Efficient Markets Hypothesis (EMH)
Discuss these observations in the light of the EMH. 1.Annual market returns in consecutive years have a negative correlation of -0.25.
(a) Annual market returns are negatively correlated This observation suggests that, over annual time periods, the market tends to systematically overreact to new information and hence that the market may not be semi-strong form efficient. [1⁄2] In addition, trading rules could be developed based on this information that could generate excess, risk-adjusted returns, which suggests that this observation is inconsistent with the weak form of the EMH. [1⁄2]
Discuss these observations in the light of the EMH. 2.The closing value of the index of the 100 stocks with the highest market capitalisation has been found to be 1% higher on average on Fridays than on Mondays.
(b) The index is higher on Fridays than on Mondays The observation suggests that there is a consistent tendency for prices on Fridays to be 'inflated', while prices on Mondays are 'depressed', ie there is a systematic bias present in the prices. [1⁄2] Trading rules could be developed based on this information (eg buy on Monday, sell on Friday) that could generate excess, risk-adjusted returns, which suggests that this observation is inconsistent with the weak form of the EMH. [1⁄2]
Discuss these observations in the light of the EMH. 3. Announcements of changes in companies' dividend policies typically take three months to become fully reflected in the quoted share price.
(c) Announcements take three months to be reflected If the semi-strong form of the EMH holds, public dividend announcements should have an immediate effect on the share prices as the market should respond quickly and accurately to new information. [1⁄2] This observation suggests that the market is not semi-strong form efficient. [1⁄2]
Discuss these observations in the light of the EMH. 4. The prices of a particular subset of stocks have been consistently observed to fall immediately following a favourable announcement and to rise immediately following an unfavourable announcement.
(d) Prices fall following a favourable announcement The prices are reacting when information is made public. This suggests that the prices have previously been distorted by insider information. [1⁄2] Therefore, this observation contradicts the strong form of the EMH. [1⁄2]
Three forms of the EMH are commonly distinguished:
1. Weak form - market prices incorporate all of the information contained in historical price data. If markets are weak form efficient, then technical analysis cannot be used to generate excess risk-adjusted returns. 2 Semi-strong form - market prices incorporate all publicly available information. If markets are semi-strong form efficient, then fundamental analysis cannot be used to generate excess risk-adjusted returns. 3. Strong form - market prices incorporate all information, whether or not it is publicly available. If markets are strong form efficient, then insider trading cannot be used to generate excess risk-adjusted returns. In practice the level of efficiency depends on whether information is freely available, which in turn may depend on the level of disclosure required by regulation. The importance of market efficiency derives from the fact that if markets are inefficient then investors with better information may be able to generate higher investment returns. If, however, they are efficient then active investment management is difficult to justify.
At the quarterly meeting of the Auger Close Investment Club, four members are making proposals The existence of fund managers who sell their services based on their alleged ability to select over-performing sectors and stocks and so add value to portfolios demonstrates that capital markets are not efficient for new equity investment for the club. Anna wants to buy shares in Armadillo Adventures, claiming that they have performed poorly in recent weeks and are due an upturn. Brian wants to invest in Biscuits-R-Us. They have recruited a new head of marketing, who has had success at other companies. Brian feels that this new appointment will have a positive effect on the firm. Cathy selects shares at random. This quarter she is recommending the club buy into Cash 4 Kidneys PLC. Dennis wants the club to buy shares in Diamond Dentists ('DD'). His brother works for a major health insurer and has insider information that DD's shares will rise sharply in the near future, when it is announced that his company has appointed DD as its 'dentist of choice'. For each club member, describe how their share selection strategy would work in strongly efficient, semi-strongly efficient, weakly efficient and inefficient markets.
Anna Anna makes her recommendation based on the past price history of the investment. If weak form EMH holds, then the current share price already reflects the information contained in the past price history, so there would be no advantage in using this approach. [1] Similarly, if the semi-strong or strong form of EMH holds, there is no advantage in using this approach. [1⁄2] If the market was inefficient, Anna's strategy may be beneficial. [1⁄2] Brian Brian makes his recommendation based on company information that is in the public domain. If semi-strong form EMH holds, then the current share price already reflects relevant public information, so there would be no advantage in using this approach. [1] Similarly, if the strong form of EMH holds, there is no advantage in using this approach. [1⁄2] If the market is inefficient or only weak form efficient, Brian's strategy may be beneficial. [1⁄2] Cathy The approach of choosing stocks at random provides no advantage, whatever the level of market efficiency. [1⁄2] If strong form EMH holds, this strategy is no worse than any other. [1⁄2] Dennis Dennis makes his recommendation based on insider information. If strong form EMH holds, then the current share price already reflects all relevant information, so there would be no advantage in using this approach. [1] If the market is inefficient or weak or semi-strong form efficient, Dennis's strategy may be beneficial (though it could be questionable on ethical grounds). [1]
Describe what is meant by an 'efficient market'
Definition of efficient market An efficient market is one in which every security's price equals its investment value at all times. In an efficient market information is fully reflected in the price. This means that share prices adjust instantaneously and without bias to new information.
