The Efficient Market Hypothesis



•Any informarion that could be used to predict stock performance should already be reflected in
stock prices.
–Random walk
•Random and unpredictable
•Do security prices reflect information ?
•Why look at market efficiency?
–Implications for business and corporate finance
–Implications for investment
Efficient Market Hypothesis (EMH)

Figure 11.1 Cumulative Abnormal Returns before Takeover Attempts: Target Companies
bod30611_1101


Figure 11.2 Stock Price Reaction to CNBC Reports
bod30611_1102


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

•Weak
•Semi-strong
•Strong
Forms of the EMH

•Technical Analysis - using prices and volume information to predict future prices.
–Weak form efficiency & technical analysis
•Fundamental Analysis - using economic and accounting information to predict stock prices.
–Semi strong form efficiency & fundamental analysis
Types of Stock Analysis

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

•Even if the market is efficient a role exists for portfolio management:
•Appropriate risk level
•Tax considerations
•Other considerations
Market Efficiency & Portfolio Management

•Event studies
•Assessing performance of professional managers
•Testing some trading rule
Empirical Tests of Market Efficiency

•1. Examine prices and returns over time
How Tests Are Structured


Returns Over Time
0
+t
-t
Announcement Date

•2. Returns are adjusted to determine if they are abnormal.
–Market Model approach
•a.  Rt = at + btRmt + et
• (Expected Return)
•b.  Excess Return =
     (Actual - Expected)
• et = Actual - (at + btRmt)
How Tests Are Structured (cont’d)

•2. Returns are adjusted to determine if they are abnormal.
–Market Model approach
•c.  Cumulate the excess returns over time:
0
+t
-t
How Tests Are Structured (cont’d)

•Magnitude Issue
•Selection Bias Issue
•Lucky Event Issue
Issues in Examining the Results

Weak-Form Tests
•Serial Correlation
•Momentum
•Returns over Long Horizons

Predictors of Broad Market Returns
•Fama and French
–Aggregate returns are higher with higher dividend ratios
•Campbell and Shiller
–Earnings yield can predict market returns
•Keim and Stambaugh
–Bond spreads can predict market returns

•P/E Effect
•Small Firm Effect (January Effect)
•Neglected Firm
•Book-to-Market Effects
•Post-Earnings Announcement Drift
•
Anomalies

Figure 11.3 Returns in Excess of Risk-Free Rate and in excess of the Security Market Line for 10
Size-Based Portfolios, 1926 – 2005
bod30611_1103

Figure 11.4 Average Monthly Returns as a Function of the Book-To Market Ratio, 1963 – 2004
bod30611_1104


Figure 11.5 Cumulative Abnormal Returns in Response to Earnings Announcements
bod30611_1105


Interpreting the Evidence
•Risk Premiums or Inefficiencies
–Disagreement here
•Data Mining or Anomalies