Testing the Efficient Market Hypothesis and its Critics - Application on the

Montenegrin Stock Exchange

Tamara Backović Vulić 1

Abstract

It seems that the panic on the capital market which caused a decreaseiof stock market
indices has been stopped. However, uncertainty of world economic development is still
very high. Research in this field has shown that the world economy is in the "U" shaped
recession and that recovery will last for 18 months. On the other hand, some economists
claim that the world is in the long term "L" shaped recession.

The capital market of Montenegro is a small market. Therefore it has a high response to
changes in the business environment, but because of its size revival will neither be quick
nor simple. At the beginning of every crisis, investors take out their money from the
capital market and the first to feel the pressure are small, emerging markets.

If a capital market is efficient it can attract foreign investments. Since everyone has the
same information about a stock, the price of a stock should reflect the knowledge and
expectations of all investors. Consequently, an investor should not be able to receive an
abnormal return since there is no way that he could know something about a stock that
isn't already reflected in the stock's price. This research will present the results of a non-
parametric test in an econometric investigation of the capital market efficiency in
Montenegro.

The Efficient market hypothesis became controversial especially after the detection of
certain anomalies in the capital markets. Some of the main anomalies that have been
identified have been tested and presented.

Keywords: Market efficiency, Run test, Autocorrelation function, January effect,

Weekend Effect, Monday Effect, Seasonal Effect, Holiday Effect

JEL code: C22

1
MSc University of Montenegro, Podgorica Faculty of Economics, professor assistant of Econometrics, Business
Statistics, Operations Research, Applied Econometrics and Decision Making Models.
Address: EKONOMSKI FAKULTET, Jovana Tomaševića 37, 81000 Podgorica
Phone (fax): + 382 20 241 138 (+ 382 20 244 588)
e-mail address: tbackovic@gmail.com
1. A brief overview of the efficient-market hypothesis (EMH)

EMH is one of the well-known methods for measuring the future value of stock prices.
According to this hypothesis, the market is efficient if its prices are formed on the basis
of all disposable information. One stock market is efficient only if all relevant
information about company are incorporated in stock price of this company.

Business cycle theoreticians assumed that multiple regression model can be used for
forecasting business cycle movement. Scientist, Maurice Kendall had tested a computer
model for predicting share prices in 1953. Results were not satisfactory. Random
movement of share process, their unpredictability goes in favor of EMH as this example
shows that only new information can affect share price. According to EMH if there is a
possibility to predict the future price of shares, that is the first sign of an inefficient
market.

American economist, Eugene Fama, proposed three types of efficiency 2 :

- weak form;
- semi-strong form;
- strong efficiency.

Weak form efficiency claims that all past prices of a stock are reflected in today's stock
price. Therefore, technical analysis cannot be used to predict and beat a market.

Semi-strong efficiency implies that all public information is calculated into a stock's
current share price. It means that neither fundamental nor technical analysis can be used
to achieve superior gains.

Strong form efficiency is the strongest version of market efficiency. It states all
information in a market, whether public or private, is accounted for in a stock price. Not
even insider information could give an investor the advantage.

Random walk theory claims that stock market can be analyzed as random walk according
to next three facts:

- efficient markets respond very fast to new information;

- if the share price is a reflection of all available information, it is impossible to use
that information for market predictions;
- it is impossible to predict market movement other than randomly.

There are a large number of direct and indirect tests as evidence for or against the EMH.
Scientist Simon Keane in his work from 1983. provides some basic explanations of what
makes markets inefficient. His very popular idea is called “Gambler’s Fallacy”. This can

2
Eugene Fama, "Efficient capital markets: A review of theory and empirical work", Journal of Finance 25,
1970, page 383.
be explained as the belief that what “goes up must come down”. This phenomenon
exhibits itself amongst investors whose stocks’ price has risen for a period of time and so
is deemed to be “due for a fall”. Generally speaking, by knowing the relationship of the
current price to recent price movements, one can better estimate the likely direction of
future price movements, i.e. historical data such as price movement can be used to predict
future prices. This provides credibility to the argument that the market is predictable and
inefficient. Therefore, the issue is to see whether the stock market is predictable or not by
detecting serial dependence of stock returns.

