definition efficient market hypothesis: implicatio

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Chapter 8The Efficient Market Hypothesis

Konan ChanSpring, 2022

Investments Konan Chan 2

Agenda

• Definition of efficient market hypothesis• Types of efficient markets

– Weak form– Semi-strong form– Strong form

• Portfolio management under market efficiency• Empirical evidence

– Patterns against weak form EMH– Anomalies against semi-strong form EMH– Analyst and fund performance


Efficient Market Hypothesis: Definition

• Prices of securities fully reflect available information about securities

• When new information arrives, prices quickly reach the fair level which “incorporates” the information


Efficient Market Hypothesis: Implication

• Current price is the fair price (no under or over-priced)

• Prices change only in response to new information• Market is very competitive (quick price response)• New information cannot be predicted• Stock price changes follow a random walk• Investors can earn only “normal” rate of return,

which is required return (from CAPM) by bearing risks

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Reaction of Stock Price to New InfoStockPrice

Days before (-) and after (+) corporate event announcement–30 –20 –10 0 +10 +20 +30

Overreaction andreversion

Under-reaction Delayed responseEfficient-market

response to new information


Returns Before Takeover: Target Firm


Stock Price Reaction to CNBC Reports


Competition as Source of Efficiency

• Why do we expect stock prices to reflect “all available information”?

• Investor competition should imply stock prices reflect available information

• Investors exploit available profit opportunities by using information that is overlooked by others

• Competitive advantage can verge on insider trading

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Types of Market Efficiency

• Depends on the information set– Strong form– Semi-strong form– Weak form

Past prices

Publicly availableinformation

All relevant information

• Strong eff. Semi-strong eff. Weak eff.• Weak ineff. Semi-strong ineff. Strong ineff.


Weak Form Market Efficiency• Definition

– Current prices reflect all information in past trading– Information: past prices, trading volume, short positions

• Implications– Cannot make abnormal profits by using past prices– Price changes should be unpredictable (random walk)– Technical (trend) analysis should not work– Fundamental analysis may make abnormal profits

• Why trend analysis cannot work?– Past price data are easy to get– There are many smart analysts and traders in the market


Semi-Strong Form Market Efficiency

• Definition– Current prices reflect all publicly available information– Information: past prices, corporate announcements,

financial statements (fundamentals), forecasts

• Implications– Cannot make abnormal profits by publicly available info.– Fundamental analysis should not work – Insider trading may make abnormal profits

• Why fundamental analysis cannot work?– Fundamental information is open to the public


Strong Form Market Efficiency

• Definition– Current prices reflect all relevant information– Information: past prices, publicly available information,

insider (private) information

• Implications– There is no way to make abnormal profits

• Why insider trading cannot work?– SEC requires insiders report transactions each month

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Brief Summary of Market Efficiency


Technical Analysis

• Use prices and volume information to predict future prices (look for predictable patterns)

• Success depends on a sluggish response of stock prices to fundamental factors (not working under weak form efficiency)

• Examples:– Relative strength (a ratio relative to the benchmark)– Resistance level: unlikely for stock/index to rise above– Support level: unlikely for stock/index to fall below


Fundamental Analysis

• Use fundamental information, including macroeconomics, earnings, firms’ prospects, to predict stock prices

• Try to find firms that are better than everyone else’s estimate (not working under Semi-strong form efficiency)

• Try to find poorly run firms that are not as bad as the market thinks


Active or Passive Management

• Passive Management– Accept EMH– No attempt to find mispriced securities– Buy-and-hold strategy– Index Funds and ETFs– Very low costs

• Active Management– An expensive strategy– Suitable only for very large portfolios

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Portfolio Management

• EMH suggests a passive investment strategy by investing in a well-diversified portfolio

• Is portfolio management useless under EMH?


