Chapter 8 investments the efficient market hypothesis

Why are price changes random?Random Price Changes In very competitive markets, prices should react to only NEW information Flow of NEW information is random Therefore, price changes are

Chapter 8 The Efficient Market Hypothesis

8.1 Random Walks and

Efficient Market Hypothesis

Why are price changes random?

Random Price Changes

In very competitive markets, prices should react to only NEW information

Flow of NEW information is random Therefore, price changes are random Idea that stock prices follow a “Random Walk”

Random Walk and the EMH

• Stock prices that change in response to new (unpredictable) information must move unpredictably

 Random Walk

• If stock price movements were predictable, that would be evidence of stock market inefficiency because the ability to predict prices would indicate that all available information was not already reflected in stock prices

Cumulative Abnormal Returns before Takeover Attempts: Target Companies

In this case there appears to be information leakage before the announcement date (day 0), but markets adjust quickly.

Stock Price Reaction to CNBC Midday Reports

Forms of the EMH

 Weak-form hypothesis

- The relevant information is past information such as historical

prices and trading volume.

- If the markets are weak form efficient, use of such information

provides no benefit “at the margin.”

- This version of the hypothesis implies that trend analysis is

fruitless.

Forms of the EMH

 Semistrong-form hypothesis

- The relevant information is all publicly available information such

as past prices and fundamental data on firm’s prospects

- If the markets are semi-strong form efficient, then studying past

price and volume data & studying earnings and growth forecasts

provides no net benefit in predicting price changes at the margin

Forms of the EMH

 Strong-form hypothesis

- The relevant information is all information both public and private

or inside information

- If the markets are strong form efficient, use of any information

(public or private) provides no benefit at the margin.

- SEC Rule 10b-5 limits trading by corporate insiders (officers,

directors and major shareholders) Inside trading must be reported.

Relationships between forms of the EMH

• Notice that _

(but _)

• Strong form efficiency would imply that

.

semi-strong efficiency implies weak

both semi-strong and weak form efficiency hold

8.2 Implications of the EMH

(for Security Analysis)

Types of Stock Analysis

& Relationship to the EMH

Technical Analysis:

- Technical Analysis is using prices and volume information to predict

future price changes This assumes prices follow predictable trends.

- If the markets are weak form efficient or semi-strong form efficient or strong form efficient, will technical analysis be able to

consistently predict price changes? NO

Basic Types of Technical Analysis

Identifying common price patterns

One of these patterns is real and one of these is

Basic Types of Technical Analysis

Support and resistance levels

A resistance level may arise at say $31.25 if a stock repeatedly rises to

$31.25 and then declines, indicating that investors are reluctant to pay more than this price for the stock

Types of Stock Analysis & Relationship to the EMH

Fundamental Analysis:

- If the markets are weak form efficient or semi-strong form efficient or strong form efficient, will fundamental anal

ysis be able to consistently predict price changes?

Using economic and accounting information to predict stock price changes

If the markets are only weak form efficient?

Fundamental Analysis CAN predict price changes.

If the markets are semi-strong or strong form efficient?

Fundamental Analysis

Fundamental analysis assumes that stock prices should be equal to

Fundamental analysis is thus

the discounted value of the expected future cash flows the stock is expected to provide to investors

“art” of identifying over- and undervalued securities based on an analysis of the firm's financial

statements and future prospects

Fundamental Analysis

Fundamental analysis varies in technique but generally focuses on

forecasting the firm's future dividends or earnings,

discounting those future cash flows by the required rate

of return (usually obtained from the CAPM),and comparing the resulting estimated price with the current stock price

Security analysisTiming strategiesInvestment Newsletters

Buy and Hold portfoliosIndex Funds

Consistent with strong efficiency

semi-Even if the market is efficient, a role exists for portfolio man agement

Market Efficiency and Portfolio Management

Identify risk & choose appropriate risk levelTax considerations

Other considerations such as liquidity needs or diversify away from the client’s industry

8.3 Are Markets Efficient?

In practice, this means that when trying to figure out if some

portfolio manager is earning abnormal returns, we must co

mpare their performance to a randomly chosen portfolio

I.E they must outperform the random portfolio, or in practi

ce, they must beat some benchmark rate of return

Empirical Tests of Informational Efficiency

Event studies

Assessing performance of professional managers

Testing a trading rule

Empirical Tests of Inform Efficiency

Examine how quickly information is integrated into prices around an informational event

EMH suggests rapid assimilation of information into prices.

Can professional managers, using their resources and tools, “beat” the market after considering risk?

EMH suggests professionals will not outperform the market.

Testing whether a rule that uses available information

Cumulative Abnormal Returns before Takeover Attempts: Target Companies

In this case there appears to be information leakage before the announcement date (day 0), but markets adjust quickly.

Stock Price Reaction to CNBC Midday Reports

Figure 8.5: Cumulative Abnormal Returns in

Response to Earnings Announcements

Short term

momentum effect

that is counter to

efficiency

Mutual Fund Managers

So, Are Markets Efficient?

 There are enough anomalies in the empirical evidence to justify the search for underpriced securities that clearly goes on

 However, the bulk of the evidence suggests that any superior investment strategy should be taken with a lot of effort

 The market is competitive enough that only differentially superior information or insight will earn money.

 In the end it is likely that the margin of superiority that any professional manager can add is so slight that the statistician will not easily be able to detect it

Market are very efficient, but that rewards to the especially diligent, intelligent, or creative may be