Two very popular tests of market efficiency will be presented in this paper - Augmented
Dickey-Fuller (ADF) test, Run test and Autocorrelation Function (ACF) test.

Research will test if some well-known anomalies on the capital market of Montenegro do
exist in order to show if critics of EMH are justifiable. Some of the main anomalies that
have been identified are as follows: "January effect", "Monday effect", "Holiday effect"
and "Turn-of-the-month effect".

2. Testing Efficient-Market Hypothesis

The most important reference for the research was the indices data series, NEX20
attained from the NEX Montenegro stock exchange. The data is given on a daily level
and the period of observation is from March 3rd 2003 until July 31st 2009. The sample
consists of 1675 observations.

New Montenegrin Stock Exchange (NEX Montenegro) Podgorica was founded on

September, 20th in 2001. Authorization for work was obtained on November, 11th in
2001. from the Montenegrin Securities Commission. The basic goal of calculating and
publishing indices of the Securities Exchange NEX Montenegro is to provide the public
with the information on movements in certain segments of the market. The NEX
Montenegro Stock Exchange currently calculates two indices, NEX20 and NEXPIF.

Index of the NEX Montenegro Stock Exchange, also known as NEX20, consists of 20
issuers’ share determined on the basis of market capitalization, turnover and number of
concluded transactions

The start value of stock index is 1000 stock market points. Index is calculated using the
following methodology:
20

p i ,t qi , R
NEX 20  i 1
20
 1000  CT
p
i 1
i,0 qi , R
where

t - day of trading; pi , t - stock price on the day t;

R - day of index revision; pi ,0 - basic stock price on a day of index
foundation
T - moment right before index qi , R number of shares
-
calculation with the new structure
C T - correction factor for providing index continuity

The correction factor is implemented only in cases of structural index change.

2.1 Augmented Dickey–Fuller Test

The phenomenon such as white noise and random walk are always connected with EMH.
Investors react instantaneously to any informational advantages they have and no profit
can be made from information based trading.

It should be noted that the EMH and random walks do not amount to the same thing. A
random walk of stock prices does not imply that the stock market is efficient with rational
investors. A random walk is defined by the fact that price changes are independent of
each other. The Montenegrin capital market is considered an emerging capital market.
Therefore, only the weak form of EMH will be tested. It will be tested whether share
prices follow a random walk. If analyzed time series follow random walk they are
nonstationary so it could be concluded that they are unpredictable. In that case the capital
market is indicated as efficient.

Augmented Dickey–Fuller (ADF) test is the most popular stationary test. It was presented
by the statisticians David Alan Dickey and Wayne Arthur Fuller in 1979. and 1981. ADF
test is used to test the unit root hypothesis. If one time series has unit root that means it is
nonstationary and it follows random walk. Test is based on two possible equations:
Yt  Yt 1  u t or Yt  Yt 1  u t where null hypothesis can be define on two ways: H 0 :
=0 or H 0 : =1.

ADF test results for the NEX20 stock index are presented in the following table:

Null Hypothesis: CHANGE_NEX20 has a unit root

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -29.79251 0.0000

Test critical values: 1% level -2.566344
5% level -1.941013
10% level -1.616572
 Augmented Dickey-Fuller Test Equation
Dependent Variable: D(CHANGE _NEX20)
Sample (adjusted): 3/04/2003 7/31/2009
Included observations: 1674 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

PROMENA_NEX20(-1) -0.693370 0.023273 -29.79251 0.0000

R-squared 0.346636 Mean dependent var -0.000705

Adjusted R-squared 0.346636 S.D. dependent var 2.423588
S.E. of regression 1.959009 Akaike info criterion 4.183352
Sum squared resid 6420.498 Schwarz criterion 4.186591
Log likelihood -3500.465 Durbin-Watson stat 2.020564

Results in the table are based on the model Yt  Yt 1  u t . The value of ADF statistics
is -29.79251 and this value is significantly smaller than the critical tau values at 1%, 5%
and 10% significance level. The Null hypothesis is rejected. Time series NEX20 is
stationary and it doesn't have a unit rot nor it follows random walk. At the same time we
reject the hypothesis of weak for efficiency for the capital market in Montenegro.

