Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 7
Version 1.2
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Chapter 7
Efficient Capital Markets
Questions to be answered:
• What is meant by the concept that capital
markets are efficient?
• Why should capital markets be efficient?
• What are the specific factors that contribute to
an efficient market?
• Given the overall efficient market hypothesis,
what are the three subhypotheses and what are
the implications of each?
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Chapter 7
Efficient Capital Markets
• How do you test the weak-form efficient
market hypothesis (EMH) and what are the
results of the tests?
• How do you test the semistrong-form EMH
and what are the test results?
• How do you test the strong-form EMH and
what are the test results?
• For each set of tests, which results support the
hypothesis and which results indicate an
anomaly related to the hypothesis?
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Chapter 7
Efficient Capital Markets
• What are the implications of the results for
–
–
–
–
Technical analysis?
Fundamental analysis?
Portfolio managers with superior analysts?
Portfolio managers with inferior analysts?
• What is the evidence related to the EMH for
markets in foreign countries?
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Efficient Capital Markets
• In an efficient capital market, security prices
adjust rapidly to the arrival of new information,
therefore the current prices of securities reflect
all information about the security
• Whether markets are efficient has been
extensively researched and remains
controversial
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Why Should Capital Markets
Be Efficient?
The premises of an informationally efficient market:
– A large number of competing profit-maximizing but riskaverse participants analyze and value securities, each
independently of the others
– New information regarding securities comes to the market in
a random fashion
– Profit-maximizing investors adjust security prices rapidly to
reflect the effect of new information
Conclusion: the expected returns implicit in the current
price of a security should reflect its risk
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Alternative
Efficient Market Hypotheses
• Early work was based on the random walk
hypothesis, which Fama presented in terms of a
“fair game” model


EPj ,t 1 | t   1  Erj ,t 1 | t  Pj ,t
where
E  expected value operator
Pj ,t  price of security j at time t
Pj ,t 1  price of security j at time t  1
r j ,t 1  the one period present rate of return for security j during period t  1
 t  the set of informatio n that is assumed to be " fully reflected" in the
security price at time t
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Alternative
Efficient Market Hypotheses
• The difference between the actual price and the
expected price can be defined as
x j ,t 1  Pj ,t 1  EPj ,t 1 | t 
• This defines excess market value, which in an
efficient market should equal zero
E x j ,t 1 | t   0
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Alternative
Efficient Market Hypotheses
• Implies that, on average, realized returns
should equal expected returns
– I.e., returns that are realized on stock
investments should, on average, be equal to the
returns that had been expected,
– given some set of information on which to form
the expectations
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Alternative
Efficient Market Hypotheses
There are three general forms of the EMH:
– Weak-form efficient market hypothesis
– Semistrong-form EMH
– Strong-form EMH
• These differ based on the information set
(t) that is assumed
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Weak-Form EMH
• Current prices reflect all security-market
information, including the historical
sequence of prices, rates of return, trading
volume data, and other market-generated
information
• This implies that past rates of return and
other market data should have no
relationship with future rates of return
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Semistrong-Form EMH
• Current security prices reflect all public
information, including market and nonmarket information
• This implies that decisions made on new
information after it is public should not lead
to above-average risk-adjusted profits from
those transactions
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Strong-Form EMH
• Stock prices fully reflect ALL information from
public and private sources
• This implies that no group of investors should be
able to consistently derive above-average riskadjusted rates of return
• This assumes perfect markets in which all
information is cost-free and available to everyone
at the same time
– not always the case, even in the age of the internet
– another problem – some information may really be
misinformation or “noise”
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Tests and Results of
Weak-Form EMH
• Statistical tests of independence between
rates of return
– Autocorrelation tests have mixed results
– Runs tests indicate randomness in prices
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Tests and Results of
Weak-Form EMH
• Comparison of trading rules to a buy-and-hold
