The Efficient Markets Hypothesis

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The Efficient Markets Hypothesis

• Timothy R. Mayes, Ph.D.FIN 3600 Chapter 7

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Active or Passive Management?

• Investors, as a group, can do no better than the
  market, because collectively they are the
  market. Most investors trail the market because
  they are burdened by commissions and fund
  expenses. Jonathan Clements, the Wall Street
  Journal, June 17, 1997
• Fees paid for active management are not a good
  deal for investors, and they are beginning to
  realize it. Michael Kostoff, executive
  director, The Advisory Board, a Washington-based
  market research firm. InvestmentNews, February 8,
  1999
• When you layer on big fees and high turnover,
  youre really starting in a deep hole, one that
  most managers cant dig their way out of. Costs
  really do matter. George Gus Sauter, Manager
  of the Vanguard SP 500 Index Fund

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Active or Passive Management?
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Definition of Efficient Markets

• An efficient capital market is a market that is
  efficient in processing information.
• We are talking about an informationally
  efficient market, as opposed to a
  transactionally efficient market. In other
  words, we mean that the market quickly and
  correctly adjusts to new information.
• In an informationally efficient market, the
  prices of securities observed at any time are
  based on correct evaluation of all information
  available at that time.
• Therefore, in an efficient market, prices
  immediately and fully reflect available
  information.

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Definition of Efficient Markets (cont.)

• Professor Eugene Fama, who coined the phrase
  efficient markets, defined market efficiency as
  follows
• "In an efficient market, competition among the
  many intelligent participants leads to a
  situation where, at any point in time, actual
  prices of individual securities already reflect
  the effects of information based both on events
  that have already occurred and on events which,
  as of now, the market expects to take place in
  the future. In other words, in an efficient
  market at any point in time the actual price of a
  security will be a good estimate of its intrinsic
  value."

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History

• Prior to the 1950s it was generally believed
  that the use of fundamental or technical
  approaches could beat the market (though
  technical analysis has always been seen as
  something akin to voodoo).
• In the 1950s and 1960s studies began to provide
  evidence against this view.
• In particular, researchers found that stock price
  changes (not prices themselves) followed a
  random walk.
• They also found that stock prices reacted to new
  information almost instantly, not gradually as
  had been believed.

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The Efficient Markets Hypothesis

• The Efficient Markets Hypothesis (EMH) is made up
  of three progressively stronger forms
• Weak Form
• Semi-strong Form
• Strong Form

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The EMH Graphically
All historical prices and returns

• In this diagram, the circles represent the amount
  of information that each form of the EMH
  includes.
• Note that the weak form covers the least amount
  of information, and the strong form covers all
  information.
• Also note that each successive form includes the
  previous ones.

All information, public and private
All public information
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The Weak Form

• The weak form of the EMH says that past prices,
  volume, and other market statistics provide no
  information that can be used to predict future
  prices.
• If stock price changes are random, then past
  prices cannot be used to forecast future prices.
• Price changes should be random because it is
  information that drives these changes, and
  information arrives randomly.
• Prices should change very quickly and to the
  correct level when new information arrives (see
  next slide).
• This form of the EMH, if correct, repudiates
  technical analysis.
• Most research supports the notion that the
  markets are weak form efficient.

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Price Adjustment with New Information
Notes Each bar represents high, low, and close
for one-minute. Each solid gridline represents
the top of an hour, and each dotted gridline
represents a half-hour.
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Tests of the Weak Form

• Serial correlations.
• Runs tests.
• Filter rules.
• Relative strength tests.
• Many studies have been done, and nearly all
  support weak form efficiency, though there have
  been a few anomalous results.

