ECON 1710 Chapter 11 - The Efficient Market Hypothesis (EMH)

What is a random walk, in technical terms?

"Random walk" is a technical term that comes from time-series econometrics. It refers to the observation that LAST year's outcome has limited predictive power about THIS year's outcome. This means it is impossible to estimate a trend. Outcome this year = constant + last year's outcome + random error

What do tests of the weak form show?

1) In the short- and intermediate-term, the performance of individual stocks is unpredictable, BUT portfolios of well-performing stocks show momentum 2) In the long term, there is a negative serial correlation between stocks (eg. Momentum followed by correction), which gives the appearance of a market fluctuating around its fair value. However, this reversal effect implies that a contrarian investment strategy could be profitable. The overall result is a support of the weak form of EMH.

What three issues generate conflict about EMH?

1) Magnitude effect: It is unclear whether positive abnormal returns are due to a good trading strategy (which would provide evidence against EMH) or just a result of market volatility. 2) Selection bias: Part of the support from EMH comes from the limited number of successful trading strategies. These might exist; it is possible that we just don't observe these because they are NOT public. 3) "Lucky event": Beating the market is often cited as a repudiation of EMH. However, those who beat the market might just have been lucky.

What is an expert network provider?

A company which sells access to experts that have unique insights on firms. Their services are often bought by portfolio managers. This raises the risk of insider information peddling.

A challenge to the weak form is that easily observed variables predict market returns. Which variables are these, and what does EMH say about them?

A higher dividend yield, earnings yield, and high-low grade bond spread are correlated with higher market returns. EMH says that these factors are only PROXIES for variation in the market risk premium; thus, these factors do not contradict EMH.

The efficient market hypothesis (EMH) is the notion that stocks already reflect ___________. Is it supported empirically?

ALL available information (and, relatedly, that markets quickly digest ALL available information); Yes, it is empirically supported by studies.

What does EMH say about active vs. passive portfolio management?

Active management is an expensive strategy, in terms of time and fees, that is only suitable for large portfolios. For most people, a passive strategy makes sense (hold a well-diversified portfolio with no effort to beat the market, and don't worry about WHERE exactly the market is in a business cycle)

Abnormal return =

Actual (realized) return - a proxy for stock return in the absence of event

What is fundamental analysis?

Analyzing the fundamentals of a company (ie all publicly available data about its prospects) to estimate the stock price's present value. If the calculated value is above the current market value of the stock, it is undervalued by the market and you should BUY!

What does EMH say about the information that is already built into the stock price?

Any information that could be used to predict stock performance should already be built into the stock price

EMH states that any information that can be used to predict stock performance should already be reflected in stock prices. What does it say about any new "surprises"?

Any new surprises will cause changes in price, BUT are by definition unpredictable

Per EMH, can we be sure if today's stock price is too high or too low?

At the given time, using current information, we CANNOT be sure if today's stock price is too high or low. However, in the long run the prices will be correct on average.

Why is cumulative abnormal return used (instead of abnormal return) in an event study?

Cumulative abnormal return simply sums up abnormal returns over the period. This addresses leakage of information in the pre-event period.

What is a random walk, in the context of EMH?

EMH predicts that stock prices will follow a random walk - there are random, unpredictable changes in price. Price levels are rationally determined.

What is the equation for abnormal return?

Et = rt - (a + b*rmt); Et is the abnormal return; rt is the actual return; (a+b*rmt) is the predicted return in the absence of the event

Empirical tests of EMH are often done using an _____________ design.

Event study

True or false? If the market is efficient, then there is no need for any type of portfolio management.

False! Portfolio management is still necessary to: 1) Reduce firm-specific risk through diversification 2) Reduce the tax burden by shifting the constituent securities depending on the investor's tax bracket 3) Tailor the portfolio to an investor's risk aversion

True or false? The success of fundamental analysis depends on identifying well-run firms.

False; it depends on making better estimates of firms than everyone else. So, you can find firms that are actually BETTER than everyone else's estimate or firms that are NOT AS BAD as the market estimates.

Kendall (1953) found no predictable pattern in stock prices. Does this tell us that the market is irrational?

Far from it. Random price movements indicate an efficient market, as a forecast of favorable future performance just leads to favorable current performance.

After controlling for __________ and _______, Beta has no power to explain returns. This challenges the notion of rational markets.

Firm size; book to market ratio

Tests of the semi-strong form of EMH are an evaluation of ________________.

Fundamental analysis

What is the most important commodity on Wall Street?

INFORMATION. The fact that people engage in security analysis is what uncovers more information AND keeps securities efficiently priced.

Give one example of when fundamental analysis might actually work.

If you invest in a bubble and get out at the right time, because you conclude that the firms are overvalued and prices are about to crash, then you make money at the expense of investors who are more ignorant than you.

Why is the strong version of EMH so extreme?

Insider trading happens, despite SEC Rule 10b-5 (insiders must publicly report all insider trades). Because there are still gains to be made from insider trading, it seems reasonable to say that all insider information is NOT already priced in.

What do strong form tests of EMH show?

Insiders can profit more on their firm's stock, showing that this form is probably too restrictive. If this form were true, investors would not be able to profit by following insider trades.