policy is difficult because trading rules can be
complex and there are too many to test them all
– Filter rules yield above-average profits with small
filters, but only before taking into account
transactions costs
– Trading rule results have been mixed, and most have
not been able to beat a buy-and-hold policy
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Tests and Results of
Weak-Form EMH
• Testing constraints
– Use only publicly available data
– Include all transactions costs
– Adjust the results for risk
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Tests and Results of
Weak-Form EMH
• Results generally support the weak-form
EMH, but results are not unanimous
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Tests and Results of
Semistrong-Form EMH
• Studies to predict future rates of return
using public information beyond market
information
– Time series analysis
– Cross-section distribution
• Event studies examine how fast stock prices
adjust to significant economic events
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Tests and Results of
Semistrong-Form EMH
• Test results should adjust a security’s rate of return for
the rates of return of the overall market during the
period considered:
Arit = Rit - Rmt
where:
Arit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
• This was the adjustment made by researchers before
1970; subsequently, researchers also adjusted for the
level of the stock’s beta
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Tests and Results of
Semistrong-Form EMH
Arit = Rit - E(Rit)
where:
– E(Rit) = the expected rate of return for stock I during
period t based on the market rate of return and the
stock’s normal relationship with the market (its beta)
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Tests and Results of
Semistrong-Form EMH
• Time series tests for abnormal rates of return
– short-horizon returns have limited results
– long-horizon returns analysis has been
successful based on
• dividend yield (D/P)
• default spread
• term structure spread
– Quarterly earnings reports may yield abnormal
returns due to
• unanticipated earnings change
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Tests and Results of
Semistrong-Form EMH
Tests of standardized unexpected earnings
(SUE) normalize the difference in actual
and expected earnings by the standard error
of estimate from the regression used to
derive the expected earnings figure
SUE =
Reported EPSt - Predicted EPSt
Standard Error of Estimate for the
Estimating Regression Equation
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Tests and Results of
Semistrong-Form EMH
• Large SUEs result in abnormal stock price
changes, with over 50% after the announcement
• Unexpected earnings can explain up to 80% of
stock drift over a time period
• Tend to follow a pattern of under-reaction
followed by over-reaction
• These are evidence against the EMH
• Additional tests include calendar studies …
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Tests and Results of
Semistrong-Form EMH
• The January Anomaly
– Stocks with negative returns during the prior
year had higher returns right after the first of
the year - studies indicate an excess return on
AMEX but not on NYSE
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Tests and Results of
Semistrong-Form EMH
• Other calendar effects
– All the market’s cumulative advance occurs
during the first half of trading months
– Monday/weekend returns were significantly
negative
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Tests and Results of
Semistrong-Form EMH
• Predicting cross-sectional returns
– All securities should have equal risk-adjusted returns
• Studies examine alternative measures of size or
quality as a tool to rank stocks in terms of riskadjusted returns
• Tests face a joint hypothesis problem – results are
dependent on both of two factors:
– market efficiency
– the asset pricing model used
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Tests and Results of
Semistrong-Form EMH
• Price-earnings ratios and returns
–
–
–
–
Examine historical P/E ratios and returns
Stocks are divided into five P/E classes
Low P/E stocks had higher returns and had lower risk
Publicly available P/E ratios could be used for
abnormal returns
– This is inconsistent with semistrong efficiency
– Similar results are found with Market-to-Book ratios
(will come back to this in a bit …)
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Tests and Results of
Semistrong-Form EMH
• The size effect (total market value)
– All stocks on NYSE and AMEX were ranked by market
value and divided into ten equally weighted portfolios
– The risk-adjusted returns for extended periods indicate
that the small firms consistently experienced
significantly larger risk-adjusted returns than large
firms
– Could this have caused the P/E results previously
studied?
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Tests and Results of
Semistrong-Form EMH
• The P/E studies and size studies are dual
tests of the EMH and the CAPM
• Abnormal returns could occur because
either
– markets are inefficient or
– market model is not properly specified and
provides incorrect estimates of risk and
expected returns (but why should low P/E
stocks tend to be riskier than high P/E stocks?)
