Investment Analysis & Portfolio Management Market Efficiency

MARKET EFFICIENCY
Investors determine stock prices on the basis of the expected cash flows to be received from a stock and the
risk involved. Rational investors should use all the information they have available or can reasonably obtain.
This information set consists of both known information and beliefs about the future.
 Information is the key to the determination of stock prices and therefore is the central issue of the
efficient markets concept.

What is meant by Efficient Market?

An efficient market (EM) is defined as one in which the prices of all securities quickly and fully reflect all
available relevant information.

 In an efficient market, the current market price of a security absorbs all relevant information.
 In an efficient market, securities prices reflect available information so as to offer an expected return
consistent with the level of risk.

This concept postulates that investors will assimilate all relevant information into prices making their buy and
sell decisions. Therefore, the current price of a stock reflects

1. All known information, including

 Past information (e.g., last year’s or last quarter’s earnings)
 Current information as well as events that have been announced but are still forthcoming (such as a
stock split)

2. Information that can reasonably be inferred; for example, if many investors believe that the Fed( Federal
Reserve (US central bank)) will cut interest rates at its meeting next week, prices will reflect (to a large
degree) this belief before the actual event occurs.

To summarize, a market is efficient relative to any information set if investors are unable to earn abnormal
profits (returns beyond those warranted by the amount of risk assumed) by using that information set in their
investing decisions.
Efficient market can exist if the following conditions come about:

1. A large number of rational, profit-maximizing investors exist who actively participate in the market by
analyzing, valuing, and trading stocks. These investors are price takers; that is, one participant alone cannot
affect the price of a security.
2. Information is costless and widely available to market participants at approximately the same time.
3. Information is generated in a random fashion such that announcements are basically independent of one
another.
4. Investors react quickly and fully to the new information, causing stock prices to adjust accordingly.

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The result of these conditions that exist is that markets efficiently reflect available information about
securities. Although mistakes are made, and some irrational behavior does occur, by and large the market
does a good job when it comes to pricing securities.

FORMS OF MARKET EFFICIENCY

We have defined an efficient market as one in which all relevant information is reflected in stock prices quickly
and fully. Thus, the key to assessing market efficiency is to determine how well information is reflected in
stock prices. In a perfectly efficient market, security prices quickly reflect all available relevant information,
and investors are not able to use available information to earn excess returns because it is already impounded
in prices. In such a market, every security’s price is equal to its intrinsic (investment) value, which reflects all
information about that security’s prospects.

We define the major concept involved with efficient markets as the efficient market hypothesis (EMH).

The efficient market hypothesis (EMH) is an economic and investment theory that attempts to explain how
financial markets move. It was developed by economist Eugene Fama in the 1960s, who stated that the prices
of all securities are completely fair and reflect an asset’s intrinsic value at any given time.
There are three different forms of the efficient market hypothesis:
 Weak-form EMH
 Semistrong-form EMH
 Strong-form EMH
WEAK-FORM EMH:
Prices of the securities instantly and fully reflect all information of the past prices. This means future price
movements cannot be predicted by using past prices and that no form of technical analysis can be effectively
utilized to help investors in making trading decisions.
Advocates for the weak form efficiency theory believe that if the fundamental analysis is used, undervalued
and overvalued stocks can be determined, and investors can research companies' financial statements to
increase their chances of making higher-than-market-average profits.
SEMISTRONG-FORM EMH:
The semi-strong form efficiency theory follows the belief that because all information that is public is used in
the calculation of a stock's current price, investors cannot utilize either technical or fundamental analysis to
gain higher returns in the market.
Those who subscribe to this version of the theory believe that only information that is not readily available to
the public (Insider information) can help investors boost their returns to a performance level above that of the
general market.
STRONG-FORM EMH:
Asset prices fully reflect all of the public and inside information available. Therefore, no one can have an
advantage in the market in predicting prices since there is no data that would provide any additional value to
the investors.

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TESTS OF EFFICIENT MARKET HYPOTHESES

Now that you understand the three components of the EMH and what each of them implies regarding the
effect on security prices of different sets of information, we can consider the tests used to see whether the
data support the hypotheses. Therefore, in this section we discuss the specific tests and summarize the results
of these tests.

