Efficient Market Hypothesis The concepts

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Efficient Market HypothesisThe concepts
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Topics

• What if you figure a stock price moving pattern?
• Some formal definitions
• Implications of Efficient Market Hypothesis
• Price modeling
• Empirical studies

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What if

• What if you have figured out the following
• Buy if out of the 20 trading days for the past
  month, stock XYZ has been rising for more than
  10.
• Sell if out of the 20 trading days for the past
  month, stock XYZ has been falling for more than
  10.
• Follow this rule strictly, return is abnormally
  high.

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Stock price reflects information

• If you have spotted such price pattern that seems
  to guarantee you a sure profit, what should you
  do?
• You should definitely exploit it. (How? Borrow as
  much as you can to invest according to your
  strategy.)
• The process of exploiting the pattern actually
  ironically destroy the pattern because
• You would bid up XYZ share price when you think
  it is hot. ? Price gt ? ExpectedReturn
• You would bid down XYZ share price when you think
  it is cold. ? Price gt ? ExpectedReturn
• The fact that you have figured out a stock price
  movement is very likely to be reflected by the
  stock price.
• The more greedy (which is rational. More
  precisely, is the higher the ability for you to
  raise fund) you are, the faster your pattern will
  be eliminated by your own hands.
• Bottom line info, private or public, is
  reflected in stock prices.

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Price movement pattern
Investors behaviors tend to eliminate any profit
opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by
finding the pattern in the stock price
movements, everyone would have done it and the
profits would be competed away.
Time
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The army

• If you are one of the stock hunters, actively
  looking for price patterns, who are you competing
  with?

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The army

• If you are one of the stock hunters, actively
  looking for price patterns, who are you competing
  with?

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The army

• If you are one of the stock hunters, actively
  looking for price patterns, who are you competing
  with?

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The army

• Imagine not only you, there is essentially an
  army of intelligent, well-informed security
  analysts, traders, who literally spend their
  lives hunting for mis-priced securities or
  securities that follow a pattern based on
  currently available information.
• They have high-tech computers, subscription to
  professional database, up-to-date information on
  thousands of firms, state-of-the-art analytical
  technique, etc.
• These people can assess, assimilate and act on
  information, very quickly.
• In their intense search for mis-priced
  securities, professional investors may police
  the market so efficiently that they drive the
  prices of all assets to fully reflect all
  available information.

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Implications

• Competition for finding mis-priced securities is
  fierce.
• Such competition always kills the sure-profit
  pattern. Were there one, it would have been
  exploited by someone who first spotted it. Thus,
  roughly speaking, no arbitrage should hold.
• The first one does make abnormal profit, but
  Economic profit ? gross profit
• The very first one is not likely to be you.
• Even if you are the very first one, you are
  likely to pay higher brokerage and commission
  fees than institutional investors.
• The implications
• stock prices should have reflected all available
  information.
• stock prices should be unpredictable.

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Unpredictability

• Prices are unpredictable in the sense that stock
  prices should have reflected all available
  information.
• Thus if stock prices change, it should be
  reacting only to new information.
• The fact that information is new means stock
  prices are unpredictable.

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Market efficiency

• If all past information is incorporated in the
  price then it should be impossible to
  consistently beat the market using technical
  analysis and the like.
• Definition 1
• Eugene Fama defined Market Efficiency as the
  state where "security prices reflect all
  available information.
• Definition 2
• Financial markets are efficient if current asset
  prices fully reflect all currently available
  relevant information.

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The right question to ask

• If new information becomes known about a
  particular company, how quickly do market
  participants find out about the information and
  buy or sell the securities of the company based
  on the information?
• How quickly do the prices of the securities
  adjust to reflect the new information?
• The issue is not merely black or white. We know
  that the market should neither be strictly
  efficient nor strictly inefficient. The question
  is one of degree.
• We should ask how efficient the market really
  is?

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Subsets of available informationFor a given stock
All Available Information including inside or
private information
All Public Information
Information in past stock prices
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3 forms of market efficiency hypothesis
Since we are more interested in how efficient is
the capital market, we define the following 3
forms of market efficiency hypothesis A market
is efficient if it reflects ALL available
information 1 Strong-form - ALL available
info 2 Semi-strong form - ALL available
info 3 Weak-form - ALL available info
All Available Information including inside or
private information
All Public Information
Information in past stock prices
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3 forms of market efficiency hypothesis

• Weak-form
• Stock prices are assumed to reflect any
  information that may be contained in the past
  stock prices.
• For example, suppose there exists a seasonal
  pattern in stock prices such that stock prices
  fall on the last trading day of the year and then
  rise on the first trading day of the following
  year. Under the weak-form of the hypothesis, the
  market will come to recognize this and price the
  phenomenon away.
• Anticipating the rise in price on the first day
  of the year, traders will attempt to get in at
  the very start of trading on the first day. Their
  attempts to get in will cause the increase in
  price to occur in the first few minutes of the
  first day. Intelligent traders will then
  recognize that to beat the rest of the market,
  they will have to get in late on the last day.
  The consequences, therefore, is the elimination
  of the pattern as price in the last trading day
  should be bid up.