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Tests and Results of
Semistrong-Form EMH
• Adjustments for riskiness of small firms did
not explain the large differences in rate of
return
• The impact of transactions costs of investing
in small firms depends on frequency of trading
– Daily trading reverses small firm gains
• The small-firm effect is not stable from year to
year
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Tests and Results of
Semistrong-Form EMH
• Neglected Firms
– Firms divided into three groups based on number of
analysts following a stock
– Neglected firm effect caused by lack of information,
crosses size classes
– Contradictory results from another study – confounding
with capitalization effect
• Trading volume
– Studied relationship between returns, market value, and
trading activity
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Tests and Results of
Semistrong-Form EMH
• Firm size has emerged as a major predictor
of future returns
• This is an anomaly in the efficient markets
literature
• Attempts to explain the size anomaly in
terms of superior risk measurements,
transactions costs, analysts attention,
trading activity, and differential information
have not succeeded
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Tests and Results of
Semistrong-Form EMH
• Book value-market value ratio
– As a predictor of stock returns
– Significant positive relationship between the current
values for this ratio and future stock returns are
evidence against EMH
• Size and BV/MV dominate other ratios such as
E/P ratio or leverage
• But this combination may only work during
expansive monetary policy
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Tests and Results of
Semistrong-Form EMH
• Event studies
– Stock split studies show that splits do not result in
abnormal gains after the split announcement, but before
– Initial public offerings seem to be underpriced by about
15%, but that varies over time, and the price is adjusted
within one day after the offering
– Being listed on an exchange may offer some short term
profit opportunities (but volatility increases and price
decreases again after listing)
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Tests and Results of
Semistrong-Form EMH
• Event studies (continued)
– Unexpected world events and economic news
are quickly adjusted to and do not provide
opportunities
– Announcements of accounting changes are
quickly adjusted for and do not seem to provide
opportunities
– Corporate events such as mergers and offerings
are adjusted to within a few days
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Summary on the
Semistrong-Form EMH
• Evidence is mixed
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Summary on the
Semistrong-Form EMH
• Evidence is mixed
• Strong support from numerous event studies
with the exception of exchange listing
studies
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Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
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Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
– Dividend yields
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Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
– Dividend yields, risk premiums
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Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
– Dividend yields, risk premiums, calendar
patterns
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Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
– Dividend yields, risk premiums, calendar
patterns, and earnings surprises
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Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets are
not semistrong efficient
– Dividend yields, risk premiums, calendar
patterns, and earnings surprises
• This also included cross-sectional predictors
such as size, the BV/MV ratio (when there
is expansive monetary policy), E/P ratios,
and neglected firms.
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Tests and Results of
Strong-Form EMH
• Strong-form EMH contends that stock
prices fully reflect all information, both
public and private
• This implies that no group of investors has
access to private information that will allow
them to consistently earn above-average
profits
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Testing Groups of Investors
• Corporate insiders
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Testing Groups of Investors
• Corporate insiders
• Stock exchange specialists
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Testing Groups of Investors
• Corporate insiders
• Stock exchange specialists
• Security analysts
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Testing Groups of Investors
•
•
•
•
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
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Corporate Insider Trading
• Insiders include major corporate officers,
directors, and owners of 10% or more of
any equity class of securities
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Corporate Insider Trading
• Insiders include major corporate officers,
directors, and owners of 10% or more of
any equity class of securities
• Insiders must report to the SEC each month
on their transactions as insiders
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Corporate Insider Trading
• Insiders include major corporate officers,
directors, and owners of 10% or more of
any equity class of securities
• Insiders must report to the SEC each month
on their transactions as insiders
• These insider trades are made public about
six weeks later and allow for study
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Corporate Insider Trading
• Corporate insiders generally experience
above-average profits especially on
purchase transactions
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Corporate Insider Trading
• Corporate insiders generally experience
above-average profits especially on
purchase transaction
• This implies that many insiders had private
