Market Efficiency
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Efficient Markets
How well do markets respond to new information?
If the market is efficient, should it be possible to decide between a
profitable and unprofitable investment given current information?
Efficient Markets
 The prices of all securities quickly and fully reflect all
available information
 Current price reflects
o Past information
o Current information
o Information that can be reasonably inferred
 The market is efficient if investors are unable to earn
abnormal profits by using information available
 The adjustment in prices is unbiased
o Adjustment on the average balancing out and
correct
Conditions for an Efficient Market
Large number of rational, profit-maximizing investors that
 Actively participate in the market and
 Individuals cannot affect market prices (price takers)
Information is costless, widely available, generated in a random
fashion
Investors react quickly and fully to new information
Consequences of Efficient Market
Quick price adjustment in response to the arrival of random
information
Prices reflect all available information
Price changes are independent of one another and move in a
random fashion
 Price changes are independent of past price changes
because changes are based upon new information which is
independent of past information
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Market Efficiency Forms
Efficient market hypothesis
 To what extent do securities markets quickly and fully
reflect different available information?
Three levels of Market Efficiency
 Weak form
o market level data
o past price or volume information
 Semistrong form
o public information
o past information
 Strong form
o All public information
o all (nonpublic) information
Weak Form
Prices reflect all past price and volume data
Past price changes unrelated to future price changes
Implication for technical analysis, which relies on the past history
of prices, is that it is of little or no value in assessing future
changes in price
Market adjusts or incorporates this information quickly and fully
Semistrong Form
Prices reflect all publicly available information and all past
information
Investors cannot act on new public information after its
announcement and expect to earn above-average, risk-adjusted
returns
Encompasses weak form as a subset
Tested by event analysis
Strong Form
Prices reflect all information, past, current and private
No group of investors should be able to earn abnormal rates of
return by using publicly and privately available information
Encompasses weak and semistrong forms as subsets
Evidence on Market Efficiency
Keys to testing validity of any of the three forms of the EMH:
 In order for the EM not to exist abnormal returns must be
achieved
o Consistently
o For an extended time over which excess returns are
earned
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Economically efficient markets
 Assets are priced so that investors cannot exploit any
discrepancies and earn unusual returns transaction costs
matter
Weak Form Evidence
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Tests:
 Statistical test for independence (randomness) of stock
price changes
o If independent, trends in price changes do not exist
o Serial correlation test between price changes for
various lags
 Specific Trading Rules after transaction costs
o Technical Analyst believe that trends do exist and
can be used successfully
o Overreaction hypothesis (DeBondt & Thaler)
provide contraevidence to the weak-form
hypothesis
 People overreact to unexpected and dramatic
news
 Stocks with extreme positions go through
reversals
Semistrong Form Evidence
Event studies
 Empirical analysis of stock price behavior surrounding a
particular event
 Examine company unique returns
o The residual error between the security’s actual
return and that given by the index model
o Abnormal return (Arit) =Rit - E(Rit)
Where:
Arit = the abnormal rate of return for security
i during period t
Rit = the actual rate of return on security i
during period t
E(Rit) = the expected rate of return for
security i during period t, based on the
market model relationship
o Cumulative abnormal return (CAR) is the sum of
the individual Arit for stock i
Stock splits
 Implications of split reflected in price immediately
following the announcement
Accounting changes
 Quick reaction to real change in value
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Initial public offerings
 Only issues purchased at offer price yield abnormal returns
(under-pricing by Investment bankers)
Announcements and news (economic, monetary, political,
company,etc.)
 Little impact on price after release
Strong Form Evidence
Test performance of groups which have access to nonpublic
information
 Corporate insiders have valuable private information
 Evidence that many have consistently earned abnormal
returns on their stock transactions
Insider transactions must be publicly reported
Implications of Efficient Market Hypothesis
What should investors do if markets efficient?
Technical analysis
 Not valuable if weak form holds
Fundamental analysis of intrinsic value
 Superior fundamental analysis becomes necessary
 Those that use the same data and make the same
interpretations experience average results
For professional money managers
 Less time spent on individual securities
o Passive investing favored (Index fund management)
o Otherwise must believe in superior insight
Tasks if markets informationally efficient
 Maintain correct diversification
 Achieve and maintain desired portfolio risk
 Manage tax burden
 Control transaction costs
Market Anomalies
www.investorhome.com
Exceptions that appear to be contrary to market efficiency
Earnings announcements affect stock prices
SUE (Latane′ Jones & Rieke,1974)
 SUE=unexpected earnings/standard error of the estimate
 Adjustment occurs before announcement but significant
amount after
 Contrary to efficient market because the lag should not
exist
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Market Anomalies
Low P/E ratio stocks tend to outperform high P/E ratio stocks
 Low P/E stocks generally have higher risk-adjusted returns
(Basu,1977)
 But P/E ratio is public information
 Should portfolio be based on P/E ratios?
o Also consider financial strength of the company,
dividend yield should be higher than the average,
company has an increasing earnings growth
o Low P/E strategy does well in a “full blown” bear
market
o Could result in an undiversified portfolio
Size effect
 Tendency for small firms to have higher risk-adjusted
returns than large firms(Banz,1981; Reingnanum, 1981)
 Data on small vs large cap funds:
DATE
SMALL CAP FUNDS LARGE CAP FUNDS
1926-1979 12.2%
8.2%
1980-1996 13.3%
15.9%
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January effect
 Tendency for small firm stock returns to be higher in
January (Keim,1983)
 Of the 30.5% small size premium, half of the effect occurs
in January (Haugen & Jorion,1996)
Value Line Ranking System
 Advisory service that ranks 1700 stocks from best (1) to
worst (5)
o Probable price performance in next 12 months
 1980-1993, Group 1 stocks had annualized return of 19.3%
 Best overall performance by any investment letter
 Transaction costs may offset returns (Stickel,1985)
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Conclusions About Market Efficiency
Support for market efficiency is persuasive
 Much research using different methods
 Also many anomalies that cannot be explained
satisfactorily
Markets very efficient but not totally
 To outperform the market, fundamental analysis beyond the
norm must be done
If markets operationally efficient, some investors with the skill to
detect a divergence between price and semistrong value earn profits
 Excludes the majority of investors
 Anomalies offer opportunities
Controversy about the degree of market efficiency still remains
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