The Efficient Market Hypothesis

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Lecture 8

• The Efficient Market Hypothesis

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Introduction

• Efficient Market Hypothesis (EMH) The hypothesis
  that prices of securities fully and immediately
  reflect available information about securities.
• How? Market participants process all relevant
  information rationally and quickly.
• Relevant information
• Published economic reports
• News articles about a firm
• Seasonality of a firms earnings
• Information from a firms annual report

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Introduction

• Why important?
• Adam Smiths invisible hand.
• How does it work?
• Competition as the source of efficiency
• Random walk The notion that stock price changes
  are random and unpredictable.

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Versions of the EMH

• What is meant by the term all available
  information?
• Weak-form EMH
• Stock prices reflect all past market trading
  information.
• History of past prices, trading volume, short
  interest
• Semistrong-form EMH
• Stock prices reflect all publicly available
  information
• Past market trading fundamental data, quality
  of mgmt, earnings forecast, balance sheet
  composition
• Strong-form EMH
• Stock prices reflect all available information
  inside information

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Implications of the EMH

• Prices should react quickly and accurately to new
  info.
• Price changes should be random and unpredictable
• Cov(rt , rt-j)0
• Famous 100 bill story
• (Fundamental risk-return tradeoff)

Overreaction
Stock price
Efficient reaction
Delayed reaction
time
Announcement
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Implications of the EMH

• An efficient market protects a fool from himself
• Prices should convey information
• The only way to make abnormal profits should be
• Superior information
• Superior information processor (Peter Lynch,
  Warren Buffett)
• Most importantly An efficient market yields an
  optimal allocation of resources.

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Implications of the EMH

• Others
• Technical analysis (charting) is useless.
• Fundamental analysis is mostly useless.
• Investors should follow passive (but dynamic)
  portfolio management.
• Grossman-Stiglitz paradox
• For markets to be efficient, there must be some
  who believe markets are inefficient.
• As long as there are enough people that believe
  markets are inefficient, markets will be more and
  more efficient.

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Tests of the EMH

• Issues
• The magnitude issue
• Volatility of stock prices are too high to
  measure some small magnitude events
• The selection bias issue
• Suppose you had a profitable strategy, would you
  publish it in WSJ?
• The lucky event issue

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Tests of the EMH

• Continuing Issues
• Is the trading strategy implementable?
• Trading costs, taxes, short-selling constraints
• Survivorship bias
• Only firms that have been relatively successful
  survive.
• Joint-test problem
• How do you measure abnormal return?
• Bottomline It is very difficult to conduct a
  definitive test of EMH

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Tests of the EMH

• Weak-form Tests
• Performance of individual stocks is highly
  unpredictable.
• Performance of portfolios
• Returns over short horizons Evidence of momentum
• Returns over long horizons Evidence of price
  reversals

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Tests of the EMH

• Semistrong-form tests (Market anomalies)
• January (turn-of-year) effect
• Small stocks outperform large stocks by an
  average of 3
• Effect is consistent (50 years, other countries)
• Most of the effect in the first 5 days of January
• Explanation tax-loss selling
• End-of-month effect
• Large returns on the last day of month

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Tests of the EMH

• Cont. semistrong-form tests (Market anomalies)
• Day-of-the-week effect
• Large negative returns on Mondays
• Time-of-day effect
• Positive returns in the first 45 and the last 15
  minutes of trading day
• Holiday effect
• Positive returns the day before holidays
• Small firm effect
• Small firms outperform large stocks on a
  risk-adjusted basis

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Tests of the EMH

• Cont. semistrong-form tests (Market anomalies)
• Low-beta firm effect
• Low-beta stocks outperform large-beta stocks on a
  risk-adjusted basis
• Neglected firm effect
• Stocks with low analyst interest outperform
• B/M effect
• High B/M outperform low B/M

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Tests of the EMH

• Strong-form tests
• Insider trading
• Market-timing
• IPO
• SEO
• Share repurchase

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Conclusion

• Bottomline
• Difficult to conduct a definitive test of EMH
• Evidence in favor of EMH
• Prices react quickly to information
• No serial correlation in individual daily stock
  returns
• Most money managers do not outperform the market
• The ones that outperform cannot do it
  consistently
• Even the strongest anomalies are not consistent
  in time
• Evidence against the EMH
• 1929, 1987 market crashes
• Speculative bubbles
• Anomalies
• Limits of arbitrage (Arbitrage is usually risky)

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Conclusion

• Last word
• Markets are very efficient
• However, there may be rewards to especially
  diligent, intelligent, or creative investors.