information from which they derived aboveaverage returns on their company stock
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Corporate Insider Trading
• Studies showed that public investors who
traded with the insiders based on announced
transactions would have enjoyed excess
risk-adjusted returns, but the markets now
seem to have eliminated this inefficiency
(soon after it was discovered)
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Corporate Insider Trading
• Other studies indicate that you can increase
returns from using insider trading
information by combining it with key
financial ratios and considering what group
of insiders is doing the buying and selling
• Next group – Stock Exchange Specialists
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Stock Exchange Specialists
• Specialists have monopolistic access to
information about unfilled limit orders
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Stock Exchange Specialists
• Specialists have monopolistic access to
information about unfilled limit orders
• You would expect specialists to derive
above-average returns from this
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Stock Exchange Specialists
• Specialists have monopolistic access to
information about unfilled limit orders
• You would expect specialists to derive
above-average returns from this
• The data generally supports this
• Next group – Security Analysts
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Security Analysts
• Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
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Security Analysts
• Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
• This looks at whether, after a stock selection
by an analyst is made known, a significant
abnormal return is available to those who
follow their recommendation
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The Value Line Enigma
• Value Line (VL) publishes financial
information on about 1,700 stocks
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The Value Line Enigma
• Value Line (VL) publishes financial
information on about 1,700 stocks
• The report includes a timing rank from 1
down to 5
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The Value Line Enigma
• Value Line (VL) publishes financial
information on about 1,700 stocks
• The report includes a timing rank from 1
down to 5
• Firms ranked 1 substantially outperform the
market
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The Value Line Enigma
• Value Line (VL) publishes financial information
on about 1,700 stocks
• The report includes a timing rank from 1 down to
5
• Firms ranked 1 substantially outperform the
market
• Firms ranked 5 substantially underperform the
market
• Ability to profit from this after transactions costs
depends upon the frequency of rebalancing
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The Value Line Enigma
• Changes in rankings are quickly price
adjusted into the market
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The Value Line Enigma
• Changes in rankings are quickly price
adjusted into the market
• Some contend that the Value Line effect is
“merely” a consequence of the unexpected
earnings anomaly, due to changes in
rankings from unexpected earnings
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Security Analysts
• There is evidence in favor of existence of
superior analysts who apparently possess
private information
• Next group – Professional Money Managers
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Professional Money Managers
• Trained professionals, working full time at
investment management
• If any investor can achieve above-average
returns, it should be this group
• If any non-insider can obtain inside
information, it would be this group, due to
the extensive management interviews that
they conduct
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Performance of
Professional Money Managers
• Most tests examine mutual funds
• New tests also examine trust departments,
insurance companies, and investment advisors
• Risk-adjusted, after expenses, returns of mutual
funds generally show that most funds did not
match aggregate market performance
– Most underperform
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Performance of
Professional Money Managers
• Quote from “Wall Street:”
– “Do you want to know why fund managers can’t beat
the S&P 500? Because fund managers are sheep … and
sheep get slaughtered.”
– Fund managers also face agency problems that
contribute to poor performance
– Compensation structure encourages “sheep-like”
behavior
• Some notable exceptions include:
– “The Superinvestors of Graham-and-Doddsville”
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Conclusions Regarding the
Strong-Form EMH
• Mixed results, but some support
• Tests for corporate insiders and stock
exchange specialists do not support the
hypothesis (Both groups seem to have
monopolistic access to important
information and use it to derive aboveaverage returns)
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Conclusions Regarding the
Strong-Form EMH
• Tests results for analysts are concentrated on Value
Line rankings
– Results have changed over time
– Currently tend to support EMH
• Individual analyst recommendations seem to
contain significant information
• Performance of professional money managers
seems consistent with strong-form EMH
– But, tend to underperform S&P 500 by an even larger
margin (more than administrative costs and costs of
research) than an explanation of market efficiency
would suggest
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Implications of
Efficient Capital Markets
• Overall results indicate the capital markets are
relatively efficient with respect to numerous sets
of information
• But numerous anomalies and inconsistencies also
remain
• There are substantial instances where the market
fails to rapidly adjust to public information
– So, what techniques will or won’t work?
– What do you do if you can’t beat the market?