Like most hypotheses in finance and economics, the evidence on the EMH is mixed. Some studies have
supported the hypotheses and indicate that capital markets are efficient. Results of other studies have
revealed some anomalies (A market anomaly refers to the difference in a stock’s performance from its
assumed price) related to these hypotheses, indicating results that do not support the hypotheses.

WEAK-FORM HYPOTHESIS TESTS:

Researchers have formulated two groups of tests of the weak-form EMH. The first category involves statistical
tests of independence between rates of return. The second set of tests entails a comparison of risk–return
results for trading rules that make investment decisions based on past market information relative to the
results from a simple buy-and-hold policy, which assumes that you buy stock at the beginning of a test period
and hold it to the end.

1. Statistical Tests of Independence:

The EMH contends that security returns over time should be independent of one another because new
information comes to the market in a random, independent fashion, and security prices adjust rapidly to this
new information.
Two major statistical tests have been employed to verify this independence.
 autocorrelation test
 runs test
Autocorrelation test:
First, autocorrelation tests of independence measure the significance of positive or negative correlation in
returns over time. Does the rate of return on day t correlate with the rate of return on day t − 1, t − 2, or t – 3.
Those who believe that capital markets are efficient would expect insignificant correlations for all such
combinations.
Several researchers have examined the serial correlations among stock returns for several relatively short
time horizons including 1 day, 4 days, 9 days, and 16 days. The results typically indicated insignificant
correlation in stock returns over time. Some recent studies that considered portfolios of stocks of different
market size have indicated that the autocorrelation is stronger for portfolios of small market size stocks.
Run Test:
The second statistical test of independence as discussed by DeFusco et al. (2004), is the runs test. Given a
series of price changes, each price change is either designated a plus (+) if it is an increase in price or a minus
(−) if it is a decrease in price. The result is a set of pluses and minuses as follows: + + + − + − − + + − − + +. A

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run occurs when one or more changes are the same; one or more consecutive positive or negative price
changes constitute one run. When the price changes in a different direction, such as when a negative price
change is followed by a positive price change, the run ends and a new run may begin. To test for
independence, you would compare the number of runs for a given series to the number in a table of
expected values for the number of runs that should occur in a random series.

Studies that have examined stock price runs have confirmed the independence of stock price changes over
time. The actual number of runs for stock price series consistently fell into the range expected for a random
series. Therefore, these statistical tests of stocks on the NYSE and on the NASDAQ market have likewise
confirmed the independence of stock price changes over time.
Although short-horizon stock returns (monthly, weekly, and daily) have generally supported the weak-form
EMH,

2. Tests of Trading Rules:

The second group of tests of the weak-form EMH was developed in response to the assertion that some of
the prior statistical tests of independence were too rigid to identify the intricate price patterns examined by
technical analysts. They typically look for a general consistency in the price trends over time. Such a trend
might include both positive and negative changes. Therefore, technical analysts believed that their
sophisticated trading rules could not be properly tested by rigid statistical tests.

The trading rule studies compared the risk–return results derived from trading-rule simulations (duplicate),
including transaction costs, to the results from a simple buy-and-hold policy.

Three major pitfalls (problems) can negate the results of a trading-rule study:

1. The investigator should use only publicly available data when implementing the trading rule. As an
example, the trading activities of some set of traders/investors for some period ending December 31 may not
be publicly available until February 1. Therefore, you should not factor in information about the trading
activity until the information is public.

2. When computing the returns from a trading rule, you should include all transaction costs involved in
implementing the trading strategy because most trading rules involve many more transactions than a simple
buy-and-hold policy.

3. You must adjust the results for risk because a trading rule might simply select a portfolio of high-risk
securities that should experience higher returns.

One of the most popular trading techniques is the filter rule, wherein an investor trades a stock when the
price change exceeds a filter value set for it. As an example, an investor using a 5 percent filter would identify
a positive breakout if the stock were to rise 5 percent from some base, suggesting that the stock price would
continue to rise. A technician would acquire the stock to take advantage of the expected increase. In
contrast, a 5 percent decline from some peak price would be considered a negative breakout, and the
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technician would expect a further price decline and would sell any holdings of the stock and possibly even sell
the stock short.
Studies of this trading rule have used a range of filters from 0.5 percent to 50 percent. The results indicated
that small filters would yield above-average profits before taking account of trading commissions.
If the behavior of the stock price changes is random, filter rule should not outperform a simple buy and hold
strategy.

