How Efficient Is the Market?

Efficient Market Hypothesis (EMH)Random Walk Hypothesis

Forms of EMHImplications of EMH

PredictabilityAnomalies

Professional Management

Investments 13 2

Efficient Market Hypothesis Definition

Prices of securities fully reflect all available information about these securities

Question Is a $20 bill you find while walking down a

busy street worth $20?

Investments 13 3

Random Walk Hypothesis Tracing the evolution of several economic

variables predict stock prices? Kendall (1953) no predictable patterns Random Walk

Stock prices are random More precisely

Expected return is positive over time Positive trend and random around the trend

Investments 13 4

Random Walk Hypothesis Positive Trend with random fluctuation

TimeTime

Security Security PricesPrices

Investments 13 5

Efficient Markets and Random Walk Stock prices fully and immediately

reflect all available information Once information becomes available,

market participants analyze it Competition assures that prices reflect

all available information

Investments 13 6

Forms of EMH Meaning of all available information

Weak Form Information contained in market trading data Past prices, volumes, interest rate, CPI, etc. Technical analysis (e.g. trend-chasing or

“charting”) is irrelevant Semi-strong Form

All publicly available information All earnings forecasts, accounting information Fundamental analysis is irrelevant

Strong Form All information relevant to the firm including

insider information Insider Trading

Investments 13 7

More on Fundamental Analysis Stock price should be equal to discounted

value of expected future cash flow! Information used

Earnings and dividend forecasts Future interest rate forecasts Firm risk evaluation

Process Step 1: examine past earnings and company

balance sheets Step 2: evaluation of quality of the firm’s

management, firm’s standing in its industry, and prospects of the industry

Step 3: determine the present discounted value of all the payments to a shareholder

Investments 13 8

Forms of EMH

Strong Form Set

Semi-strongForm Set

WeakForm Set

Investments 13 9

Fundamental vs. Technical Analysis

Is it like

astronomy vs. astrology?

Depends if you believe in EMH...

Investments 13 10

Implications of EMH Active Management (against EMH?)

Stock picking (security analysis) Market Timing Economically feasible only for managers of large

portfolios Do even large mutual funds have the ability to

uncover mispriced securities? Passive Management (for EMH?)

A well-diversified portfolio Buy and hold strategy Index Funds

Investments 13 11

Implications of EMH Role of Portfolio Management

Diversification Idiosyncratic risk should be diversified away at

a minimal cost Appropriate risk level

Provide the systematic risk level that investors can tolerate

Tax considerations Growth vs Income stocks, munis vs Treasuries

Other considerations

Investments 13 12

Are Markets Efficient? EMH implies

A great deal of portfolio managers’ activities (the search for mispriced securities) is wasted effort

Active management may hurt clients because of costs and imperfectly diversified portfolios

Not hailed by professional portfolio managers Empirical tests of the hypothesis

Tests of predictability in stock returns (weak EMH) Testing some trading rules (weak EMH) Event studies (semi-strong EMH) Studying insider trades (strong EMH) Assessing performance of professional managers

Investments 13 13

Predictability – Short-Term Auto (serial) correlation

Return correlation of two consecutive periods

Returns over short horizons (monthly or less) Lo, Mamaysky and Wang (2000, JF)

Technical trading offers excess return Lehman (1990, QJE), Conrad and Kaul (1988, JB),

Lo and MacKinlay (1988, RFS) Positive short-term correlation

21 ][

i

i,ti,t ,rrCov

Investments 13 14

Predictability – Intermediate-Term Returns over intermediate horizons (3-12 mon)

Jagadeesh and Titman (1993, JF) Stocks exhibit a momentum property in which good or

bad recent performance continues Performance of individual stocks

Highly unpredictable Portfolios of the past winners appear to outperform

portfolios of the past losers.

Momentum strategy: Long on winners and short on losers (still works)

Investments 13 15

Predictability – Long-Term Returns over long horizons (multi-years)

DeBondt and Thaler (1985, JF) Negative long-term serial correlation over long

horizons (5-year prediction, 3-year estimation) Stocks exhibit a price-reversal property in which

good or bad recent performance reverses Fama and French (1988, JF)

Contrarian profits reflect time-varying risk premium Contrarian strategy:

Long on losers and short on winners

Investments 13 16

Anomalies Small-firm-in-January effect

Stocks of small firms have earned abnormal returns, primarily in the month of January

Neglected-firm effect and liquidity effects The tendency of investments in stock of less well-

known firms to generate abnormal returns Book-to-market ratios

The higher the book-to-market ratio, the higher returns

P/E effect Portfolios of low P/E stocks exhibit higher average

risk-adjusted returns than high P/E stocks Closed-end fund puzzle: Price < NAV

Investments 13 17

Royal Dutch vs. Shell – Where Is Arbitrage?

Investments 13 18

Why Do Anomalies Happen? Limits to arbitrage

Fundamental risk in exploiting arbitrage opportunities Implementation costs Models risk (i.e. a model not properly accounting for

risk) Liquidity issues and non-traded assets

Behavioral effects Overconfidence Mental accounting Prospect theory etc…

Investments 13 19

Event Studies Cumulative Abnormal Return (CAR)

Market Model approach Non-event time: run rit = ai + bi rmt + eit Event time:

Excess Return = (Actual - Expected) eit = Actual - (ai + bi rmt) CARt = e-T+ e-T+1 +…+et

00 +T+T-T-T

CARCAR

tt

Investments 13 20

Event Studies – CAR for Target Companies before Takeover Attempts

Investments 13 21

Anomalies after Earnings Announcements Earnings Announcements

Foster, Olsen, and Shevlin (1984, Accounting Review)

Investments 13 22

Professional Management Some evidence of persistent positive

and negative performances Potential measurement error for

benchmark returns Style changes Risk premiums

Superstar phenomenon or statistical outliers?..

Investments 13 23

Persistence of Mutual Fund PerformanceCarhart (1997, JF) - not much of a long term persistence!

Investments 13 24

Wrap-up What is an efficient market? What is the weak form of EMH? What is the semi-strong form of EMH? What is the strong form of EMH? What is the evidence of predictability? What is the relationship between an

anomaly and EMH?