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Serial Correlations

• The following chart shows the relationship (there
  is none) between SP 500 returns each month and
  the returns from the previous month. Data are
  from Feb. 1950 to Sept. 2001.
• Note that the R2 is virtually 0 which means that
  knowing last months return does you no good in
  predicting this months return.
• Also, notice that the trend line is virtually
  flat (slope 0.008207, t-statistic 0.2029, not
  even close to significant)
• The correlation coefficient for this data set is
  0.82

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Serial Correlations (cont.)
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The Semi-strong Form

• The semi-strong form says that prices fully
  reflect all publicly available information and
  expectations about the future.
• This suggests that prices adjust very rapidly to
  new information, and that old information cannot
  be used to earn superior returns.
• The semi-strong form, if correct, repudiates
  fundamental analysis.
• Most studies find that the markets are reasonably
  efficient in this sense, but the evidence is
  somewhat mixed.

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Tests of the Semi-strong Form

• Event Studies
• Stock splits
• Earnings announcements
• Analysts recommendations
• Cross-Sectional Return Prediction
• Firm size
• BV/MV
• P/E

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Analysts Performance
This chart from the Wall Street Journal, shows
that when analysts issue sell recommendations,
those stocks frequently outperform those with buy
or hold ratings. If the professionals cant get
it right, who can?
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Mutual Fund Performance

• Generally, most academic studies have found that
  mutual funds do not consistently outperform their
  benchmarks, especially after adjusting for risk
  and fees.
• Even choosing only past best performing funds
  (say, 5-star funds by Morningstar) is of little
  help. A study by Blake and Morey finds that
  5-star funds dont significantly outperform 3-
  and 4-star funds over time.
• However, it does seem that you can weed out the
  bad funds (1- and 2-stars). Funds that have
  performed badly in the past seem to continually
  perform badly in the future.

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The Strong Form

• The strong form says that prices fully reflect
  all information, whether publicly available or
  not.
• Even the knowledge of material, non-public
  information cannot be used to earn superior
  results.
• Most studies have found that the markets are not
  efficient in this sense.

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Tests of the Strong Form

• Corporate Insiders.
• Specialists.
• Mutual Funds.
• Studies have shown that insiders and specialists
  often earn excessive profits, but mutual funds
  (and other professionally managed funds) do not.
• In fact, in most years, around 85 of all mutual
  funds underperform the market.

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Anomalies

• Anomalies are unexplained empirical results that
  contradict the EMH
• The Size effect.
• The Incredible January Effect.
• P/E Effect.
• Day of the Week (Monday Effect).

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The Size Effect

• Beginning in the early 1980s a number of studies
  found that the stocks of small firms typically
  outperform (on a risk-adjusted basis) the stocks
  of large firms.
• This is even true among the large-capitalization
  stocks within the SP 500. The smaller (but
  still large) stocks tend to outperform the really
  large ones.

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The Incredible January Effect

• Stock returns appear to be higher in January than
  in other months of the year.
• This may be related to the size effect since it
  is mostly small firms that outperform in January.
• It may also be related to end of year tax selling.

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The P/E Effect

• It has been found that portfolios of low P/E
  stocks generally outperform portfolios of high
  P/E stocks.
• This may be related to the size effect since
  there is a high correlation between the stock
  price and the P/E.
• It may be that buying low P/E stocks is
  essentially the same as buying small company
  stocks.

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The Day of the Week Effect

• Based on daily stock prices from 1963 to 1985
  Keim found that returns are higher on Fridays and
  lower on Mondays than should be expected.
• This is partly due to the fact that Monday
  returns actually reflect the entire Friday close
  to Monday close time period (weekend plus
  Monday), rather than just one day.
• Moreover, after the stock market crash in 1987,
  this effect disappeared completely and Monday
  became the best performing day of the week
  between 1989 and 1998.

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Summary of Tests of the EMH

• Weak form is supported, so technical analysis
  cannot consistently outperform the market.
• Semi-strong form is mostly supported , so
  fundamental analysis cannot consistently
  outperform the market.
• Strong form is generally not supported. If you
  have secret (insider) information, you CAN use
  it to earn excess returns on a consistent basis.
• Ultimately, most believe that the market is very
  efficient, though not perfectly efficient. It is
  unlikely that any system of analysis could
  consistently and significantly beat the market
  (adjusted for costs and risk) over the long run.