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3 forms of market efficiency hypothesis

• Semi-strong-form
• Stock prices are assumed to reflect any
  information that is publicly available.
• These include information on the stock price
  series, as well as information in the firms
  accounting reports, the past prices and reports
  of competing firms, announced information
  relating to the state of the economy, and any
  other publicly available information relevant to
  the valuation of the firm.

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3 forms of market efficiency hypothesis

• Strong-form
• Stock prices are assumed to reflect ALL
  information, regardless of them being public or
  private.
• Under this form, those who acquire insider
  information act on it, buying or selling the
  stock. Their actions affect the price of the
  stock, and the price quickly adjusts to reflect
  the insider information.

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3 forms of market efficiency hypothesis

• If Weak-form of the hypothesis is valid
• Technical analysis or charting becomes
  ineffective. You wont be able to gain abnormal
  returns based on it.
• If Semi-strong form of the hypothesis is valid
• No analysis will help you attain abnormal returns
  as long as the analysis is based on publicly
  available information.
• If Strong-form of the hypothesis is valid
• Any effort to seek out insider information to
  beat the market are ineffective because the price
  has already reflected the insider information.
  Under this form of the hypothesis, the
  professional investor truly has a zero market
  value because no form of search or processing of
  information will consistently produce abnormal
  returns.(Even if Steve Jobs is your uncle, you
  cant profit from listening to his phone calls
  and trading APPLE stocks.)

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Why do we care about capital market efficiency?

• As an analyst
• As an investment manager
• As a corporate financial manager
• As a marketing manager
• As an accounting manager

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Why do we care about capital market efficiency?

• As an analyst
• If market is efficient, what is your marginal
  contribution for your securities firm? It should
  be zero, because you will not be able to spot
  mis-priced securities to produce additional
  returns on the portfolios that you are managing.
  Heat Debate.
• Analysts total contribution to the society
  should be big. Because in scouting the capital
  market, they essentially make sure asset prices
  are effective as signals to others.
• If the market is truly efficient
• gt 0ltTotal contribution ? marginal contribution0

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Why do we care about capital market efficiency?

• As an investment manager
• Investment decisions of the managers of any firms
  are based to a large extent on signals they get
  from the capital market.
• If the market is efficient, the cost of acquiring
  capital will accurately reflect the prospects for
  each project.
• This means the firms with the most attractive
  investment opportunities will be able to obtain
  capital at a fair price which reflects their true
  potentials.
• The right investment will be made, and the
  society is said to be allocationally-efficient.
  Everyones better off.

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Why do we care about capital market efficiency?

• As a corporate financial manager
• To raise capital, you consider getting debt- or
  equity-financing. (Corporate Finance)
• If the market is efficient, you know that
  equity-financing requires a rate of return which
  is fair because the price has already reflected
  all available information.
• If the market is efficient, you would never feel
  your firms stock being under- or over-valued at
  any point in time. In essence, there is no timing
  decision to issuing equity.
• More profoundly, if market is efficient, every
  alternative way of raising capital would require
  the same rate of return for the same project. And
  no one capital-raising method is superior than
  the other.

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Why do we care about capital market efficiency?

• As a marketing manager
• You may consider advertising at the Wall Street
  Journal about how impressive your company has be
  doing in the past few years.
• If the market is efficient, there is no need to
  do that. Because your stock price has already
  reflected those. There is absolutely no impact
  for the ad on the stock price. And placing an ad
  is like burning money.
• A more sensible interpretation is that, ads
  dont easily fool investors.

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Why do we care about capital market efficiency?

• As an accounting manager
• Will change in accounting practices (e.g.,
  different depreciation methods straight-line vs
  accelerated) impact the companys stock price?
• No if the market is semi-strong efficient.
  Because informed, rational analysts will adjust
  the different accounting procedures used by
  different firms and assess prospects based on
  standardized numbers.
• Thus, the adjustment in accounting technique will
  have no effect on the opinions of those analysts
  or on the stock price of the firm.

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Expected return-risk

• The Efficient Market Hypothesis imposes no
  structure on stock prices. However, what is
  abnormal return?
• Abnormal return Actual return Expected return
• This means we have to know what exactly is
  expected return.
• Thats why we may rely on an asset pricing model.
  
