? (Continued)

Book-to-market ratio Fama and French (1992) also find an anomaly and show that higher book-to market portfolios (portfolios composed of high book value of equity to market value of equity ratio) have higher average monthly rate of returns. Post-earnings-announcement price drift Ball and Brown (1986) show that contrary to EMH, stock prices do not react to the announcements as quick as they should. Rendlemen, Jones and Latane (1982) find that if the firms announce good (bad) news then there is a positive (negative) abnormal return in the announcement day.
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Are Markets Efficient? (Continued)

However, the cumulative abnormal returns of positive surprise rise even after the announcement date (momentum) and the negative-surprise firms continue to suffer negative abnormal returns.

Strong-form Tests
We do not expect markets to be strong-form efficient. If insiders trade then they can have abnormal profits because of their superior information. Jaffe (1974) shows that the stock prices tend to increase (decrease) after insiders intensively bought (sold) shares.
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Are Markets Efficient? (Continued)

How are these anomalies interpreted in the finance literature?
Fama and French (1993) argue that size and bookto-market ratios are risk factors as CAPM beta. Thus it is not against the efficieny hypothesis that these factors are significant when explaining the abnormal returns in the market On the other hand, Lakonishok, Shleifer, and Vishney (1995) argue that security analysts overprice firms with recent good performance and underprice firms with recent poor performance.

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Are Markets Efficient? (Continued)

Noisy market hypothesis:
The market prices may contain pricing errors (noises) relative to their intrinsic (true) values. On average the prices may be correct but at any time some stocks may be overpriced and inflate market returns relative to the true values. Since indexed portfolios invest in securities in proportion to their market capitalization (stock price times number of shares), there portfolios invest more in overpriced securities. Thus, this capitalization-weighted investment strategy is overweight the firms with the worst return prospects.

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Are Markets Efficient? (Continued)

The advocates of noisy market hypothesis suggest to employ fundamental index portfolios to invest. Fundamental index portfolios are formed by investing in securities in proportion to their intrinsic values. Problem: true intrinsic values

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Mutual Fund and Analyst Performance

Can the skilled investors make consistent abnormal profits?
Looking at the performance of market professionals (stock market analysts and mutual fund managers) Can they generate performance superior to that of a passive index fund? The research related to mutual fund managers indicate that the performance of the professional managers is consistent with the market efficiency. There are not that many performances that is superior to the passive strategies. Studies of mutual fund performance can be affected by survivorship bias.
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Mutual Fund and Analyst Performance (Continued)

Survivorship Bias
The tendency for the less successful funds to go out of business over time and leave the sample. It looks like there is persistency in the performance even if there is none in reality. Only the successful funds stayed in the sample so they look persistently outperforming the market since the rest, unsuccessful ones, have already left the stage

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