The Efficient Market Hypothesis

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Chapter 8

• The Efficient Market Hypothesis

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Random Walk and the EMH

• Stock prices should reflect all current
  information.
• Expectations of future performance should effect
  current performance/prices
• Stock price changes thus respond to new
  information, which is unpredictable

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• Changes in stock prices are random/unpredictable
  thus follow a random walk.
• Evidence of efficiency prices determined
  rationally.
• EMH prices of securities fully reflect
  available information about securities.

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EMH and Competition

• Stock prices fully and accurately reflect
  publicly available information
• Once information becomes available, market
  participants analyze it
• Competition assures prices reflect information

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EMH and All Available Information

• Weak Form Stock prices reflect all information
  that can be derived from past trading data, e.g.
  price, volume. Trend analysis/charting is futile.
  
• Semi Strong Form All publicly available
  information (management style, balance sheet,
  forecasts) are reflected in prices.

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• Strong Form All public/private information is
  included in the stock price. Insider information
  is irrelevant as insiders bid up prices to
  competitive levels.

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Technical Analysis

• Search for recurring and predictable patterns in
  stock prices.
• Stock prices change slowly, such that adjustment
  can be exploited
• Example Relative Strength, compare stock
  performance relative to market (SP500). An
  increasing ratio indicates profitable
  opportunities to buy.
• EMH says this is worthless.

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Fundamental Analysis

• Using economic and accounting information to
  determine the present value of the payments
  stockholders will receive.
• Values above the current price indicate buying
  opportunities.
• Competition by well financed firms will result in
  prices that account for most information.
• Must identify companies that are undervalued or
  overvalued by others to profit.

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Implications of Efficiency for Active or Passive
Management

• Active Management
• Security analysis
• Timing
• Passive Management
• Buy and Hold
• Index Funds

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Market Efficiency and Portfolio Management

• Even if the market is efficient a role exists for
  portfolio management
• Diversification
• Tax considerations
• Other considerations

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Issues of Efficiency Debate

• Magnitude How does one measure the contribution
  of the manager.
• Selection bias Schemes that fail get publicity,
  those that succeed are kept quiet.
• Lucky event Chance says someone must win

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EMH Tests

• Weak form tests Predictability in stock
  returns.
• Semi strong form tests Market anomalies.
• Strong form tests Insider Information

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Momentum in stock prices

• Indicated by positive serial correlation over
  short holding periods.
• LoMacKinlay (1988) find weakly and monthly
  holding periods show a small amount of serial
  correlation in a broad portfolio
• May relate to lag in which positive info
  influences large, then small stocks.

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Reversals?

• Longer holding periods show () serial
  correlation.
• Indication of fad/overshooting.
• Varying risk premiums
• Small number of observations.

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Losers become winners and vice versa

• Thaler and DeBondt (1985) Poorly performing
  stocks in previous 3-5 yrs likely to give you
  above average returns over next 3 years.
• Evidence of castles in the air fading or forming
  versus efficient markets reacting to interest
  rate movements.

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Interest Rates and Reversals

• As interest rates rise, bond prices fall as do
  stock prices.
• Bonds/stocks offer low to negative returns over
  the period in which rates rose.
• Rates fall revert to mean, and stock prices rise,
  ie above average returns.

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January and Friday Effects

• Abnormal effect of higher stock returns during
  the first few days of January. Particularly
  evident in small firms.
• Tax effects drive prices down in Dec.
• Small firms more volatile, ie losses.
• Lack of institutional investors, transactions
  costs allows this effect to continue.
• Blue Monday buy on Mon., sell Fri.

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Fundamentals and Stock Price Anomalies

• Look for securities that
• Are relatively small
• Sell at low multiples compared to earnings.
• Have low prices relative to asset value
• Have high dividend yields.

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Smaller is better

• Since 1926 small company stocks have produced a
  rate of return 2 higher than large stocks.
• Results of Fama and French confirm similar
  finding when controlling for beta.
• Beta poor measure of risk for small firms.
• Survivorship bias
• Results did not hold during late 90s.

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P/E ratios

• During 1980s, as P/E ratio increased return
  decreased.
• Relationship varies over time.
• P/E ratio low for a reason, ie financial
  collapse.

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Price to book value

• Book value the value of a companys assets as
  recorded on its books.
• Stocks with low price to book value tend to have
  higher future returns.
• Consistent with Warren Buffetts investment
  strategy.
• These stocks may be fundamentally riskier.

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Dividend Yields

• Strategy of buying stocks with highest dividend
  yield does not consistently beat market. Dogs
  of the Dow
• Related to interest rate movements and mean
  reversion.

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Implications of Test Results

• Risk Premiums or market inefficiencies
• Anomalies or data mining
• Behavioral Interpretation
• Inefficiencies exist
• Caused by human behavior

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Behavioral Possibilities

• Forecasting Errors
• Overconfidence
• Regret avoidance
• Framing and mental accounting errors

25
Mutual Fund and Professional Manager Performance

• Some evidence of persistent positive and negative
  performance
• Near term.
• Survivorship bias, ie loser funds do not exist
  over a long period of time. Incubator funds.
• 2/3 of existing funds outperformed by SP 500.
• As size of fund increases the number of stocks
  available to trade decreases.