• e.g.,CAPM, to find a risk-adjusted return that
  the market will be rewarding.)
• Defining abnormal return inherently involves
  assuming a pricing model. If we find abnormal
  returns, we conclude that the market is
  inefficient. But then, we can also say that the
  pricing model we used is invalid.
• The challenge here is testing market efficiency
  inevitably involves testing a joint hypothesis
• H0 both market is efficient and the pricing
  model is valid.
• H1 EITHER market is inefficient OR the pricing
  model is invalid.

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4 basic traits of efficiency

• An efficient market exhibits certain behavioral
  traits. We can examine the real market to see if
  it conforms to these traits. If it doesnt, we
  can conclude that the market is inefficient.
• Act to new information quickly and accurately
• Price movement is unpredictable (memory-less)
• No trading strategy consistently beat the market
• Investment professionals not that professional

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1) Act to news quickly accurately
Stock price ()
Days relative to announcement day
0
t
-t
The timing for a positive news
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1) Act to news quickly accurately
Stock price ()
Days relative to announcement day
0
t
-t
If the market is efficient, 1) at time 0, the
positive news come, there is an immediate jump of
the share price to the RIGHT level. (i.e., the
PINK path) 2) There is no delays in analyzing
news and slowly reflecting in the share price
like the ORANGE path does. 3) There is also no
over-reaction like the BLUE path does, and then
subsequently adjustment back to the correct level.
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2) Memory-less price movement

• If the market is efficient (WEAK-FORM),
• The so-called momentum is nothing. (Google
  Stock momentum)
• momentum is like, if once started on a downward
  slide, stock prices develop a propensity to
  continue sliding. The expected change in todays
  price would, in fact, be related (correlated
  positively) with the price changes in the past.
• 2) If the market is efficient, prices only move
  in response to news. More precisely, news is
  any discrepancy between the publics expectation
  and the actual realized event. E.g, Suppose
  everyone expects RIMs sales should have gone up
  by 30. If RIM does announce that its sales has
  gone up by 30, it is not a news. If it has gone
  up by 29 instead, it is a news, a negative one
  though.
• 3) To detect memory or momentum, we try to
  see if
• Cov(?Pt, ?Pt-i) is significantly different from
  zero or not, for i ? 0

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3) No superior trading strategies

• One way to test for market efficiency is to test
  whether a specific trading rule or investment
  strategy, would have CONSISTENTLY produced
  abnormally high return.
• Problem about such test is
• What is abnormal return again? We run into the
  problem of joint hypothesis testing again in
  order to find an expected return as benchmark.
• What kind of information you use to construct an
  investment strategy? Can you be sure the
  information you are based on really reflect what
  WAS available when the decision to invest was
  made.
• E.g., Last quarters earning is out around
  February of next year. If a WINNING investment
  strategy says invest in the top 10 companies
  last year by Jan, it is not an employable
  strategy.
• What is the cost of implementing a strategy?

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4) Professionals arent that professional

• If professional investors consistently beat the
  market, we conclude that the market is not that
  efficient.
• If the market is really efficient, we should not
  see professionals making abnormally high returns.
• The puzzle is we do see professionals, like
  Peter Lynch and Warren Buffet, having amazing
  records.
• A defense, a weak one though, is
• Suppose we take a thousand people in a gigantic
  stadium. Have them flip coins. Suppose head is
  winning and tail is losing. There is no
  surprise to find a few individual flippers with
  unbelievable records of success and failure.
  Those having 20 heads in a row goes on TV and
  showcase their exceptional flipping skills. But
  we know theyre just plain lucky.

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So whats the value for portfolio management

• If capital markets are efficient, should we just
  throw darts at the financial page to pick stocks
  instead of spending time carefully construct a
  stock portfolio?
• The answer is 3 NO NO NO.
• As you have learnt, you need to have a
  well-diversified portfolio that is tailored
  towards your risk-preference.
• Depending on your age, your risk-preference, your
  current situation, your tax bracket, and all
  other relevant factors, your portfolio should be
  carefully constructed.
• Dont forget that there is value for
  diversification. There is value for you to learn
  options. There is value for you to tailor a
  future payoff profile specific to your own needs.
  Throwing darts to pick stocks does not guarantee
  your specific needs are met.

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So whats the value for portfolio management

• The conclusion is
• capital market is neither purely efficient nor
  purely inefficient.
• The right question to ask is the degree of
  efficiency of capital market.
• The more efficient capital market is, the better
  off the society.
• But even if it is efficient, it doesnt imply
  knowledge of finance is useless. Because you have
  learnt diversification and portfolio theory that
  is based on maximizing happiness.
• Price movements are random. But it in NO way
  implies prices are random. Prices
  reflect/incorporate available information. The
  driving force to their random movements is that
  news comes randomly.

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