Explain why investors will still wish to have as much information as possible concerning a company and its securities before investing in it even if the Efficient Markets Hypothesis applies.
Even if markets are efficient, investors will still wish to have as much information as possible concerning a company and its securities in order to identify the characteristics of the shares, eg the volatility of returns, risk, income and capital growth etc. An appreciation of these will enable investors to make an informed decision whether or not to hold the security as part of a portfolio designed to meet their investment objectives.
Explain what is meant by an 'excessively volatile' market.
Excessively volatile markets An excessively volatile market is one in which the changes in the market values of stocks (the observed volatility) are greater than can be justified by the news arriving. This is claimed to be evidence of market over-reaction, which is not compatible with efficiency. [2]
Discuss the implications of the Efficient Markets Hypothesis
Implications of the Efficient Markets Hypothesis The past history of prices is a subset of publicly available information, so a market must be weak form efficient if it is semi-strong form efficient. Similarly, if it is strong form efficient it must also be semi-strong and weak form efficient. The Efficient Markets Hypothesis does not imply that beating the market is impossible, since investors could out-perform the market by chance, or by accepting above average levels of risk. However, it does imply that it is not possible consistently to achieve superior risk-adjusted investment performance net of costs without access to superior information. Weak form efficiency implies that it is impossible to achieve excess risk-adjusted investment returns purely by using trading rules based upon the past history of prices and trading volumes. It therefore suggests that technical analysis cannot be justified. If only weak form efficiency applies, excess risk-adjusted returns are still possible by good fundamental analysis of public information. The semi-strong form means that prices adjust instantaneously and without bias to newly published information. This implies that it is not possible to trade profitably on information gained from public sources. So neither fundamental analysis (without insider information) nor technical analysis will yield excess risk-adjusted returns. Fundamental analysis may still, however, aid investors in selecting the investments that are most suitable for meeting their investment needs and objectives. If the strong form is correct then the market reflects all known knowledge about the company and consequently excess risk-adjusted returns are possible only by chance. This implies that insiders cannot profit from dealing on inside information, ie insider trading is not profitable.
Informational efficiency
Many studies show that the market over-reacts to certain events and under-reacts to other events. The over/under-reaction is corrected over a long time period. If this is true then traders could take advantage of the slow correction of the market, and efficiency would not hold.
Explain the practical and conceptual difficulties in using a test of an excessively volatile market to establish whether or not a market is efficient.
Practical and conceptual difficulties These include: ☘️ the difficulty of choosing an appropriate terminal value for the share price ☘️ the difficulty of choosing an appropriate discount rate at which to discount future cashflows - in particular, should it be constant? [1] [1] ☘️ possible biases in the estimates of the variances because of autocorrelation in the time series data used [1] ☘️ possible non-stationarity of the time series data used, ie it may have stochastic trends which invalidate the measurements obtained for the variance of the stock price satisfied [1⁄2] ☘️ the distributional assumptions underlying the statistical tests used might not be ☘️ the distributional characteristics of the share prices and dividends are unlikely to remain constant over a long period of time. [1⁄2]
Volatility tests
Shiller first formulated the claim of 'excessive volatility' into a testable proposition in 1981. He found strong evidence that the observed level of volatility contradicted the EMH. However, subsequent studies using different formulations of the problem found that the violation of the EMH only had borderline statistical significance. Numerous criticisms were subsequently made of Shiller's methodology. These criticisms covered: ☘️the choice of terminal value for the stock price ☘️the use of a constant discount rate 🍀bias in estimates of the variances due to autocorrelation 🍀possible non-stationarity of the series, ie the series may have stochastic trends that invalidate the measurements obtained for the variance of the stock price.
Under-reaction to events
Stock prices continue to respond to earnings announcements up to a year after their announcement. Abnormal excess returns for both the parent and subsidiary firms following a de-merger. Abnormal negative returns following mergers.
