Chapter 11 Efficient Market Hypothesis

Main Notion in 1950's?

is that if the economy runs in cycles then stock prices should also follow cycles too, therefore stock prices should be PREDICTABLE

Why is the market efficient?

it is the composition between investors who do not believe the market is efficient

Passive management

just buy markets on index funds

*Short Horizon* How can we test a weak form of efficiency?

look for serial correlation within stock prices

Active management

tries to beat the market

Market Anomolies

*Tests of Semi-Strong Efficiency results that are contrary to semi strong form efficiency

3 Market Anomalies

1.January Effect 2.Book to market effect 3.Post earnings drift

3 Issues surrounding Efficient market debates?

1.Magnitude issue 2.The Selection Bias issue 3.Can academics distinguish skill from luck?

Three Forms of Efficient Market

1.Weak form 2.Semi-Strong form 3.Strong form

Why do we need portfolio management if the efficient market is correct?

1.diversification 2.tax purposes 3.age of investors/ risk profile

Efficient Market Hypothesis (EMH) Implies 3 things?

1.only new information causes stock prices to change 2.but new information is by definition unpredictable 3.therefore stock price changes are also unpredictable (aka *Random walk*)

2 forms of serial correlation

1.positive 2.negative

Implications of Semi-Strong Form Efficiency

>Information from public sources such as wall street journal, CNBC, Annual reports, Barrons. cannot beat the market >Fundamental analysis cannot be used to beat the market >passive management is better than active management because of fees and lower transactions cost

Implications of Weak form Efficiency

>cant use stock price patterns to predict future stock price movements >technical analysis will not allow investors to consistently beat the market

Who created these 3 forms of market efficiency?

Eugene Fama

Under long term Horizon test of weak efficiency a famous study as conducted by Debondt & Thar which looked @ 35 of the worse performing stocks over 5 yrs & 35 of the best performing stocks for the same amount of time.... *What did the study find? and what does it support?*

Found that the worse performing portfolios outperformed the better portfolios by 25% >*supports the contrarian/value investing philosophy*

Who tested the notion in the 1950's? And what did he find?

Maurice Kendall found there were No patterns in prices which reveals that it was an Efficient Market (or well functioning market)

The Selection Bias issue

Outcomes we can observe are pre-selected in favor of market efficiency (you wouldn't go public with rule that worked)

*Long Horizon* tests of Weak form Efficiency

Problem of Statistical validity weak due to a few data points

Random Walk

Stock price changes are random and unpredictable *Empirically testable*

Strong Form

Stock prices reflect all info including Public and PRIVATE >Gold standard

Magnitude Issue

academics may not be able to measure small improvements and performance due to overall volatility

Argument of EMH (efficient market hypothesis) Supporters

argue that anomalies are results of data mining

Semi-Strong form

asserts that stock prices fully reflect all publicly available information

Weak form

asserts that stock prices reflect all of info available in the past history of changing data such as price and volume

Price / Book value Ratio

equal to Book value per share / Market Value per share

Efficient Market Hypothesis (EMH)

hypothesis that stock prices will fully reflect the available information about the firm which means that current stock prices are correct given that information

data mining

if you go through enough data you will eventually find something

Is active management better than passive management?

passive management often beats active management

Negative Correlation

positive returns tend to be followed by negative returns

Positive Correlation

positive returns tend to follow positive returns

Problem with January Effect

problem is it doesn't always occur and hasn't disappeared

January effect

says small stocks outperform large stocks in January (especially during the first couple of days) -observed world wide

Post Earnings Drift

stock prices don't fully react to new information **normally new information causes stock prices to move up or down

Book to Market Efficiency

tendency of investments in stocks with high ratios of book value / market value to generate abnormal returns **High BV high return**

Technical analysis

the search for recurrent and predictable patterns in stock prices (weak form)

resistant levels or support levels

these values are said to be price levels above which it is difficult for stock prices to rise or below which it is unlikely to fall and they are believed to be levels determined by market psychology

Fundamental analysis

uses earnings and dividend prospects of the firm exceptions of future interest rates and risk evaluation of the firm to determine proper stock prices