Market Efficiency

FINANCE 350 Global Financial Management

Professor Alon Brav Fuqua School of Business Duke University
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The Three Forms of Market Efficiency

Definition: A market is efficient if all available information is used in pricing securities (informational efficiency). Weak-form efficiency:
Security prices reflect all information contained in the record of past prices. Technical analysis does not provide excess returns.

Semi-strong-form efficiency:
Security prices reflect all publicly available information. Fundamental analysis does not provide excess returns.

Strong-form efficiency:
Security prices reflect all information, whether publicly available or not. Inside information does not provide excess returns.

The Efficient Market Hypothesis (EMH) and the joint hypothesis problem
All statements about market efficiency are conditioned on an asset pricing model used to test efficiency. That is, any test of efficiency is a joint test of efficiency and the asset-pricing model. Given a particular pricing model, you might find evidence against market efficiency. Another explanation, however, is that the market is efficient and you are using the wrong pricing model. This is a common dilemma in testing joint hypotheses.
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The Joint-Hypothesis Problem

It is a disappointing fact that, because of the joint-hypothesis problem, precise inferences about the degree of market efficiency are likely to remain impossible Rationality is not established by the existing tests and the jointhypothesis problem likely means that it cannot be established.

Tests of Weak form Market Efficiency

Technical analysis refers to methods for detecting recurrent patterns in prices. Using only price histories - chartists, moving average, oscillators, Elliot Wave Theory. Sentiment indicators: TRIN, Sentiment Surveys. Academics believe that EMH implies technical analysis has no merit. Empirical evidence The weak form of market efficiency is sometimes rejected, but the magnitudes of the inefficiencies are very small relative to transactions costs. A variety of filter rules, price-volume rules, moving average rules and other technical analysis strategies generally fail to find exploitable inefficiencies in the US stock market. (See Fama and Blume (1966), Brock, Lakonishok and LeBaron (1992)). However, there is some evidence of technical strategies working in foreign exchange markets, suggesting foreign exchange markets are weakly inefficient (See Arnott and Pham (1993), Chang (1996).)
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Tests of Weak form Market Efficiency

Park and Irwin (2004): Early studies indicated that technical trading strategies were profitable in foreign exchange markets and futures markets, but not in stock markets before the 1980s. Modern studies indicated that technical trading strategies consistently generated economic profits in a variety of speculative markets at least until the early 1990s. Among a total of 92 modern studies, 58 studies found positive results regarding technical trading strategies, while 24 studies obtained negative results. Ten studies indicated mixed results. Despite the positive evidence on the profitability of technical trading strategies, it appears that most empirical studies are subject to various problems in their testing procedures, e.g., data snooping, ex post selection of trading rules or search technologies, and difficulties in estimation of risk and transaction costs.

Weak form Efficiency: Winners and Losers

Source: DeBondt and Thaler (1986)

Weak form Efficiency: Momentum

H=3 0.015 H=6 H=9 H=12

0.010

0.005

0.000 L=3 L=6 L=9 L=12

Source: Jegadeesh and Titman (1993)

Semi Strong Form Efficiency: The small firm effect Average Stock Return By Month: 1926-82
8%

6%

Large Cap

Small Cap

4%

2%

0%

-2% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Semi Strong Form Efficiency: The small firm effect Average Stock Return By Month: 1983-98
6%

4%

Large Cap

Small Cap

2%

0%

-2%

-4% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

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Semi Strong Form Efficiency:

Value/Growth Strategies (Book Value / Market Value)

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Source: Lakonishok, Shleifer and Vishny (1994)

Semi Strong Form Efficiency:

High Volume Premium
cumulative returns
1.75% 1.50% 1.25% 1.00% 0.75% 0.50% 0.25%

high volume normal volume

low volume day

5 10 15 20
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Source: Gervais, Kaniel and Mingelgrin (2001)

Equity Mutual Funds vs S&P500

100 80 60
47

89

85

84 78 71 56 60 53 37 31 20 15 38 74 76 76 59

82

57

55

40 20 0

33

43

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Source: Bogle (1991), and Ross et al. (1999)

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Adjustments to New Information

Price ($)
220 180 140 100 Delayed reaction Efficient-market reaction Overreaction and correction

-8 -6 -4 -2 0 +2 +4 +6 +8

Days relative to announcement day

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Semi Strong Form Efficiency:

Post Earnings Announcement Drift

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Source: Bernard and Thomas (1989)

Concluding Comments
Bodie, Kane and Marcus, Investments, Chapter 12:
We conclude that markets are very efficient, but that rewards to the especially diligent, intelligent, or creative may in fact be waiting. (page 405)

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