Portfolio Management under EMH

• A role exists for portfolio management• Choose portfolios to meet the investor’s needs

– Risk level (diversifications)– Tax status– Unique needs (age, employment, etc)


Resource Allocation

• If markets were inefficient, resources would be systematically misallocated

• Firm with overvalued securities can raise capital too cheaply

• Firm with undervalued securities may have to pass up profitable opportunities because cost of capital is too high


Issues in Market Efficiency

• Magnitude Issue– Only managers of large portfolios can earn enough trading

profits to make the exploitation of minor mispricing worth the effort.

• Selection Bias Issue– Only unsuccessful investment schemes are made public;

good schemes remain private.

• Lucky Event Issue– True probability of successful investments is

unobservable

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Weak-Form Tests: Return Patterns

• Returns over the Short Horizon– Momentum: Good or bad recent performance continues

over short to intermediate time horizons• Returns over Long Horizons

– Reversals: Episodes of overshooting followed by corrections


Momentum

• Past winners (based on past 3 to12 month returns) outperform past losers (Jegadeesh and Titman, 1993)

• Against weak-form market efficiency

– Winners and losers have similar betas

– No return difference after one year


Profits of Momentum Strategy


Return Reversal• Long-term past losers

outperform• There is long-term

return reversal• Do investors over-

react? (DeBondt and Thaler, 1985)

• Controversial issue: irrational investor?

• Related to book-to-market effect (Famaand French, 1996)

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Predictors of Broad Market Returns

• Dividend yield– Aggregate returns are higher when D/P is higher (Fama

and French, 1988)• Earnings yield

– Earnings yield can positively predict market returns (Campbell and Shiller, 1988)

• Bond spread– Bond spreads can predict market returns (Keim and

Stambaugh, 1986)

• Explanation– Market inefficiency or higher market risk premium?


Semistrong Tests: Anomalies

• Anomalies– Empirical patterns in returns that are difficult to reconcile

with the efficient market hypothesis

• P/E effect• Small firm effect (January effect)• Book-to-market effect • Post-earnings announcement drift• Neglected firm effect and liquidity effects


P/E Effect

• Low P/E firms generate higher risk-adjusted returns than high P/E firms


Size Effect (small firm effect, January effect)

• Small firms outperform large firms (by Banz, 1981)• The outperformance only happens in January,

especially the first few days (by Keim, 1983)

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Book-to-market effect (Value effect)

• High B/M firms outperform low B/M firms for 5 years (by Fama and French, 1992; Lakonishok, 1994)

B/M

11.011.8 11.7 11.7

13.1 13.4 13.4

15.516.1

17.3

0

2

4

6

8

10

12

14

16

18

20

1 2 3 4 5 6 7 8 9 10

Ann

ual r

etur

n (%

)

Book-to-market decile: 1 = low, 10 = high


Value Strategies

• Value strategy – Choose high B/M firms, or– Buy high B/M (value) firms, and simultaneously

sell low B/M (growth) firms

• Other indicators for value firms– High earnings-to-price, or E/P ratio (inverse of P/E)– High dividend-to-price (dividend yield), or D/P ratio– High cash flows-to-price, or C/P ratio– Low sales growth rate


Simple Value Strategy• One-way sort to show value strategy profits• Contrarian strategy to exploit the over-reaction

– Buy stocks with low expected growth (high C/P, E/P)– Buy stocks with poor past performance (low GS)– Blue circle (value stocks), red circle (glamour stocks)

1 2 3 4 5 6 7 8 9 10 V - G

B/M 9.3 12.5 14.6 15.4 15.8 16.6 18.4 18.9 19.6 19.8 10.5

C/P 9.1 12.2 14.5 15.7 16.6 17.1 18.0 19.2 19.9 20.1 11.0

E/P 11.1 12.6 14.3 15.2 16.0 16.7 18.8 19.1 19.6 19.0 7.9

GS 19.5 19.5 18.8 18.3 17.1 17.1 16.5 16.4 15.5 12.7 6.8

Average annual returns over 5 post-formation years


Post-Earnings Announcement Drift(SUE Effect, Earnings Momentum)