SEMISTRONG-FORM TESTS:

Semistrong-form tests are largely tests of the speed of price adjustments to publicly available information.
The question is whether investors can use publicly available information to earn excess returns, after proper
adjustments.
Studies that have tested the semistrong-form EMH can be divided into the following sets of studies:
 Event studies
 Portfolio studies or Return Prediction
1. EVENT STUDIES:

Event studies examine how fast stock prices adjust to specific significant economic events. Event can be
anything e.g. dividend announcement, stock split or any other changing in the particular stock.

The approach would be to test whether it is possible to invest in a security after the public announcement of
a significant event (e.g., dividend announcement, stock splits,) and experience significant abnormal rates of
return. Again, advocates of the EMH would expect security prices to adjust rapidly, such that it would not be
possible for investors to experience superior risk-adjusted returns by investing after the public
announcement and paying normal transaction costs.

Steps in event study:

1. Identify the event to be studied and pin point the data on which the event was announced.( to do this
study include multiple firms with the same event form different dates)
2. Collect returns data around the announcement date of event. (Before, after and whenever event is
announced)
3. Calculate the abnormal (excess) returns by period around the announcement date for each firm in the
sample.
Formula to calculate abnormal return:

Abnormal return = ARit = Rit - E (Rit)

Where
ARit =the abnormal rate of return for security i during period t
Rit =the actual rate of return on security i during period t
E (Rit) = the expected rate of return for security i during period t

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4. Compute the average abnormal returns across all firms.

5. Compute the cumulative abnormal return (CAR). Cumulative Abnormal Return (CAR) The sum of the
individual abnormal returns over the time period under examination.

If the Cumulative Abnormal Return (CAR) is around the zero then it is semistrong-form of efficient market and
if it is not around the zero then it is inefficient market.

2. PORTFOLIO STUDY OR RETURN PREDICTION:

Portfolio study examines the possibility of earning superior risk-adjusted returns by trading on observable
characteristics of firm like P/E ratio, dividend yield etc.

Steps in Portfolio study:

1. Define the variable (characteristics) on which firm will be classified (e.g. high or low dividend, high or low
P/E ratio etc.)
2. Classify firms into portfolio based upon the magnitude of the variable. (Based on investors priority)
3. Compute the returns for each portfolio.
4. Calculate the abnormal (excess) returns for each portfolio.
5. Assess whether the average abnormal returns are different across the portfolio or not.

If the average abnormal returns different across the portfolios then we can say that it is not a semistrong-
form of efficient market. If the average abnormal returns same across the portfolios then we can say that it is
a semistrong-form of efficient market.

3. STRONG-FORM TESTS:
The strong form of the EMH states that stock prices quickly adjust to reflect all information, including private
information. Thus, no group of investors has information that allows them to earn abnormal profits
consistently, even those investors with monopolistic access to information. Note that investors are prohibited
not from possessing monopolistic information, but from profiting from the use of such information.
One way to test for strong-form efficiency is to examine the performance of groups presumed to have access
to “true” nonpublic information. If such groups can consistently earn above-average risk-adjusted returns,
this version of the strong form will not be supported.
Testing Group of Investors:

 Corporate Insiders:
Insiders include major corporate officers, directors and owners of 10% or more of any equity class of
securities.
 Stock Exchange Specialists:
Specialists have monopolistic access to information about unfilled limit order.
 Security Analyst:
There is evidence in favor of existence of superior analyst who apparently possess private
information.
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 Professional Money Managers:

Trained professionals working full time at investment management.
STRONG-FORM EVIDENCE:

Test for corporate insiders and stock exchange specialist do not support the hypothesis (both group seems to
have monopolistic access to important information and use it to derive above average returns.)

MARKET ANOMALIES
Market efficiency hypothesis suggests that markets are rational and their prices fully reflect all available
information. Due to the timely actions of investors prices of stocks quickly adjust to the new information, and
reflect all the available information. So no investor can beat the market by generating abnormal returns. But
it is found in many stock exchanges of the world that these markets are not following the rules of EMH. The
functioning of these stock markets deviate from the rules of EMH. These deviations are called anomalies.
Anomalies could occur once and disappear, or could occur repeatedly.

