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Chapter 8: The Efficient Market Hypothesis Hady Abdul Khalek, CFA Define an efficient capital market and discuss arguments supporting the concept of efficient capital markets; An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and therefore the current prices of securities reflect all information about the security. This is referred to an informationally efficient market. Why Do Efficient Markets Exist? Large number of profit maximizing participants New information flows to the market in a random fashion Prices adjust rapidly to that new information Makes it difficult, if not impossible, to consistently outperform the market – Doesn’t mean you can’t generate higher rates of return Describe and contrast the forms of the efficient market hypothesis (EMH) (i.e., weak, semi-strong, strong); Weak-Form EMH: assumes that current stock prices fully reflect all security market information including the historical sequence of price, rates of return, trading volume data and other market-generated data. Implications: rates of return are independent. You should gain little from any trading rule that decides whether to buy or sell a security based on past data. Semi Strong-Form EMH: Asserts that security prices adjust rapidly to the release of all public information (earnings, dividend announcements, P/E, D/P, BV/MV, stock splits, political news…). Implications: This implies that investors who base their decisions on important information after it is public should not derive above average profits from their transactions because the security price already reflects all such new public information. Strong-Form EMH: Contends that stock prices fully reflect all information from public and private sources. This means that no group of investors has monopolistic access to information relevant to the formation of prices. Implications: no person can gain abnormal returns for the possession of private information Describe the tests used to examine the weak form, the semi-strong form, and the strong form of the EMH; Two tests used to examine the weak form of the EMH are: 1- Statistical tests of independence between rates of return a- Autocorrelation tests (+ or -). Result: statistical insignificant correlation in stock returns over time b- Run test Result: studies that have examined stock price runs have confirmed the independence of stock price changes over time. 2- Tests of Trading Rules: Comparison of risk-return results for trading rules that make investment decisions based on past market information versus results from a simple buy-and-hold policy which assumes that you buy a stock at the beginning of a test period and hold it to the end. Example: filter rules. Result: when trading commissions are considered, all trading profits turned to losses. In general, these trading rules would not outperform a buy-and-hold policy on a risk- adjusted basis after taking commissions into account The test for semi-strong form of the EMH; 1. Time series and cross sectional tests: where investigators attempt to predict the future rates of return for individual stocks using public information Results: Numerous studies on examining the ability to predict differential rates of return over time indicate that markets are not semi- strong efficient. Such evidence includes: calendar patterns (January effect, Monday effect, weekend effect) and quarterly earnings surprises. Studies on size, BV/MV ratios, E/P ratios and neglected firms effect also were not semi-strong efficient and did not support the hypothesis. 2. Event studies: Abnormal rates of return for the periods immediately after the announcement of significant events. how fast stock prices adjust to specific economic events. Identify various market anomalies and explain their implications for the semi-strong form of the EMH; Anomalies are results that do not support the EMH. such anomalies include: Earning surprises: Quarterly Earnings Studies: Favorable information contained in quarterly earnings reports is not instantaneously reflected in stock process. Small firms January effect Investors engage in tax selling at the end of the year to establish losses on stocks that have declined, then they tend to reacquire these stocks or other attractive stocks in January. thus downward price pressure occur in late Nov. and Dec. and upward price pressure in Jan. Abnormal returns were recognized during January Price/earning ratio Firms with low P/E ratios will outperform firms with high P/E ratios i.e. P/E ratios can be used as an indicative of abnormal returns Neglected firms Grouping firms into: highly followed, moderate followed, neglected. price/book value ratio Negative relationship between P/BV and returns Event Anomalies include: Empirically look for abnormal returns that may exist before or after the release of info about a significant firm event Stock splits: Splits do not result in higher rates of return for stockholders after the split. Initial Public Offering: (IPO) underwriters tend to under price an IPO, however prices adjust within one day after the offering. Unexpected World Events and economic news: Announcement of accounting Changes: Securities markets react quickly to news of changes Corporate Events: (M&A, security offerings…) results support the EMH Event/Analysis Semi Strong EMH Semi Strong EMH Stock Splits SUPP IPO’ SUPP Economic news SUPP Accounting SUPP Changes Corporate Events SUPP P/BV CONTRA Calendar Effects CONTRA Earnings Surprise CONTRA Firm Size CONTRA Tests for Strong-Form EMH: Insider Trading: Corporate Insiders enjoyed above average returns especially on purchase transactions Exchange Specialists: have access to limit orders. Specialists gained above normal rates of return. Security Analysts: are analysts able to select stocks that are undervalued? Value Line Advisors Enigma Analysts recommendations was controversial Performance of Money Managers: Commission fees, management fees hinder the ability of money mangers to produce abnormal returns Explain the overall conclusions about each form of the EMH; The weak form EMH implies that a trend analysis is fruitless. Though past stock price and volume data are publicly available, the weak form asserts that such data would not contain reliable signals about future stock movements. Even if there was information, all investors would have learned those signals and those signals would ultimately lose their value rendering the signal useless. The semi-strong form asserts that all publicly available information regarding the prospects for the firm must already be reflected in the stock price. Such information includes fundamental data, quality of management, balance sheet composition and earnings forecasts. However, well researched and widely disseminated research articles indicate that investors can still profit from learning about those past events. Empirical data regarding support for the semi-strong EMH is questionable. The strong form EMH asserts that stock prices reflect all available information relevant to the firm, including information available only to insiders. This form is rather extreme and as a result this form of the EMH is not supported by empirical research. Explain the implications of stock market efficiency for technical analysis and fundamental analysis; Technical analysis contradicts weak-form EMH. They hypothesize that stock prices move in a gradual manner which causes trends in stock price movements that persist for certain periods. Fundamental analysts believe that there is an intrinsic value for the aggregate stock market, various industries or individual securities and that these values depend on underlying economic factors (future earnings, cash flows, interest rates…). - If intrinsic value > market value => buy as long as costs are covered - If intrinsic value < market value => sell Discuss the implications of efficient markets for the portfolio management process and the role of the portfolio manager; EMH implies that analysis that looks at only prior economic events is not likely to help the manager outperform a buy-and-hold policy because the market adjusts rapidly to known economic events. Although the market experiences long run movements, it is hard to take advantage of these in an efficient market, unless the investment analyst/manager does a superior job in estimating the relevant economic variables that cause long-run movements. Historical data alone are thus not enough. Portfolio managers should continually evaluate investment advice to see if it is superior. Lacking access to superior analytical advice, the manager should run the portfolio like an index fund. In contrast, those with superior analytical ability should be able to make decisions, but should concentrate on mid-cap/neglected firms where there is a greater probability of finding improperly valued stocks. During this analysis, they ought to focus on book value / market value ratio, and size. Explain the rationale for investing in index funds. Believers in the EMH espouse that active management is largely wasted effort and unlikely to justify the expenses incurred. Index funds are passively managed funds where the holdings are in proportion to their representation in a market index such as the S&P 500. Proponents of the EMH advocate a passive investment strategy that makes no attempt to beat the performance of the market. Passive portfolios only attempt to achieve diversification without attempting to find over or under-valued stocks. A passive strategy is generally considered to be a buy and hold strategy. Because the EMH indicates that stock prices are at fair levels, given all available information, it makes no sense to buy and sell securities since transactions create taxes and trading costs reducing the performance of the fund. As a result, believers in the EMH tend to be passive investors who purchase index funds to achieve diversification, low transaction costs and market related performance.
"Chapter 8 The Efficient Market Hypothesis"