Describe how you would test if a market is 'excessively volatile'.
Testing if a market is excessively volatile To test if a market is excessively volatile you need a long history of prices and cashflows for one of the securities in question - eg for the market in a particular equity, you would need many months or years of share prices and dividend payments. [11⁄2] A discounted cashflow model based on the actual dividends that were paid and some terminal value for the share could then be used to calculate a perfect foresight price for the equity. This would represent the 'correct' equity price if market participants had been able to predict future dividends correctly. [1⁄2] The difference between the perfect foresight price and the actual price arises from the forecast errors of future dividends. If market participants are rational, there should be no systematic forecast errors. [1⁄2] Also if markets are efficient, then broad movements in the perfect foresight price should be correlated with moves in the actual price as both are reacting to the same news and hence the same changes in the anticipated future cashflows. [1⁄2] If instead the actual price changes are greater, then this would suggest that the market in the particular equity is excessively volatile. [1] [Total 7] This was the approach adopted by Shiller.
Tests of the EMH
Tests of the EMH are fraught with difficulty. Consequently, the empirical evidence is inconclusive concerning the extent to which security markets are in fact efficient in practice. However: ☘️ studies of directors' share dealings suggest that, even with inside information, it is difficult to out-perform ☘️ studies have failed to identify a difference between the returns on stocks selected using technical analysis and those from purely random stock selection ☘️ research has concentrated on the semi-strong form of the EMH and in particular tests of informational efficiency and volatility tests.
Discuss the following statement: The existence of fund managers who sell their services based on their alleged ability to select over-performing sectors and stocks and so add value to portfolios demonstrates that capital markets are not efficient.
The Efficient Markets Hypothesis (EMH) suggests that it is not possible to achieve excess risk adjusted investment returns using investment strategies based only on certain subsets of information. The existence of fund managers who sell their services based on their alleged ability to select over-performing sectors and stocks does not demonstrate that capital markets are inefficient. [1] In particular, the semi-strong form of the EMH suggests that excess risk-adjusted investment returns cannot be obtained using only publicly available information. [1⁄2] In certain investment markets, it may therefore be possible (and legal) to achieve excess returns using privileged or inside information, which would not contradict the semi-strong form of the EMH. [1⁄2] More generally, the EMH does not preclude managers achieving higher investment returns by adopting 'riskier' investment strategies and receiving due reward for the risks taken. [1⁄2] It says precisely that it is not possible to develop investment strategies that yield excess risk- adjusted returns - though it is difficult to determine exactly how risk should be interpreted in this context. [1⁄2] Some fund managers must necessarily achieve higher than average returns over a given short time period - eg several years. The point of the EMH is that managers cannot consistently achieve above excess returns. Moreover, they cannot guarantee to achieve excess returns over any particular time period. [1] Finally, rather than reflecting any market inefficiency in contradiction of the EMH, the existence of such managers may instead reflect the following facts: Individual investors may be unaware of the EMH or choose not believe it and hence may be inclined to believe the claims of such managers and so place money with them. [1⁄2] Certain individual investors may choose to believe the claims of such managers, reflecting the fact that investment decisions are often made on the basis of subjective and emotional factors, in addition to, or instead of, on the basis of financial theory. [1] For the above reasons, the existence of such fund managers does not therefore demonstrate that capital markets are inefficient. [1⁄2]
Explain the implications of the Efficient Markets Hypothesis for investment trading strategies.
The Efficient Markets Hypothesis implies that it is impossible, except by chance, to make abnormal profits using trading strategies that are based on only past share prices (weak form), publicly available information (semi-strong form) or any information (strong form). In practice, however, the definition has sometimes been refined to preclude the possibility of systematically higher returns after allowing for transaction costs. Market efficiency also implies that active investment management (which aims to enhance returns by identifying under- or over-priced securities) cannot be justified and consequently provides a rationale for passive investment management strategies, such as index tracking.
Describe the three different forms of the Efficient Markets Hypothesis
Three forms of Efficient Markets Hypothesis The strong form requires that prices reflect all information that is currently known - whether or not it is publicly available. The semi-strong form requires that prices reflect all information that is publicly available. The weak form requires that prices fully reflect all information contained in the past history of prices.
Over-reaction to events
☘️ Past winners tend to be future losers and the market appears to over-react to past performance. 🍀 Certain accounting ratios appear to have predictive powers, an example of the market apparently over-reacting to past growth. ☘️ Firms coming to the market have poor subsequent performance.
