Chapter 10
Market Efficiency
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 markets respond to new information is a
very important part of obtaining the equilibrium
relationship predicted by the capital market theory
• 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
Efficient Markets
Definition of “all available information”
• All known information including:


Past information (e.g., last year’s earnings)
Current information as well as events that have been
announced but are still forthcoming (e.g., stock splits
and dividends)
• Information that can be reasonably inferred

For example, if many investors believe that interest rates
will decline soon, prices will reflect this belief before the
actual decline occurs
Conditions for an Efficient Market
Why the markets can be expected to be efficient?
• Large number of rational, profit-maximizing
investors


Actively participate in the market
Individuals cannot affect market prices (i.e., pricetakers)
• Information is costless and widely available to
market participants at approximately the same time
• Information is generated in a random fashion (e.g.,
announcements or currency is devalued)
• Investors react quickly and fully to new information
causing stock prices to adjust accordingly
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 (EMH)

The proposition that securities markets are efficient,
with prices of securities reflecting their true economic
value
• Three levels of Market Efficiency



Weak form – prices reflect past market data (i.e.,
historical price and volume information for stocks
and indexes)
Semi-strong form – prices reflect all public
information
Strong form – prices reflect 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
• For example: earnings, dividends, stock split
announcements, new product developments,
financing difficulties, and accounting changes
• Investors cannot act on new public information
after its announcement and expect to earn aboveaverage, risk-adjusted returns
• Encompasses weak form as a subset since market
data are part of the larger set of all publicly
available information
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 and represents the highest level of
market efficiency
Evidence on Market Efficiency
• Keys to testing the validity of any of the three
forms of market efficiency


Consistency of returns in excess of risk
Length of time over which returns are earned
•
Short-lived inefficiencies appearing on a random
basis do not constitute evidence of market
inefficiencies, at least in an economic sense
• Economically efficient markets

Assets are priced so that investors cannot exploit
any discrepancies and earn unusual returns
•
Transaction costs matter
Weak-Form Evidence
Ways to test for weak-form efficiency
• Test for independence (randomness) of stock price
changes [Random Walk Hypothesis]

If stock prices are independent, trends in price
changes do not exist
•
Knowing and using the past sequence of price
information is of no value to an investor
• Test for profitability of trading rules after brokerage
costs

Simple buy-and-hold better
•
Buying a portfolio of stocks and holding it until a
common liquidation date
Weak-Form EMH
• Stock price changes in an efficient market should be
independent
• Statistical tests of price changes are mostly supportive
of weak-form EMH
• The sign test involves classifying each price change by
its sign, which means whether it was +, 0, or –
• Then the “runs” in the series of signs can be counted
and compared to known information about a random
series
• Runs tests
•
•
looking for patterns in signs of returns
i.e. + + - + - +
Weak-Form EMH
• The signs test supports independence of stock price
changes
• Although some runs do occur, they fall within the limits
of randomness since a truly random series will exhibit
some runs
• Technical trading rules
•
•
Technical analysts believe that trends not only exist
but can also be used successfully
Little evidence exists that technical trading, based
solely on past price and volume data, can outperform
a simple buy-and-hold strategy
Two Apparent Contradictions to the
Weak-Form 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


Overreaction Hypothesis [DeBondt & Thaler
(1985)]
stocks that have done well over the past 3-5 year
period, will do poorly over the subsequent 3-5 year
period
Two Apparent Contradictions to
the Weak-Form EMH
• Contrarian strategies are trading strategies
designed to exploit the overreaction hypothesis
• Since the underlying rationale is to purchase or sell
stock in anticipation of achieving future results that
are contrary to their past performance record
• DeBondt and Thaler are testing whether the
overreaction hypothesis is predictive
• In other words, knowing past stock returns appears
to help significantly in predicting future stock
returns
Semi-Strong-Form Evidence
• Event studies



Empirical analysis of stock price behaviour
surrounding a particular event
Usually use an index model of stock returns such as
single-index model
Examine company unique returns
•
•
•
The residual error between the security’s actual return
(Rit ) and that given by the index model E(Rit)
Abnormal return (Arit) = Rit - E(Rit)
n
Cumulative abnormal return (CAR) = Σ Arit
t=1
CAR is the sum of the individual abnormal returns over
the period of time under examination
Semi-Strong-Form Evidence
• Stock splits

