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