How Efficient Is the Market?
Efficient Market Hypothesis (EMH)
Random Walk Hypothesis
Forms of EMH
Implications of EMH
Predictability
Anomalies
Professional Management
Efficient Market Hypothesis

Definition


Prices of securities fully reflect all
available information about these
securities
Question

Is a $20 bill you find while walking down a
busy street worth $20?
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Random Walk Hypothesis
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Tracing the evolution of several economic
variables  predict stock prices?
Kendall (1953)  no predictable patterns
Random Walk
 Stock prices are random
 More precisely


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Expected return is positive over time
Positive trend and random around the trend
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Random Walk Hypothesis

Positive Trend with random fluctuation
Security
Prices
Time
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Efficient Markets and Random Walk
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
Stock prices fully and immediately
reflect all available information
Once information becomes available,
market participants analyze it
Competition assures that prices reflect
all available information
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Forms of EMH

Meaning of all available information
 Weak Form
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

Semi-strong Form
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
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Information contained in market trading data
Past prices, volumes, interest rate, CPI, etc.
Technical analysis (e.g. trend-chasing or
“charting”) is irrelevant
All publicly available information
All earnings forecasts, accounting information
Fundamental analysis is irrelevant
Strong Form
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
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All information relevant to the firm including
insider information
Insider Trading
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More on Fundamental Analysis


Stock price should be equal to discounted
value of expected future cash flow!
Information used

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Earnings and dividend forecasts
Future interest rate forecasts
Firm risk evaluation
Process

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Step 1: examine past earnings and company
balance sheets
Step 2: evaluation of quality of the firm’s
management, firm’s standing in its industry, and
prospects of the industry
Step 3: determine the present discounted value of
all the payments to a shareholder
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Forms of EMH
Strong
Form Set
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Semi-strong
Form Set
Weak
Form Set
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Fundamental vs. Technical Analysis

Is it like
astronomy vs. astrology?

Depends if you believe in EMH...
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Implications of EMH
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Active Management (against EMH?)
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Stock picking (security analysis)
Market Timing
Economically feasible only for managers of large
portfolios
Do even large mutual funds have the ability to
uncover mispriced securities?
Passive Management (for EMH?)



A well-diversified portfolio
Buy and hold strategy
Index Funds
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Implications of EMH

Role of Portfolio Management
 Diversification


Appropriate risk level


Provide the systematic risk level that investors
can tolerate
Tax considerations

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Idiosyncratic risk should be diversified away at
a minimal cost
Growth vs Income stocks, munis vs Treasuries
Other considerations
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Are Markets Efficient?
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EMH implies
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A great deal of portfolio managers’ activities (the
search for mispriced securities) is wasted effort
Active management may hurt clients because of
costs and imperfectly diversified portfolios
Not hailed by professional portfolio managers
Empirical tests of the hypothesis
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Tests of predictability in stock returns (weak EMH)
Testing some trading rules (weak EMH)
Event studies (semi-strong EMH)
Studying insider trades (strong EMH)
Assessing performance of professional managers
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Predictability – Short-Term
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Auto (serial) correlation

Return correlation of two consecutive periods

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Cov[ ri,t 1 ,ri,t ]
i
2
Returns over short horizons (monthly or less)
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Lo, Mamaysky and Wang (2000, JF)
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Technical trading offers excess return
Lehman (1990, QJE), Conrad and Kaul (1988, JB),
Lo and MacKinlay (1988, RFS)

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Positive short-term correlation
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Predictability – Intermediate-Term
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Returns over intermediate horizons (3-12 mon)

Jagadeesh and Titman (1993, JF)
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Stocks exhibit a momentum property in which good or
bad recent performance continues
Performance of individual stocks

Highly unpredictable

Portfolios of the past winners appear to outperform
portfolios of the past losers.
Momentum strategy:

Long on winners and short on losers (still works)
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Predictability – Long-Term
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Returns over long horizons (multi-years)
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DeBondt and Thaler (1985, JF)
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Fama and French (1988, JF)
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Negative long-term serial correlation over long
horizons (5-year prediction, 3-year estimation)
Stocks exhibit a price-reversal property in which
good or bad recent performance reverses
Contrarian profits reflect time-varying risk premium
Contrarian strategy:

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Long on losers and short on winners
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Anomalies
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Small-firm-in-January effect
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Neglected-firm effect and liquidity effects


The higher the book-to-market ratio, the higher
returns
P/E effect
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The tendency of investments in stock of less wellknown firms to generate abnormal returns
Book-to-market ratios


Stocks of small firms have earned abnormal
returns, primarily in the month of January
Portfolios of low P/E stocks exhibit higher average
risk-adjusted returns than high P/E stocks
Closed-end fund puzzle: Price < NAV
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Royal Dutch vs. Shell – Where Is Arbitrage?
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Why Do Anomalies Happen?

Limits to arbitrage
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Fundamental risk in exploiting arbitrage
opportunities
Implementation costs
Models risk (i.e. a model not properly accounting
for risk)
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Liquidity issues and non-traded assets
Behavioral effects
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Overconfidence
Mental accounting
Prospect theory
etc…
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Event Studies
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Cumulative Abnormal Return (CAR)

Market Model approach
Non-event time: run rit = ai + bi rmt + eit
 Event time:

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Excess Return = (Actual - Expected)
eit = Actual - (ai + bi rmt)
CARt = e-T+ e-T+1 +…+et
CAR
-T
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0
t
+T
19
Event Studies – CAR for Target Companies
before Takeover Attempts
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Anomalies after Earnings Announcements

Earnings Announcements

Foster, Olsen, and Shevlin (1984, Accounting Review)
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Professional Management
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Some evidence of persistent positive
and negative performances
Potential measurement error for
benchmark returns
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Style changes
Risk premiums
Superstar phenomenon
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or statistical outliers?..
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Persistence of Mutual Fund Performance
Carhart (1997, JF) - not much of a long term persistence!
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Wrap-up
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What is an efficient market?
What is the weak form of EMH?
What is the semi-strong form of EMH?
What is the strong form of EMH?
What is the evidence of predictability?
What is the relationship between an
anomaly and EMH?
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