Chapter 8 The Efficient Market Hypothesis

Efficient Market Hypothesis (EMH)

Do security prices reflect relevant information fully and immediately? What kind of information? Past prices, trading volume, etc Weak form EMH Public information announced Semi-strong EMH Private information of managers Strong EMH Competition assures prices to reflect information Once information becomes available, market participants analyze it and trade on it2

What are the implications of the EMH?

Implications for investment Will it be possible to beat the market consistently over time? In efficient markets, technical trading rules should not work since all of the past information is contained in current prices Empirical evidence is mixed Evidence of overreaction or underreaction to information, etc.

Do stock prices follow random walk? Stronger assumption than the EMH In fact, EMH allows a submartingale process Expected price is increasing over time Positive trend and random about the trend

Implications for corporate finance and business Should be difficult to find a project with positive NPVs3

Security Prices

Random Walk with Positive Trend

Time

4

Implications for Active or Passive Management

Active Management Security analysis Technical analysis Market timing Fundamental analysis Stock selection

Passive Management Buy and Hold Index Funds

Empirical evidence Investing in passively managed funds such as index fund has outperformed actively managed funds for the last several decades. What does this imply? It is difficult to beat the market consistently over time5

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

6

Then, do we need portfolio managers in an efficient market?

Even if the market is efficient, there exists a role for portfolio managers Find an optimal portfolio on the efficient frontier Two-fund separation theorem Maintain appropriate risk level Tax considerations

7

Types of Security Analysis

Technical Analysis Use prices and volume information to predict future prices Mainly for market timing purpose Related to the weak form efficiency

Fundamental Analysis Use economic and accounting information to predict stock prices Mainly for stock selection purpose Related to the semi-strong form efficiency This includes Economic Analysis Industry Analysis Security Analysis8

Empirical Tests of Market Efficiency

Weak form efficiency Test profitability of some trading rules to see whether past price or volume contains useful information

Semi-strong form efficiency Perform event studies around important announcements to see whether public information is reflected immediately

Strong form efficiency Assess performance of professional managers or insiders to see whether they have superior information unknown to public investors

9

How Tests Are Structured

Examine prices and returns over time Serial correlation? Seasonality? Any predictability?

Calculate abnormal returns around event windows Using the market model, estimate the following: a. Rt = at + btRmt + et Expected Return = at + btRmt Excess Return = Actual Expected return = (at + btRmt + et) (at + btRmt) = et b. Cumulate the excess returns over event windows10

Abnormal returns around the Event

-t

Announcement Date

0

+t

Cumulative Abnormal Returns around the Event

-t

0

+t

11

Tests of Weak Form EMH

Returns over short horizons Very short horizons (over a couple of weeks) Small magnitude of positive trends and reversals 3~12 months Some evidence of positive momentum

Returns over long horizons (over 3~5 years) Pronounced negative correlation, i.e., reversals

12

Monthly abnormal returns on momentum portfolios

Possible explanations? Time-varying risk premium vs. market inefficiency? Industry effect? Under-reaction to information? (behavioral finance)

13

Cumulative monthly returns on momentum

Increase up to one-year after the portfolio formation, and then, reverse thereafter.16 14 Cumulative monthly returns (%) . 12 10 8 6 4 2 0 1 6 11 16 21 26 31 36 41 46 51 56 Event Months since portfolio form ation (6- m onth/ 6- m onth m entum strategy) om

14

Tests of Semi-strong Form EMH

Small Firm Effect (January Effect) Book-to-Market ratios Earnings-to-price ratios Cash flow-to-price ratios Dividend-to-price ratios Post-Earnings Announcement Drift

15

Size effect (Small firm effect)

Why does the small firm effect concentrate in January?

16

Book-to-market effect

Value vs. Growth stocks Value premium? Fama-French 3-factor model MKT, SMB, HML

17

Post-Earnings Announcement Drift

Under-reaction to earnings announcements?

18

Cumulative excess returns around stock split

Does the stock split add value to the firm? Information leakage prior to the event

19

Tests of Strong Form EMH: Professional Manager Performance

Some evidence of persistent positive and negative performance of mutual funds Potential measurement problems Performance depends on investment style, e.g., momentum, value strategies, etc. Could be compensation for risk

Superstar phenomenon Only a small portion survives

20

Implications of Test Results

Risk premiums or market inefficiencies More relevant question is How efficient is the market?

True anomalies or data mining Behavioral Interpretation Inefficiencies exist Caused by human behavior

21

Behavioral Possibilities

Forecasting Errors Overconfidence Regret avoidance Loss aversion (disposition effect)

22