Market Efficiency

1
Market Efficiency
2
Key Concepts and Skills

• Define various forms of the Efficient Markets
  Hypothesis
• Study some evidence which forms of the EMH seem
  to be true, if any?

3
Some beliefs

• Momentum investors tend to believe an increasing
  stock price is good news for the future.
• Contrarian investors tend to believe an
  increasing stock price is bad news for the
  future.
• This represents a statistical disagreement on
  autocorrelation.
• There are more complicated charting strategies.
• www.chartpatterns.com

4
The Definition

• A capital market is said to be efficient if asset
  prices fully reflect available information.
• What kind of information?
• Strong form (all obtainable private information)
• Semi-strong form (all public information)
• Weak form (prices, or history of prices)

5
Weak form EMH

• If the weak form of the EMH is true, then
  investors will be unable to predict future
  unexpected returns using price data.
• There are no price patterns that are good or
  bad news.
• Which would imply there is no autocorrelation in
  stock returns

6
Evidence of Random Walk Exhibit A
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Evidence of Random Walk Exhibit B
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Conclusions

• If the weak-form EMH is true, it should be
  impossible to earn abnormal profits from
  employing a trading rule based on price data.
• Which would imply, if true, that technical
  analysis will not work.
• This is with good reason If a simple trading
  rule existed, enough people would use it that
  its efficacy would disappear!

9
Autocorrelation at long horizons

• In contrast to the previous picture, stocks seem
  (?) to have negative autocorrelation at
  long-horizons.
• De Bondt and Thaler compared
• Loser portfolio (35 stocks with worst
  performance)
• Winner portfolio (35 stocks with best
  performance)
• Losers outperform winners by 25 in subsequent 3
  year period.

10
Semi-strong EMH

• If markets were completely SS-efficient, then
  fundamental analysis (the research of stocks,
  attempting to find undervalued ones) would not
  pay.
• Much of Wall Street would shut down
• If markets were completely SS-inefficient, then
  it would be extremely easy to make lots of money.
• A thought maybe markets are somewhat efficient?

11
Tests of semi-strong EMH

• If semi-strong EMH holds, we should find that
  stock prices respond to new information quickly
  and accurately.
• Event Studies
• In other words, new occurrences should not result
  in sustained profit opportunities.
• Stock Split
• MA announcement

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Event Study Takeover Announcements
Announcement Date
13
An efficiency failure

• When 3Com divested Palm Computing, they retained
  a 95 stake.
• On Palms IPO day, the price per share went from
  38 (offer price) to 95.06.
• Palms market cap was 54.3 billion.
• 3Coms market cap was 28 billion.
• Why?
• You would like to buy 3Com and sell Palm.
• For an IPO, it is difficult to short-sell.

14
Evidence

• Most event studies do not conclude that there are
  profit opportunities.
• The market seems to be relatively semi-strong
  efficient (to the most obvious events). Any
  exceptions?
• Some continuing positive return after good
  earnings announcements.
• IPOs tend to under-perform over moderate lengths
  of time.
• Most violations of SSEMH are more subtle and
  temporary.

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Implication of EMH cont.

• If markets are efficient, then you should usually
  trust market prices.
• Consider that markets tend to be more efficient
  for more liquid, actively traded instruments.
• Markets are less efficient when arbitrage/
  competition is weaker.
• Long-horizons?