Chapter 10
Market Efficiency
Warren Buffet
• "I'd be a bum on the street with a tin cup if
the markets were always efficient"
• ….”Observing correctly that the market was
frequently efficient, they went on to conclude
incorrectly that it was always efficient."
Learning Objectives
• Explain the concept of efficient markets.
• Describe the three forms of market efficiency
– weak, semi-strong, and strong
• Discuss the evidence regarding the Efficient
Market Hypothesis.
• State the implications of market efficiency for
investors.
• Outline major exceptions to the Efficient
Market Hypothesis.
Efficient Markets
• How well do markets respond to new
information?
• 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
Conditions for an Efficient Market
• Large number of rational, profit-maximizing
investors
–
–
Actively participate in the market
Individuals cannot affect market prices
• Information is costless, widely available
• Information is 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 makes the
reward for analysis low
• Prices reflect all available information
• Price changes are independent of one
another and move in a random fashion
–
New information is independent of past
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 - market level data
Semi-strong form - all public information
Strong form - all information, both public and
private
Cumulative Levels of Market Efficiency and
the Information Associated with Each
Strong Form
All Information
Semi-Strong Form
Public Information
Weak Form
Market Data
Weak Form
• Prices reflect all past price and volume data
• Technical analysis, which relies on the past
history of prices, is of little or no value in
assessing future changes in price
• Market adjusts or incorporates this
information quickly and fully
Semi-Strong Form
• Prices reflect all publicly available 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
Strong Form
• Prices reflect all information, public 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 semi-strong forms as
subsets
Evidence on Market Efficiency
• Keys:
–
–
Consistency of returns in excess of risk
Length of time over which returns are earned
• Economically efficient markets
–
Assets are priced so that investors cannot
exploit any discrepancies and earn unusual
returns
•
Transaction costs matter
Weak-Form Evidence
• Test for independence (randomness) of stock
price changes
–
–
If independent, trends in price changes do not
exist
Overreaction hypothesis and evidence
• Test for profitability of trading rules after
brokerage costs
–
Simple buy-and-hold better
Weak-Form EMH
• Mostly supportive of weak-form EMH
• E.g. technical trading rules have not
consistently outperformed the market on
average
• Runs tests
• looking for patterns in signs of returns
• i.e. + + - + - +
• Filter rules
• sell after falls a certain % or buy after rises a certain
%
Two Apparent Contradictions to the WeakForm EMH
1. Momentum or persistence in stock
returns
– tendency of stocks that have done well over
the past 6 to 12 months to continue to do
well over the next 6 to 12 months
2. “Contrarian” Strategies
– stocks that have done well over the past 3-5
year period, will do poorly over the
subsequent 3-5 year period
Semi-Strong-Form Evidence
• Event studies
–
–
Empirical analysis of stock price behaviour
surrounding a particular event
Examine company unique returns
•
•
•
The residual error between the security’s actual return
and that given by the index model
Abnormal return (Arit) = Rit - E(Rit)
Cumulative abnormal return (CAR) =
n
Σ Arit
t=1
Semi-Strong-Form Evidence
• Stock splits
–
Implications of split
reflected in price
immediately following the
announcement
• Accounting changes
–
Quick reaction to real
change in value
• Initial public offerings
–
Only issues purchased at
offer price yield abnormal
returns
• Announcements and news
–
Little impact on price after
release
Professional Portfolio Manager
Performance
• Substantial evidence that they do not
outperform the market (or earn abnormal
risk-adjusted returns) over the long run
• Based on fund averages
• Based on persistence in manager performance
(evidence on this point is weaker)
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 are
efficient?
• Technical analysis
–
Not valuable if weak-form holds
• Fundamental analysis of intrinsic value
–
–
Not valuable if semi-strong-form holds
Experience average results
Implications of Efficient Market
Hypothesis
• For professional money managers
–
Less time spent on individual securities
•
•
–
Passive investing favoured
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
• Exceptions that appear to be contrary to
market efficiency
• Earnings announcements affect stock prices
–
–
Adjustment occurs before announcement, but
also significant amount after
Contrary to efficient market hypothesis because
the lag should not exist
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
But P/E ratio is public information
• Should portfolio be based on P/E ratios?
–
Could result in an undiversified portfolio
Market Anomalies
• Size effect
–
Tendency for small firms to have higher riskadjusted returns than large firms
• January effect
–
–
Tendency for small firm stock returns to be higher
in January
Of 30.5% small-size premium, half of the effect
occurs in January
Market Anomalies
• Value Line Ranking System
–
Advisory service that ranks 1,700 stocks from
best (1) to worst (5)
•
–
1980-1993, Group 1 stocks had annualized
return of 19.3%
•
–
Probable price performance in next 12 months
Best investment letter performance overall
Transaction costs may offset returns
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
Conclusions about Market Efficiency
• If markets operationally efficient, some
investors with the skill to detect a divergence
between price and semi-strong value earn
profits
–
–
Excludes the majority of investors
Anomalies offer opportunities
• Controversy about the degree of market
efficiency still remains
The (Mis)Behavior of Markets
“Efficient Markets theory is elegant but flawed, as
anyone who lived through the booms and busts of the
1990s can now see. The old financial orthodoxy was
founded on two critical assumptions in Bachelier’s key
model: Price changes are statistically independent, and
they are normally distributed. The facts, as I vehemently
argued in the 1960s and many economists now
acknowledge, show otherwise.”
Benoit Mandelbrot
Motivation
• The Gaussian paradigm of independent normally
distributed asset returns has been challenged:
On daily data 7 std events are 10, 000,000 times
more frequently than random data
• Modeling financial price variations accurately is
an essential step in engineering risk management
techniques, portfolio optimization, derivative
pricing, fund management and trading.
• Where should I start? →extreme events, crashes
Studying Extremes
• Markets as complex dynamical systems reveal
their properties better in extremes
• Extreme Value Theory is an emerging
discipline of statistics for extreme events and
statistical analysis of data showing clear nonnormal behavior
– Aims to characterize extreme events
– Focus is on the tails of the data