(Fig 10.4 pg 281)
Implications of split
reflected in price
immediately following
the announcement and
not the event itself
• Accounting changes

Quick reaction to real
change in economic
value (e.g., depreciation,
inventory reporting [LIFO
vs. FIFO])
• Initial public offerings


Only issues purchased
at offer price yield
abnormal returns
This is attributed to
underpricing by the
underwriters
• Announcements and
news


Little impact on price
after release
Involving economic news
(e.g., inflation or Bank of
Canada rate)
Professional Portfolio Manager
Performance
• There is substantial evidence that portfolio
managers do not outperform the market (or earn
abnormal risk-adjusted returns) over the long
run
• The average active portfolio manager may
underperform the market index by 50 to 200
basis points
• Based on fund averages (US-based equity
mutual funds & pension funds)
Strong-Form Evidence
• Test performance of groups which have access to
nonpublic (private) information



Corporate insiders have valuable private
information
A corporate insider is an officer, director, or major
stockholder of a corporation who might be expected
to have valuable inside information
Evidence that many have consistently earned
abnormal returns on their stock transactions
(strong-form efficiency is not supported)
• Insider transactions must be publicly reported
(OSC requires reporting y the tenth day of the next
month)
Implications of Efficient Market
Hypothesis
• What should investors do if markets are
efficient?
• 1- Technical analysis


Not valuable if weak-form holds
The evidence accumulated to date
overwhelmingly favors the weak-form EMH and
casts doubt on technical analysis
Implications of Efficient Market
Hypothesis
• 2- Fundamental analysis



Seeks to estimate the intrinsic value of a
security
Not valuable if semi-strong-form holds (since
stock prices reflect all relevant publicly available
information, gaining access to information
others already have is of no value)
EMH suggests that investors who use the same
data and make the same interpretations as
other investors will experience average results
Implications of Efficient Market
Hypothesis
• 3- Money Management
• For professional money managers (assuming that
the market is efficient)

Less time spent on assessing individual securities
•
•
Passive investing favored (one passive investment
strategy that is becoming increasingly popular is
indexing, which involves the construction of portfolios
designed to mimic the performance of a chosen
market benchmark portfolio, such as S&P/TSX
Composite Index)
Otherwise, must believe in superior insight
Implications of Efficient Market
Hypothesis
• 3- Money Management

Tasks that portfolio managers have to perform
if markets are informationally efficient
•
•
•
•
Maintain correct amount of diversification
Achieve and maintain a desired level of
portfolio risk
Manage tax burden
Control transaction costs (can be done through
index funds)
Market Anomalies
• Exceptions (techniques or strategies) that
appear to be contrary to market efficiency
• Regardless of how persuasive the case for
market efficiency is, debate of this issue id
likely to persist
Market Anomalies
• Size effect
Tendency for small firms to have higher riskadjusted returns than large firms
 Market betas could not account for the abnormal
returns
 Bid-ask spreads, which are higher for smaller
stocks, could not account for the abnormal returns
As a result, when trading on the TSX, the small-firm
strategy may be a viable strategy for increasing
portfolio returns without an offsetting increase in risk

Market Anomalies
Seasonality in stock returns
• January effect




Tendency for small firm stock returns to be higher in
January
Of the 30.5% small-size premium, half of the effect
occurs in January
Referred to as “the small firm in January effect”
because it is most prevalent for the returns of smallcap stocks
More than half of the excess January returns
occurred during the first five trading days of that
month
Market Anomalies
Seasonality in stock returns
• Day-of-the-week effect

The average Monday return is negative and
significantly different from the average return of the
other four days
• Day-of-the-month effect

Returns tend to be higher on the last trading day of
each month
Conclusions about Market
Efficiency
• Support for market efficiency is persuasive


Much research using different methods
Also many anomalies that cannot be explained
satisfactorily
• Markets are quite efficient, but not totally


To outperform the market, superior
fundamental analysis (beyond the norm) must
be done
The fundamental analysis that is done
everyday is already reflected in stock prices
Conclusions about Market
Efficiency
• If markets are operationally efficient, some
investors with the skill to detect a divergence
between price and semi-strong value (price based
on all available public information) earn profits


Excludes the majority of investors
Anomalies offer opportunities
• Controversy about the degree of market efficiency
still remains
• The evidence to date suggests that investors face
an operationally efficient market