ADF test results for the random walk model with a drift, Yt  1  Yt 1  u t , are given
in the next table:

Null Hypothesis: CHANGE_NEX20 has a unit root

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -30.06529 0.0000

Test critical values: 1% level -3.434052
5% level -2.863062
10% level -2.567628

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(CHANGE_NEX20)
Method: Least Squares
Included observations: 1674 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

PROMENA_NEX20(-1) -0.701962 0.023348 -30.06529 0.0000

C 0.159417 0.048034 3.318837 0.0009

R-squared 0.350912 Mean dependent var -0.000705

Adjusted R-squared 0.350524 S.D. dependent var 2.423588
S.E. of regression 1.953172 Akaike info criterion 4.177980
 Sum squared resid 6378.478 Schwarz criterion 4.184459
Log likelihood -3494.969 F-statistic 903.9214
Durbin-Watson stat 2.016101 Prob(F-statistic) 0.000000

We got almost the same situation for new random walk model. ADF value is -30.06529
and its also smaller than critical tau statistic values for 1%, 5% i 10% significance value.
Null hypothesis cannot be rejected. Montenegrin capital market doesn't satisfy weak form
of market efficiency.

2.2 Run test

The Run test is also known as Geary test and it is a non-parametric statistical test
whereby the number of sequences of consecutive positive and negative returns is
tabulated and compared against its sampling distribution under the random walk
hypothesis. A run is defined as the repeated occurrence of the same value or category of a
variable. It is indexed by two parameters, which are the type of the run and the length.
Stock price runs can be positive, negative, or have no change. The length is how often a
run type occurs in succession. Under the null hypothesis that successive outcomes are
independent, the total expected number of runs is distributed as normal with the
following mean:
n  2n A n B
E ( R) 
n

and the following standard deviation:

2 n A n B ( 2n A n B  n)
R 
n 2 (n  1)

where n is the total number of observations, nA is the number of first run cycle, and nB is
the number of second run cycle. Number of runs is marked with R. If the number of
observations is large its distribution is almost equal to normal distribution. The test for
serial dependence is carried out by comparing the actual number of runs, a r in the price
series, to the expected number μ. The null proposition is: H 0 : E(runs) = E(R).. and
checks a randomness hypothesis for a two-valued data sequence. It can be used to test the
hypothesis that the elements of the sequence are mutually independent. If the number of
observations is large its distribution is almost equal to normal distribution. That is why
we can use standard normal Z distribution for implementing Run test.

The formula for standard score is:

R  E ( R)
Z
R
If calculated Z value is grater than critical value with appropriate significance level, than
we can reject Null hypothesis and conclude that analyzed NEX20 stock index cannot be
predicted. In that case capital market of Montenegro will satisfy weak form of market
efficiency.

The results of basic parameters for the Run test applied on time series NEX20 are given
in the table bellow:

2003 2004 2005 2006 2007 2008 2009

nA 100 129 155 149 143 90 76
nB 64 99 98 104 119 172 75
n 218 262 260 260 262 262 152
R 100 124 127 101 71 99 58
E(R) 59.72 98.49 117.85 120.20 130.90 119.17 76.00
R 3.95 6.00 7.23 7.38 8.01 7.28 6.06
Z 10.19 4.25 1.27 -2.60 -7.48 -2.77 -2.97
Z =0.05 ±1.96 ±1.96 ±1.96 ±1.96 ±1.96 ±1.96 ±1.96
Z =0.05 ±2.58 ±2.58 ±2.58 ±2.58 ±2.58 ±2.58 ±2.58
Hipoteza H1 H1 H0 H1 H1 H1 H1

According to results, only in year of 2005. the capital market of Montenegro is weak-
form efficient. In every other year of analyzed period, this market is inefficient.

If we provide Run test for the whole period, results will be:

2003 - 2009
nA 842
nB 731
n 1676
R 680
E(R) 735.49
R 17.93
Z -3.09
Z =0.05 ±1.96
Z =0.05 ±2.58
Hipoteza H1

So the final conclusion would be that the Montenegrin capital market doesn't satisfy the
weak form of efficiency. It is inefficient because movement of the stock prices can be
predicted.
2.3 Autocorrelation function

The autocorrelation function (ACF) test is examined to identify the degree of

autocorrelation in a time series. It measures the correlation between the current and
lagged observations of the time series of stock returns.

If time series has unit root, than the autocorrelation function slowly decrease starting
from the value of one and the partial correlation function has only first value which
differs from zero. If one time series has two unit roots, ACF act the same way as for the
one unit root series, but the PACF has only first two nonzero values.

Correlogram and the values of ACF and PACF are as follows:

Autocorrelation Partial Correlation AC PAC Q-Stat Prob

1 0.298 0.298 149.04 0.000

2 0.114 0.028 170.97 0.000
3 0.074 0.036 180.17 0.000
4 0.104 0.077 198.29 0.000
5 0.103 0.053 216.29 0.000
6 0.036 -0.020 218.52 0.000
7 0.015 -0.004 218.90 0.000
8 0.018 0.005 219.43 0.000
9 0.077 0.065 229.31 0.000
10 0.041 -0.005 232.14 0.000
11 0.008 -0.012 232.24 0.000
12 0.061 0.063 238.44 0.000
13 0.043 0.001 241.64 0.000
14 0.107 0.085 260.97 0.000
15 0.084 0.029 272.84 0.000
16 0.073 0.029 281.76 0.000
17 0.009 -0.042 281.90 0.000
18 -0.009 -0.029 282.03 0.000
19 0.006 -0.004 282.10 0.000
20 0.066 0.065 289.39 0.000

Based on the results of correlogram, ACF and PACF statistics we can make a conclusion
that the NEX20 index represent stationary time series. Correlogram so as the values of
ACF and PACF decrease slowly and ACF and PACF have very small values which all
implies that the analyzed series is stationary. Stationary goes hand in hand with
inefficiency of Montenegrin capital market.
3. Testing Montenegrin stock market anomalies

For almost ten years after publication of Fama's classic exposition in 1970, the Efficient
Markets Hypothesis dominated the academic and business scene. But soon after that,
critics of EMH have produced a wide range of arguments.

The assumption that investors are rational and therefore value investments rationally –
that is, by calculating the net present values of future cash flows, appropriately
discounted for risk – is not supported by the evidence, which shows rather that investors
are affected by: herd instinct, a tendency to "churn" their portfolios, a tendency to under-
react or over-react to news or asymmetrical judgements about the causes of previous
profits and losses.

Furthermore, many alleged anomalies have been detected in patterns of historical share
prices. The best known of these are: the January effect, the Monday effect and the
Holiday effect which will be tested and presented in this work.

3.1 January Effect

The month of January in the stock market has strong significance in predicting the trend
of the stock market for the rest of the calendar year. This phenomena occurs between the
last trading day in December of the previous year and the fifth trading day of the new
year in January. The January Effect is a result of tax-loss selling which causes investors
to sell their losing positions at the end of December. Therefore, the main characteristics
of the January Effect are an increase in buying securities before the end of the year for a
lower price, and selling them in January to generate profit from the price differences.

Test of January effect is given from the year of 2004. The stock market NEX Montenegro
was founded in March 2003. so there were no market activities in January 2003.

Growth rate of stock market index NEX20 in 2004.