• Firms whose actual earnings beat the market consensus outperform firms whose actual earnings disappoint the market (Ball and Brown, 1968)

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Long-run Performance of IPOs


Stock Returns of Repurchases


Anomalies against Semi-strong EMH

• Size (January) effect• B/M (value) effect • Post-earnings-announcement drift• Neglected-firm effect• Long-run underperformance of IPOs and SEOs• Long-run outperformance of repurchases

Other Predictors (Anomalies)

• Volatility– Idiosyncratic volatility is negatively associated w/ returns

• Accruals and earnings quality– High accruals (signal low earnings quality) predict low

future returns

• Growth– High growth (capital expenditure, asset growth, share

issuance) firms tend to have low future returns

• Profitability– Gross profitability is postively associated w/ returns


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Strong-Form Tests: Inside Information

• Insiders make profitable trades


Interpreting the Anomalies• Risk or mispricing (e.g., value effect)

– Fama and French (FF) argue that these effects can be explained by risk premiums.

– Lakonishok, Shleifer, and Vishny (LSV) argue that these effects are evidence of inefficient markets.

• Anomalies or data mining?– Book-to-market, size, and momentum may be real

anomalies (i.e., worldwide evidence).• Anomalies over time?

– Some anomalies have disappeared.– Abnormal returns decay 60% after publication of

anomalies

Bubbles and Market Efficiency

• Speculative bubbles can raise prices above intrinsic value

• Even if prices are inaccurate, it can be difficult to take advantage of them

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Stock Market Analysts

• Analysts are overly positive about firm prospects• Positive changes in recommendations associated with

5% increase, negative with 11% decrease in stock prices (Womack, 1996)

• Level of analyst consensus is an inconsistent predictor of future performance (Jegadeesh et al, 2004)

• Firms with most-favorable recommendations outperform firms with least-favorable recommendations (Barber et al., 2001)

• Analysts seem to add value

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Mutual Fund Performance

• The conventional performance benchmark today is a four-factor model, which employs:– the three Fama-French factors (the return on the market

index, and returns to portfolios based on size and book-to-market ratio)

– plus a momentum factor (a portfolio constructed based on prior-year stock return).

• Ri – Rf = ai + bi (RM – Rf) + si (RS – RB)+ hi (RH – RL) + pi(RW – RL) + e

– Abnormal returns are measured by the intercept (alphas)


Mutual Fund Alphas, 1993-2007

• On average, negative alpha• Funds do not outperform the benchmarks


Performance Persistence of Funds

• Consistency, the “hot hands” phenomenon– Some evidence of persistency (Carhart, 1997)

Mutual Fund Managers• Berk and Green (2004): Skilled managers with abnormal

performance will attract new funds until additional cost, complexity drives alphas to zero

• Chen, Ferson, and Peters (2010): On average, bond mutual funds outperform passive bond indexes in gross returns, underperform once fees subtracted

• Kosowski, Timmerman, Wermers, and White (2006): Stock-pricing ability of minority of managers sufficient to cover costs; performance persists over time

• Samuelson (1989): Records of most managers show no easy strategies for success


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Lessons from Mutual Funds

• The performance of professional managers is broadly consistent with market efficiency.

• Most managers do not do better than the passive strategy.

• There are, however, some notable superstars:– Peter Lynch, Warren Buffett, John Templeton, George

Soros– No easy strategies to guarantee success in the market


Are Market Efficient?• There are strong believers in the semi-strong form market

efficiency (e.g., Eugene Fama)• There are also many who believe that market can be

temporarily inefficient in reflecting information into the price (e.g., Josef Lakonishok), even these people believe that market is efficient in the long-run. In other words, market cannot be inefficient for a very long time.

• It is still controversial even after so many studies because it is very difficult to conduct tests– Benchmark problems, sample selection bias, unrealistic

trading strategies, etc.• It is still in debate whether the market is efficient.

definition efficient market hypothesis: implicatio

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