the efficient market hypothesis chapter 8. learning objectives understand the concept of market...
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The Efficient Market Hypothesis
Chapter 8
Learning Objectives
Understand the concept of market efficiency
Understand the investment implications of the various levels of market efficiency
Develop a thorough understanding of the tests of market efficiency and observed market anomalies
Market Efficiency A market is efficient when it uses all available
information is quickly incorporated into prices.
Efficiency is the degree to which prices reflect
available information.
If prices reflect all available information then
what causes prices to move?
New Information When information is released it contains two
components Anticipated: Information already included in the price Unexpected: New information that is not currently priced
The market prices assets based on what is expected to happen (Anticipated Information)
Unexpected information causes the market to change its expectations → Moving prices Result: Prices change until expected returns are exactly
commensurate with risk.
4
11-5
Stock Price Reaction to CNBC Reports
A Random Walk Unexpected information arrives RANDOMLY Therefore price changes will be random
Price tomorrow = today’s price + random (+/-) If price changes are random does that mean they
are uncaused?
6
7
Price: This Week & Next
Do you see a pattern?
Why are price changes random?
Prices react to information Flow of information is random Results in random price changes
How prices move
Stock prices are the consequence of intelligent investors competing to discover relevant information These discoveries occur randomly
We expected returns to generally be positive over time
These two trends results in stock prices having:
→Positive trend with random movements around trend
Information The MOST precious commodity on Wall Street
Strong competition assures prices reflect information.
The first to learn something new will make moneyThe marginal return on research activity may be so
small that only managers of the largest portfolios will find them worth pursuing.
Only ones with enough capital to make it worth while Can use leverage to juice returns
The Value of Information: Real Ex Pacific Century Cyberworks
Was going to be added to Hong Kong Index, in a major way
Since Index would be buying up shares, price would rise, so everyone started buying shares
One investor in Japan went to Hong Kong to get as much information about the deal as possible
Discovered the share weren’t being bought on the market Shares would come from the founder, increasing the supply
What do the investors who bought need to do? What does our investor do?
Short and made millions in minutes
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Potential Causes of Efficient Markets Investor Rationality
Everyone is rational → Everyone makes the right decision
Independent Deviation from RationalityNo one is rational → Everyone makes the wrong
decision but each makes a different wrong decision Average out the wrongness
ArbitrageOnly some people are rational → Smart money takes
from less smart money
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Types of Efficient Markets
Weak
Semi-Strong
Strong
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Weak Form Efficiency
Prices reflect all information contained in past prices and volumesNo investor is able to form a trading strategy based
on historic prices and volumes and earn an excess return
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Disbelievers
Chartists, or Technical AnalystsAnalyze “charts” of a stock‘s Price and/or Volume
Chartist believe in identifiable and predictable patterns in these characteristicsMake investment decisions based on these patterns
Brokerage firms tend to love chartists
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Head and Shoulders
Why Technical Analysis Fails
-If there is a profitable pattern, everyone would do it
-If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern
Sto
ck P
rice
Time
Sell
Sell
Buy
Buy
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Semi-Strong Form Efficiency
Security prices reflect all publicly available information.Encompasses weak form efficiency
Publicly available information includes: Historical price and volume information
Published accounting statements
Information found in the WSJ
Disbelievers Fundamental Analysts
Use economic and accounting information to predict stock prices
Try to find firms that are better than everyone else’s estimate.
Try to find poorly run firms that are not as bad as the market thinks.
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Strong Form Efficiency Strong form efficiency says that anything
pertinent to the stock price and known to at least one investor is already incorporated in the security’s price.Public & PrivateImplies: Insider trading will not earn excess return
Strong form efficiency incorporates weak and semi-strong form efficiency.
Disbelievers
Pretty much everyone Insiders trading is generally profitable
Galleon Raj Rajaratnam
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EMH: Active v Passive Management Passive Management: Believes the market is efficient
→ Does NOT attempt to outsmart the marketBuy well-diversified portfolios without looking for
mispricing Index Funds and ETFs
Active Management: Believes the market is not perfectly efficient → Hunts for mispricingAn expensive strategySuitable only for very large portfolios
Are Markets Efficient: Will the Debate EndWall Street is predicated on the idea that the market is inefficient, Academics general need an efficient market Magnitude Issue
Only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort.