What is technical analysis?

Looking for patterns in the past stock price data. Technical analysis seeks to make money off of a sluggish response of stock prices to supply and demand factors.

There are some factors which seem to predict higher returns, in apparent contradiction of the EMH. What are these factors?

Lower price/earnings ratio stocks; smaller firms (small firm effect); Higher book-to-market ratio; higher volatility; low accruals; faster growth; higher gross profitability

Grossman and Stiglitz state that if you are willing to spend time gathering information, you must have an incentive to generate higher investment returns. How does this relate to EMH?

Many people spend time gathering information, especially portfolio managers. Because those people make trades on the information they gather, all this information is already PRICED IN to the stock. Thus, the gains to information gathering for all others is much lower.

Is technical analysis consistent with EMH?

NO. Technical analysis is inconsistent with ALL versions of EMH because it states that even market trading data is not yet priced in to the stock.

Do tests of the semi-strong form of EMH find an instant response of stock price to earnings announcements?

No, they find a sluggish response; this challenges EMH

In conducting technical analysis, do analysts care about the fundamentals of the underlying firm?

No. Chartists, as they are called, do not care about the future or current economic indicators concerning the firm.

EMH is based on the notion that the outcome of a _______________ market will be efficient.

Perfectly competitive

What does evidence on the performance of mutual fund managers show?

Performance is normally distributed and variable, so it is rare to consistently beat a passive strategy. This lends support to EMH.

In the weak form of EMH, what is meant by "market trading data"?

Price history, trading volume, short interest

In the semi-strong form of EMH, what is meant by "all public information on firm prospects"?

Product line, management quality, balance sheet composition, patents held, earnings, accounting (note that this includes earnings per share and dividend yield)

Smaller firms tend to have higher returns. Why might this NOT contradict the semi-strong form of EMH?

Smaller firms might just bear a risk premium due to the neglected firm effect (limited information exists on smaller firms)

What does the semi-strong form of EMH state?

Stock prices already reflect BOTH all information that can be derived from examining market trading data AND all publicly available information regarding the firm's prospects.

What does the weak form of EMH state?

Stock prices already reflect all information that can be derived from examining market trading data. Thus, trend analysis is fruitless; if such data ever conveyed reliable indicators of future performance, they are instantly priced in to the stock.

What does the strong form of EMH state?

Stock prices reflect all relevant information, INCLUDING insider information!

What are resistance and support levels in technical analysis? Describe their validity.

Technical analysts identify the resistance level (price level above which it is difficult for the stock price to rise) and the support level (price level below which it is difficult for the stock price to fall); this is defined by "market psychology". The success of this strategy depends on a sluggish price response (thinking you can make money before prices adjust to equilibrium). However, the problem is that trading rules are self-destructing; multiple people can figure out the resistance/support level and dissipate returns.

What is a problem in tests of the semi-strong and strong forms of EMH?

Tests of risk-adjusted returns are ALSO tests of the risk adjustment procedure, which can be questionable

When trying to conduct event studies (for the purposes of testing EMH), it is difficult to separate what two things?

The return caused by the event of interest; the return caused by all other factors

Lower P/E stocks tend to have higher returns. Why might this NOT contradict the semi-strong form of EMH?

These stocks may just be riskier, such that P/E ratio is just a proxy for risk.

EMH states that all available information is already priced in to the stock. If this is the case, why are there different versions of EMH?

These versions differ in what they mean by "all available information"

As the costs of taking advantage of market anomalies decrease, what happens to them? What does this show about the market?

They begin to fade. This paints a picture of a market moving toward efficiency.

Overall, what do tests of the semi-strong form of EMH show?

They point to several "market anomalies" which may lead us to infer that markets are not as efficient as we had thought. Still, we may think that these anomalies are artifacts of a poor risk adjustment procedure.

In general, what do weak form tests of EMH try to do?

They try to uncover serial correlation: that is, patterns in stock returns that persist over time (like "momentum"); if these can be found, it might disprove the assertion that all trading data is already priced into the stock.

Overall, _________ stocks have been shown to provide higher average returns than __________ stocks.

Value (low P/E, high BTM, depressed prices); glamour / growth

CAPM and EMH state that __________ should be unrelated to returns, but tests of the semi-strong form paint a different story.

Volatility

If all stocks in the market are mispriced, how is that an inefficiency?

We have an inefficient allocation of investment securities. For example, if a firm is overvalued, the firm's market price is too high and they get capital too cheap.

Empirically, do stock prices respond quickly to new information? List three event studies which have shown this.

Yes. 1) An event study of stock price response to a takeover announcement found that prices had jumped to reflect the information by the end of the trading day. Some insider trading was evident in the pre-announcement period. 2) Patell and Wolfson showed that most of a stock's response to corporate dividend and earnings announcements occurs within 10 minutes 3) Boone and Green showed that the stock price responds to a mention in a CNBC program within minutes (positive news is responded to quicker than negative news)

If you believe that you can make consistent profits from fundamental analysis, do you believe in EMH?

You may believe in the strong form, but you do not believe in the semi-strong or weak forms. This is because you think that analyzing PUBLICLY available information can yield abnormal returns. The semi-strong form tells us that this information should already be priced in.