DEFINITION:

A market anomaly refers to the difference in a stock’s performance from its assumed price trajectory
(direction), as set out by the efficient market hypothesis (EMH).

Following are some of the most common anomalies.

1. EARNINGS ANNOUNCEMENTS:

The information found in earning announcements should, and does, affect stock prices. The questions that
need to be answered are as follows:

1. How much of the earnings announcement is a “surprise”?

2. How quickly is the “surprise” portion of the announcement reflected in the price of the stock? Is it
immediate, as would be expected in an efficient market, or is there a lag in the adjustment process? If a lag
occurs, investors have a chance to realize excess returns by quickly acting on the publicly available earnings
announcements.

In theory, if markets were entirely efficient, then company earnings announcements would cause an
immediate shift in prices as the report is instantly factored into the market price. However, in practice, it can
take up to approximately 60 days for markets to adjust – with a positive earnings announcement causing an
upward drift, and a negative earnings announcement causing negative earnings drift.

To assess the earnings announcement issue properly, we must separate a particular earnings announcement
into an expected and an unexpected part. The expected part is that portion anticipated by investors by the
time of announcement and that requires no adjustment in stock prices, whereas the unexpected part is
unanticipated by investors and requires an adjustment in price.

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Latane and Jones studied quarterly earnings reports in 1968. Finding indicated a lag in the adjustment of
stock prices to the information in these reports. Following several papers that examined the value of
quarterly earnings in stock selection, Latane, Jones, and Rieke in 1974 developed the concept of
standardized unexpected earnings (SUE) as a means of investigating the earnings surprises in quarterly data.
SUE is defined as “A variable used in the selection of common stocks, calculated as the ratio of unexpected
earnings to a standardization factor.”

Formula to fin SUE:

Actual quarterly earningsPredicted quarterly earnings

SUE=
Standardization factor∨Standard error of the estimate

 The actual quarterly earnings are the earnings reported by the company and available to investors
soon after reported.
 Predicted earnings for a particular company are estimated from historical earnings data before the
earnings are reported.
 Standardized factor is the standard deviation of estimated earnings for the specified quarter.

Criteria:
If SUE greater than 3 then accepted and if it is less than 3 then rejected.

2. LOW P/E RATIOS:

One of the more enduring concepts in investments concerns the price/earnings (P/E) ratio. A number of
investors believe that low P/E stocks on average, outperform high P/E stocks. The rationale for this concept is
not clear, but the belief persists.

3. THE SIZE EFFECT:

A third potential anomaly that generated considerable attention is the firm size effect. In a well-publicized
study, Rolf Banz found that the small firms consistently experienced significantly larger risk-adjusted returns
than the larger firms.

Recall that abnormal returns may occur because the markets are inefficient or because the market model
provides incorrect estimates of risk and expected returns. It was suggested that the riskiness of the small
firms was improperly measured because small firms are traded less frequently.

JANUARY EFFECT:

The January Effect is a theory which says that every December stock prices take a dip and every January they
receive a boost. This is driven by heavy selling during December and aggressive buying during January,
particularly early in the month. Investors tend to sell off low-performing stocks at the end of each year. They
then tend to buy those stocks back a few weeks or even days later.

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The January Effect is driven by tax planning. Investors sell off stocks at a loss before the end of each year to
try and mitigate their upcoming capital gains taxes. Once the calendar rolls over, they buy those stocks back
to hold for another year of (hopeful) gains.

Investors are taxed on their collective capital gains over the course of every year, measured from January 1 to
December 31. The important thing about this is the word “collective.” An investor pays taxes on the total
results of all their investment income. So, say an investor owns stock in Company A, Company B and
Company C. They then sell off all three bundles of stock at the same time for the following results:

 Company A - $10,000 Profit

 Company B - $5,000 Profit
 Company C - $7,000 Loss
In this example, our investor’s taxable investment income would be $8,000. They would have made $15,000
from the first two investments, but they could write off the losses from Company C.

So, in an effort to minimize their tax bill as much as possible, investors will sell off assets that have taken a
loss before the end of the year. But this doesn’t mean the investors don’t want those stocks. In our example
above, the investor may believe that Company C is poised for long term growth. So the investor will sell the
stock off right before December 31, cutting their taxable investment income almost in half. Then they might
buy it right back up in January, to sit and wait for that growth.

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