Selection Bias Issue Only unsuccessful investment schemes are made
public; good schemes remain private. Lucky Event Issue
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Weak-Form Efficiency Tests
Look for patterns in stock returns Returns over the Short Horizon
Momentum: Good or bad recent performance continues over short to intermediate time horizons
Returns over Long HorizonsReversal Effect: Episodes of overshooting
followed by correction
1 2 3 4 5 6 7 8 9 100.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1.80%
2.00%
Average Returns to Momentum Portfo-lios (1967-2010)
Momentum portfolio returns based on 6-month past returns
11-28
Small Firm Effect January Effect Book-to-Market Ratios Post-Earnings Announcement Price Drift
Semistrong Tests: Anomalies
Average Annual Return: 10 Size-Based Portfolios, 1926-2010
1 2 3 4 5 6 7 8 9 100
5
10
15
20
25
19.8
17.0 16.615.9
15.2 15.1 14.613.5
12.9
11.0
Size decile: 1 = small, 10 = large
An
nu
al
retu
rn (
%)
Average Annual Return as Function of Book-to-Market Ratio, 1926-2010
1 2 3 4 5 6 7 8 9 100
2
4
6
8
10
12
14
16
18
20
11.011.8 11.7 11.7
13.1 13.4 13.4
15.516.1
17.3
Book-to-market decile: 1 = low, 10 = high
An
nu
al r
etu
rn (
%)
11-31
Study the impact of a particular event on a firm’s stock price. EX: Earnings or Dividend announcements Test of the Semi-Strong EMH
Look at how quickly prices adjust to the announcement Looking for under, over, early, delayed reactions
Event Studies
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Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing
Dividend Omissions
0.146 0.108
-0.72
0.032-0.244-0.483
-3.619
-5.015-5.411-5.183
-4.898-4.563-4.747-4.685-4.49
-6
-5
-4
-3
-2
-1
0
1
-8 -6 -4 -2 0 2 4 6 8
Days relative to announcement of dividend omission
Cum
ulat
ive
abno
rmal
ret
urns
(%
)
Efficient market response to “bad news”
CARs Around Earnings Announcements
Interpreting the Anomalies
The most puzzling anomalies are price-earnings, small-firm, market-to-book, momentum, and long-term reversal. Fama and French argue that these effects can be explained
by risk premiums. Lakonishok, Shleifer, and Vishney argue that these effects
are evidence of inefficient markets.
Interpreting the Evidence
Anomalies or data mining?Some anomalies have disappeared (e.g.
size).Book-to-market, size, and momentum may
be real anomalies as they exist in many markets and asset classes around the world.
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Mutual Funds Performance If the market is semi-strong form efficient,
then mutual fund managers, should not be able to consistently beat the average market return
When we compare the record of mutual fund performance to a market index, we see that mutual funds are not able to CONSISTENTLY beat the market.Consistent with the market being semi-strong form
efficient
Figure 8.8 Persistence of Mutual Fund Performance
Figure 8.9 Risk-Adjusted Performance in Ranking Quarter, Following Quarter
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Mutual Fund Performance
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
-2.13%
-8.45%
-5.41%
-2.17% -2.29%
-1.06%-0.51%-0.39%
All funds Small-companygrowth
Other-aggressive
growth
Growth Income Growth andincome
Maximumcapital gains
Sector
So, Are Markets Efficient?
The performance of professional managers is broadly consistent with market efficiency.
Most managers do not do better than the passive strategy.
There are, however, some notable superstars:Peter Lynch, Warren Buffett, John Templeton,
George Soros
Efficient Markets & Portfolio Management Even if the market is efficient a role
exists for portfolio management:DiversificationAppropriate risk levelTax considerations
Efficient Markets & Resource Allocation If markets were inefficient, resources would be
systematically misallocated.Firm with overvalued securities can raise capital
too cheaply.Firm with undervalued securities may have to pass
up profitable opportunities because cost of capital is too high.
Efficient market ≠ perfect foresight market
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EMH Exercises Indicate whether or not the EMH is contradicted,
if so which form of EMH is contradicted An investor consistently earn an abnormal return over
that expected by the market by examining charts of historical prices
The acquisition of the latest annual report of a company enables an investor to earn an abnormal return.
A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows.
By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments.