Security Analysis and Portfolio Management

Assignment – Semester VI

EFFICIENT MARKET HYPOTHESIS

Empirical Evidences and Implications

NIKITA JAIN

BMS III

088528
EFFICIENT MARKETS HYPOTHESIS

The efficient markets hypothesis (EMH), popularly known as the Random Walk Theory, is the
proposition that current stock prices fully reflect available information about the value of the
firm, and there is no way to earn excess profits, (more than the market overall), by using this
information. It deals with one of the most fundamental and exciting issues in finance – why
prices change in security markets and how those changes take place. It has very important
implications for investors as well as for financial managers. Many investors try to identify
securities that are undervalued, and are expected to increase in value in the future, and
particularly those that will increase more than others. Many investors, including investment
managers, believe that they can select securities that will outperform the market. They use a
variety of forecasting and valuation techniques to aid them in their investment decisions.

However, while prices are rationally based, changes in prices are expected to be random and
unpredictable, because new information, by its very nature, is unpredictable. Therefore stock
prices are said to follow a random walk.

Three Versions of the Efficient Markets Hypothesis

The efficient markets hypothesis predicts that market prices should incorporate all available
information at any point in time. There are, however, different kinds of information that
influence security values. Consequently, financial researchers distinguish among three versions
of the Efficient Markets Hypothesis, depending on what is meant by the term “all available
information”. The three forms, viz., weak, semi-strong and strong, are discussed in the following
sections.
WEAK FORM EFFICIENCY

In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past.
Excess returns cannot be earned in the long run by using investment strategies based on
historical share prices or other historical data. Technical analysis techniques will not be able to
consistently produce excess returns, though some forms of fundamental analysis may still
provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no
"patterns" to asset prices. This implies that future price movements are determined entirely by
information not contained in the price series. Hence, prices must follow a random walk. This
'soft' EMH does not require that prices remain at or near equilibrium, but only that market
participants not be able to systematically profit from market 'inefficiencies'. However, while
EMH predicts that all price movement (in the absence of change in fundamental information) is
random (i.e., non-trending), many studies have shown a marked tendency for the stock markets
to trend over time periods of weeks or longer and that, moreover, there is a positive correlation
between degree of trending and length of time period studied (but note that over long time
periods, the trending is sinusoidal in appearance). Various explanations for such large and
apparently non-random price movements have been promulgated.

The empirical evidence for this form of market efficiency, and therefore against the value of
technical analysis, is pretty strong and quite consistent. After taking into account transaction
costs of analyzing and of trading securities it is very difficult to make money on publicly
available information such as the past sequence of stock prices.

Empirical Evidence

1. Run Test. This test is used to find out whether the series of price movements have
occurred by chance. A run is an uninterrupted sequence of the same observation. A
consecutive rise in the stock prices would be counted as a positive run and decline would
be counted as a negative run. Published results of the studies using runs test have
suggested that the runs in the price series of stocks are not significantly different from the
runs in the series of random numbers.

2. Serial Correlation Tests. The random walk hypothesis implies that successive price
movements should be independent. A number of studies have attempted to test this
hypothesis by examining the correlation between the current return on a security and the
return on the same security over a previous period. A positive serial correlation indicates
that higher than average returns are likely to be followed by higher than average returns
(i.e., a tendency for continuation), while a negative serial correlation indicates that higher
than average returns are followed, on average, by lower than average returns (i.e., a
tendency toward reversal). If the random walk hypothesis were true, we would expect
zero correlation.
 Consistent with this theory, Fama (1965) found that the serial correlation coefficients for
a sample of 30 Dow Jones Industrial stocks, even though statistically significant, were
too small to cover transaction costs of trading. Subsequent studies have mostly found
similar results, across other time periods and other countries. These findings are
consistent with weak-form market efficiency.

3. Simulation Tests. The essence of this experiment was to examine the appearance of the
actual level of Dow Jones index expressed both in levels and in terms of weekly changes,
and to compare these graphs with a simulated set of graphs. A series of price changes was
generated from random number tables and then these changes were converted to graphs
depicting levels of the simulated Dow Jones index. Similar patterns were observed
between the actual and simulated series and the inference is that the actual result may
well be the result of random stock price movements.

4. Filter Tests. This test is based on the premise that once a movement in price as surpasses
a given percentage movement, the security’s price will continue to move in the same
direction. The selection of a high filter will cut down his number of transactions and will
lead to fewer false starts of signals, but it will also decrease his potential profit because
he would have missed the initial portion of the move. Conversely, the selection of a
smaller filter will ensure his sharing in the great bulk of the security’s price movement,
but he will have the disadvantage of performing many transactions, with their
accompanying high costs, as well as often operating on false signals.
It was observed that only when the filter was at its smallest did this mechanical procedure
outperform a simple buy-and-hold strategy, and even then, only the transaction costs
were considered. Similar tests of other various trading systems yielded similar results,
thus giving additional validity to the random walk theory.
SEMI-STRONG FORM EFFICIENCY

The semi-strong-form of market efficiency hypothesis suggests that the current price fully
incorporates all publicly available information. Public information includes not only past prices,
but also data reported in a company’s financial statements (annual reports, income statements,
filings for the Security and Exchange Commission, etc.), earnings and dividend announcements,
announced merger plans, the financial situation of company’s competitors, expectations
regarding macroeconomic factors (such as inflation, unemployment), etc. In fact, the public
information does not even have to be of a strictly financial nature. For example, for the analysis
of pharmaceutical companies, the relevant public information may include the current
(published) state of research in pain-relieving drugs.

Semi-strong-form efficiency implies that neither fundamental analysis nor technical

analysis techniques will be able to reliably produce excess returns. To test for semi-strong-form
efficiency, the adjustments to previously unknown news must be of a reasonable size and must
be instantaneous. To test for this, consistent upward or downward adjustments after the initial
change must be looked for. If there are any such adjustments it would suggest that investors had
interpreted the information in a biased fashion and hence in an inefficient manner.

The assertion behind semi-strong market efficiency is still that one should not be able to profit
using something that “everybody else knows” (the information is public). Nevertheless, this
assumption is far stronger than that of weak-form efficiency. Semi-strong efficiency of markets
requires the existence of market analysts who are not only financial economists able to
comprehend implications of vast financial information, but one should not be surprised that
investment companies analyzing many of the high-tech industries have started employing experts
from many non-financial areas (such as medical doctors, pharmacists, biochemists, etc.) in order
to be able to assess viability of projects undertaken by high-tech companies. Arguably,
acquisition of such skills must take a lot of time and effort. In addition, the “public” information
may be relatively difficult to gather and costly to process. It may not be sufficient to gain the
information from, say, major newspapers and company-produced publications. One may have to
follow wire reports, professional publications and databases, local papers, research journals etc.
in order to gather all information necessary to effectively analyze securities.

Empirical Evidence

The semi-strong form of the EMH is perhaps the most controversial, and thus, has attracted the
most attention. If a market is semi-strong form efficient, all publicly available information is
reflected in the stock price. It implies that investors should not be able to profit consistently by
trading on publicly available information.

1. Fama, Fisher, Jensen and Roll made a major contribution with their study of the
semistrong-form hypothesis. They tested the speed of the market’s reaction to a firm’s
announcement of a stock split and the accompanying information with respect to a
 change in dividend policy. The authors concluded that the market was efficient with
respect to its reaction to information on the stock split and also was efficient with respect
to reacting to the informational content on the stock split and also was efficient with
respect to reacting to the informational content of stock splits vis-à-vis changes in
dividend policy.

2. Ball and Brown conducted another test in this area by analyzing the stock market’s ability
to absorb the informational content of reported annual earnings per share information. In
their study the authors examined stock price movements of companies that experienced
“good” earnings reports as opposed to the stock price movements of companies that
experiences “bad” earnings reports. They found that those companies with “good”
earnings reports experienced price increases in their stock and those with “bad” earnings
reports experienced stock price declines. About 85% of the informational content of the
annual earnings announcement was reflected in stock price movements prior to the
release of the actual earnings figure.

3. Joy, Litzenberger, and McEnally conducted another stock price-earnings report test in
this area. In their study the authors tested the impact of quarterly earnings announcements
on the stock price adjustment on the stock price adjustment mechanism.

4. Another test in this area was conducted by Basu. He tested for informational content of
the price-earnings multiple. He tested to see whether low P/E stocks tended to outperform
stocks with high P/E ratios. His results indicated that the low P/E portfolios experiences
superior returns relative to the market and high P/E portfolios performed in an inferior
manner relative to the overall market.

5. Size Effect. These studies attempted to test whether smaller firms tended to experience
larger returns than the larger firms experienced over the same time period. These studies
indicated that small firms did provide the investor with significantly larger risk-adjusted
returns than did the larger firms examined.
STRONG FORM EFFICIENCY

The strong form of market efficiency hypothesis states that the current price fully incorporates all
existing information, both public and private (sometimes called inside information). The main
difference between the semi-strong and strong efficiency hypotheses is that in the latter case,
nobody should be able to systematically generate profits even if trading on information not
publicly known at the time. In other words, the strong form of EMH states that a company’s
management (insiders) are not be able to systematically gain from inside information by buying
company’s shares ten minutes after they decided (but did not publicly announce) to pursue what
they perceive to be a very profitable acquisition. Similarly, the members of the company’s
research department are not able to profit from the information about the new revolutionary
discovery they completed half an hour ago. The rationale for strong-form market efficiency is
that the market anticipates, in an unbiased manner, future developments and therefore the stock
price may have incorporated the information and evaluated in a much more objective and
informative way than the insiders. Not surprisingly, though, empirical research in finance has
found evidence that is inconsistent with the strong form of the EMH.

Empirical Evidence

Empirical tests of the strong-form version of the efficient markets hypothesis have typically
focused on the profitability of insider trading. If the strong-form efficiency hypothesis is correct,
then insiders should not be able to profit by trading on their private information. Jaffe (1974)
finds considerable evidence that insider trades are profitable.

A more recent paper by Rozeff and Zaman (1988) finds that insider profits, after deducting an
assumed 2 percent transactions cost, are 3% per year. Thus, it does not appear to be consistent
with the strong-form of the EMH.
IMPLICATIONS OF MARKET EFFICIENCY FOR INVESTORS

Much of the existing evidence indicates that the stock market is highly efficient, and
consequently, investors have little to gain from active management strategies. Such attempts to
beat the market are not only fruitless, but they can reduce returns due to the costs incurred
(management, transaction, tax, etc.). Investors should follow a passive investment strategy,
which makes no attempt to beat the market. This does not mean that there is no role for portfolio
management. Returns can be optimized through diversification and asset allocation, and by
minimization of investment costs and taxes. In addition, the portfolio manager must choose a
portfolio that is geared toward the time horizon and risk profile of the investor. The appropriate
mixture of securities may vary according to the age, goals, tax bracket, employment, and risk
aversion of the investor.

The efficient markets hypothesis (EMH) suggests that profiting from predicting price movements
is very difficult and unlikely. The main engine behind price changes is the arrival of new
information. As a result, the current prices of securities reflect all available information at any
given point in time. Consequently, there is no reason to believe that prices are too high or too
low. Security prices adjust before an investor has time to trade on and profit from a new a piece
of information. The key reason for the existence of an efficient market is the intense competition
among investors to profit from any new information. The ability to identify over- and
underpriced stocks is very valuable (it would allow investors to buy some stocks for less than
their “true” value and sell others for more than they were worth). Consequently, many people
spend a significant amount of time and resources in an effort to detect "mis-priced" stocks.
Naturally, as more and more analysts compete against each other in their effort to take advantage
of over- and under-valued securities, the likelihood of being able to find and exploit such mis-
priced securities becomes smaller and smaller. In equilibrium, only a relatively small number of
analysts will be able to profit from the detection of mis-priced securities, mostly by chance. For
the vast majority of investors, the information analysis payoff would likely not outweigh the
transaction costs. The most crucial implication of the EMH can be put in the form of a slogan:
Trust market prices!

Late 2000s Financial Crisis

The financial crisis of 2007–2010 has led to renewed scrutiny and criticism of the
hypothesis. Market strategist Jeremy Grantham has stated flatly that the EMH is responsible for
the current financial crisis, claiming that belief in the hypothesis caused financial leaders to have
a "chronic underestimation of the dangers of asset bubbles breaking". Noted financial
journalist Roger Lowenstein blasted the theory, declaring "The upside of the current Great
Recession is that it could drive a stake through the heart of the academic nostrum known as the
efficient-market hypothesis."

End