FIN 352 – Professor Dow
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Fama: Test the efficient market hypothesis
using different information sets.
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Three categories:
 Weak
 Semi-Strong
 Strong
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Some tests directly use this categorization,
others do not.
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All past-price information is fully reflected in
stock prices.
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Can’t use past prices to forecast future prices.
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If true, technical analysis is not useful.
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All public information is fully reflected in
stock prices.
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If true, fundamental analysis is not useful.
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All information is reflected in stock prices.
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Implies that trading on insider information
shouldn’t be profitable.
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Not true
But not legal
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A) Patterns in stock prices.
B) Back-testing trading rules.
C) Do categories of stocks earn abnormal
returns?
D) Event studies.
E) Do stock prices move “too much?”
F) Bubbles.
G) Do some investors outperform the
market?

Serial Correlation > 0, Momentum
Serial Correlation < 0, Mean Reversion
Serial Correlation = 0, Random Walk
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Weak Form EMH predicts random walk
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See if trading rules are profitable when
applied to historical stock price data.
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Data Mining
In-Sample vs. Out-of-Sample
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Value stocks
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Small stocks
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Or is it microcap/neglected stocks?

Is it is risk premium?
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Abnormal returns: Stocks earn greater returns
than they “should”: Ri – E(R)

Theory implies that stocks should earn abnormal
returns when news first comes out, but not
afterwards (stock prices are quick to adjust to
news)

Book gives example where they use excess
returns (Ri-Rm) to measure response to event.
Response is slower than it should be.

Increases in asset prices not justified by
“fundamentals”
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At some point, bubbles pop!

Shouldn’t have bubbles if markets are
efficient.
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Recent experience with real estate and stock
price bubbles.
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Theory: Stock price is the present value of
expected future dividend payments.

Stock prices shouldn’t vary more than dividends
or earnings do.
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But there is more variation
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Similar idea to bubbles: stock prices move based
on psychological reasons rather than
fundamental reasons.
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Why do some investors do well?
 Luck
 Higher risk
 Skill
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Mutual funds tests

Markets are broadly efficient, but some
important exceptions.
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Bubbles

Some people understand the economy better
– but do you?

Build around index funds: Well-diversified and
low cost

Do bubbles imply market timing?
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Do you want to engage in fundamental
analysis?