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Efficient Markets
and Technical Analysis
• Assumptions of technical analysis directly
oppose the notion of efficient markets
• Technicians believe that new information is
not immediately available to everyone, but
is disseminated:
– from the informed professional first …
– then to the aggressive investing public …
– and then to the masses
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Efficient Markets
and Technical Analysis
• Technicians also believe that investors do
not analyze information and act
immediately - it takes time
• Therefore, stock prices move to a new
equilibrium after the release of new
information in a gradual manner, causing
trends in stock price movements that persist
for periods
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Efficient Markets
and Technical Analysis
• Technical analysts develop systems to detect
movement to a new equilibrium (breakout) and
trade based on that
• Contradicts EMH rapid price adjustments
• If the capital market is weak-form efficient, a
trading system that depends on past trading data
can have no value
• Nonetheless, technical analysts and technical
trading systems persist
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Efficient Markets
and Fundamental Analysis
• Fundamental analysts believe that there is a
basic intrinsic value for the aggregate stock
market, various industries, or individual
securities and these values depend on
underlying economic factors
• Investors should determine the intrinsic
value of an investment at a point in time and
compare it to the market price
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Efficient Markets
and Fundamental Analysis
• If you can do a superior job of estimating intrinsic
value you can make superior market timing
decisions and generate above-average returns
• This involves aggregate market analysis, industry
analysis, company analysis, and portfolio
management
• Intrinsic value analysis should start with aggregate
market analysis
– But market is most likely to be relatively inefficient at
the firm level, and especially for smaller, less wellknown firms
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Aggregate Market Analysis with
Efficient Capital Markets
• EMH implies that past economic events
should not lead to outperforming a buy-andhold policy
• Merely using historical data to estimate
future values is not sufficient
• You must estimate the relevant variables
that cause long-run movements
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Industry and Company Analysis
with Efficient Capital Markets
• Wide distribution of returns from different
industries and companies justifies industry
and company analysis (Chapters 19 and 20)
• Must understand the variables that affect
rates of return and …
• Do a superior job of estimating movements
in these relevant valuation variables, not
just look at past data
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Industry and Company Analysis
with Efficient Capital Markets
• Important relationship between expected earnings
and actual earnings
• Accurately predicting earnings surprises allows
for superior performance
• Tests of strong-form EMH suggests existence of
superior analysts
• Studies indicate that fundamental analysis based
on E/P ratios, size, and the BV/MV ratios can lead
to differentiating future return patterns
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How to Evaluate Analysts or
Investors
• Examine the performance of numerous securities
that this analyst recommends over time in relation
to a set of randomly selected stocks in the same
risk class
• Selected stocks should consistently outperform
the randomly selected stocks (a random selection
should outperform the market about half the time,
so the results from only a few periods would be
inconclusive)
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Efficient Markets
and Portfolio Management
• Management depends on analysts
• With superior analysts, follow them and
look for opportunities in neglected stocks
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Efficient Markets
and Portfolio Management
• Without superior analysts, passive
management may outperform active
management by:
– Building a globally diversified portfolio with a
risk level matching client preferences
– Minimizing transaction costs (taxes, trading
turnover, liquidity costs)
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The Rationale and
Use of Index Funds
• Efficient capital markets and a lack of
superior analysts imply that many portfolios
should be managed passively (so their
performance matches the aggregate market,
minimizes the costs of research and trading)
• Institutions created market (index) funds
that duplicate the composition and
performance of selected index series
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Efficiency in
European Equity Markets
• Hawawini study indicates behavior of
European stock prices is similar to U.S.
common stocks
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The Internet
Investments Online
www.bloomberg.com
www.cnbc.com
www.ft.com
www.abcnews.com
www.wsj.com
www.pointcast.com www.nbcnews.com
www.msnbc.com
www.cnnfn.com
www.cnn.com
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End of Chapter 7
–Efficient Capital Markets
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Upcoming topics
• “Shift Happens”
– Michael Mauboussin
• “The Wrong 20-Yard Line”
– Ch. 15 of The Inefficient Stock Market,
by Robert A. Haugen
• Behavioral and Institutional Finance
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Copyright © 2000 by Harcourt, Inc. All rights reserved.