1.20
1.01
1.00
Growth rate in %

0.76
0.80 0.72
0.60 0.38
0.26
0.40 0.20
0.18 0.18 0.10
0.18 0.18
0.20

0.00 -0.10
-0.20
November

December
March

June

September

Octoberer
January

February

May

July
April

August
Effect according to which the value of stock in January are higher than on the rest of the
year in 2004. is not proved. In this year, growth rate of stock market index NEX20 in
January is 0.18%. Much higher values of growth rates are realized in February, 0.72%
and in September, 0.72%, and in October growth rate of NEX20 index was 1.01%.

Growth rate of stock market index NEX20 in 2005.

2.00 1.76

1.41
Growth rate in % 1.50
0.97 0.93
0.97
1.00 0.79
0.29
0.50 0.21
-0.13
-0.04 -0.31
-0.10
0.00

-0.50

November

December
March

June

September

Octoberer
January

February

May

July
April

August
We cannot prove the existence of January effect in 2005. This is the year where growth
rate of NEX20 index was 0.21% in January and 1.76% in October.

Growth rate of stock market index NEX20 in 2006.

1.04
1.20 1.09
1.00 0.72
Growth rate in %

0.80
0.60
0.31 0.28
0.40 0.25
-0.01 -0.05
0.20 0.01
-0.10 -0.06
0.00
-0.20 -0.32
-0.40
November

December
March

June

September

Octoberer
January

February

May

July
April

August

Opposite to the previous year, October was the month with the smallest "growth" rate of
stock index NEX20 in 2006. The value of growth rate in this month was -0.32%. The
highest growth rate value was in August - 1.09%. January effect wasn't significant.
January growth rate of NEX20 stock index was 0.31%.

Growth rate of stock market index NEX20 in 2007.

2.50
2.00
2.00
Growth rate in %

1.11 1.04 1.34

1.50

1.00 0.42 0.55

0.50 -0.03 0.39
-0.14
0.00

-0.50 -0.47 -0.28 -0.85

-1.00
November

December
March

June

September

Octoberer
January

February

May

July
April

August
While the highest value of growth rate in 2006. was 1.09%, the biggest growth rate of
NEX20 in 2007. was 2%, realized in March. January effect haven't been noticed in this
year. January growth rate of NEX20 index was 1.11% which is smaller than the growth
rate of the same index in March and in April.

Growth rate of stock market index NEX20 in 2008.

0.88
1.00

Growth rate in % 0.50 0.10

-0.04
0.00

-0.50 -0.47 -0.52

-0.52 -0.55
-0.66
-1.00 -0.78
-0.91
-1.34 -1.37
-1.50

November

December
March

June

September

Octoberer
January

February

May

July
April

August
The first signs of world financial crisis are noticed in 2008. Growth rate of the NEX20
stock index is negative for almost all months, except in July and Decembrer. In January,
value of this rate was -0.66% and this is opposite to January effect.

Growth rate of stock market index NEX20 in 2009.

3.50 3.01
3.00
Growth rate in %

2.50
2.00
1.50
1.00 0.65

0.50 0.13

0.00
-0.50 -0.04 -0.26 -0.41
-0.66
-1.00
March

June
January

February

May

July
April

The last analyzed year was 2009. The slow recovery from the financial crisis is shown,
but still no signs of January effect. The highest value of growth rate was in May - 3.01%.
In January, growth rate was -0.04%.

In this investigation results proved that January effect as one of the anomalies of capital
market, doesn't exist in Montenegro. This causes the rejection of this critic refere to
EMH.
3.2 Monday effect

Many studies on the behavior of stock prices have been based on the belief that stock
returns are not influenced by the day of the week. The weekend effect, also known as the
Monday effect, refers to the tendency of stocks to exhibit relatively large returns on
Fridays compared to those on Mondays. This is a particularly puzzling anomaly because,
as Monday returns span three days, if anything, one would expect returns on a Monday to
be higher than returns for other days of the week due to the longer period and the greater
risk.

