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Chapter 8 The Efficient Market Hypothesis


									           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
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
 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
 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…).
 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
 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
 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

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.
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
     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
Neglected firms
      Grouping firms into: highly followed,
      moderate followed, neglected.
price/book value ratio
      Negative relationship between P/BV and
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
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
  Empirical data regarding support for the semi-strong EMH is
 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
 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
 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.

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