Results of the Monday effect anomaly is given on the next graph:

Monday effect

Friday 0.36

Thursday 0.19

Wednesday 0.01

0.14
Tuesday
0.42
Monday

0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45

Growth rate in %

Analysis consist the growth rate for stock market index NEX20 for the 5-days a week
starting from 2003. until 2009. According to this results, there is no Monday effect on
capital market in Montenegro, because the growth rate of index NEX20 has its highest
value on Mondays which is opposite to this critics of EMH. If the value of growth rate for
the NEX20 index was highest on Fridays it will refer that the Monday effect do exist on
this market.

3.3 Holiday effect

The holiday effect refers to the tendency of the market to do well on any day which
precedes a holiday. It means that the participant on the capital market are much more
optimistic before holidays and that the growth rate of stock prices is higher in that period
comparing to those after holidays.
 Holiday effect
2009 0.13

2008 0.10

2007 -0.03

2006 1.04

2005 0.29

2004 0.10

July 13th 0.51

-0.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20

Growth rate in %

For the purpose of this work, one holiday is chosen. It is 13th July, Statehood day.
Results represented by graph shows the growth rate value one week prior to 13th of July
and the same growth rate for the rest of July starting from 2004. until 2009. As results
have shown, the growth rate one week before holiday July 13th has the value of 0.51%
but that is not the highest growth rate of the analiyzed period. The highest growth rate of
index NEX20 was realized in July 2006. Holiday effect has no significant imact on
capital market in Montenegro.

3.4 Turn-of-the-month effect

The last critic which will be presented in this research is the Turn-of-the-month effect.
This anomaly is reflected in the tendency of stock prices to increase during the last two
days and the first three days of each month. Some researchers ascribe the effect to the
timing of monthly cash flows received by pension funds and reinvested in the stock
market.

For the aim of this work, two years are randomly chosen, 2004. and 2008. Results are
described by following graph:

Turn-of-the-month-effect
December
November
Octoberer
September
August
July
June
May
April
March
February
January
-0.5 0 0.5 1 1.5 2 2.5 3

Grow th rate in %

2004. end of the month 2004

The red bar on the graph represents the monthly growth rate for index NEX20 for the last
week of the month. The yellow bar consist growth rate for the whole month. According
to the results, turn-of-the-month effect is partly present. This effect is significant in all the
months of the year 2004. except in June, July an December.

Turn-of-the-month-effect
December
November
Octoberer
September
August
July
June
May
April
March
February
January
-2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5

Grow th rate in %

2008. end of the month 2008

The effect of world financial crisis is present in 2008. Growth rates are negative for
almost all months. Turn-of-the-month effect is recognized in this year because the growth
rates are significantly higher at the end of the month comparing to those for the whole
month.

4. Conclusion

Efficient-Market Hypothesis is a cornerstone of modern financial theory. Studies from

this field of economy have made an important contribution to the understanding of the
stock market, although the present state of understanding of the issue, especially in the
emerging financial markets, is far from being conclusive.

Research consists only of tests of weak-form efficiency. The results of Montenegrin

capital market analysis shows that this market is rather inefficient. It is generally assume
that the emerging markets are less efficient than the developed market.

To investigate whether the result of inefficient capital market is valid, paper presented the
tests of capital market anomalies, such as: January effect, Monday effect, Holiday effect
and Turn-of-the-month effect. No anomalies, except for the Turn-of-the-month-effect,
were proven to exist on the Montenegrin capital market. It was proven that the stock
prices are higher at the end of every month of the year compared to the prices for the rest
of the month.

It can be concluded that the capital market in Montenegro is small, emerging and
therefore inefficient. However, the results for the capital markets in developed countries
are not that much different.

On the other hand, it would be good to mention the hypothesis of scientists, Samuels and
Yacout, who investigated the efficiency market in emerging economies. They thought
that the inefficient market in emerging economies is not such a bad thing. They noticed
that an inefficient market is better than no market at all.

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