Efficient Markets Hypothesis

- The notion that prices already reflect all available information is referred to as the
Efficient Market Hypothesis (EMH)  prices are not predictable
- An efficient market is a market that efficiently processes information:
o Prices fully reflect all available information.
o Prices react quickly and correctly to new information.
o There is no free lunch: The only way you can get higher returns is by taking on
more risks.
- Three versions of EMH:
o Weak-form EMH: prices reflect all past market trading information such as
past prices, trading volume or short interest. Implies trend analysis is useless.
 If markets are weak-form efficient, then technical analysis has no
merit.
o Semi-strong form EMH: prices reflect all public information in addition to past
prices – all fundamental data on a firm’s product line, financial data,
accounting data.
 If markets are semi-strong form efficient, then most fundamental
analysis is also useless.
 The only way to reap benefits from fundamental analysis is if your
analysis is better than any other competitors.
o Strong-form EMH: prices reflect all relevant information – public and even
including information that is only unavailable to insiders.

Active vs. Passive Management

- If markets are efficient, then is there any value to active management?
- Proponents of EMH would say no and advocate a passive investment strategy.
- The typical annual charge for an actively managed equity fund is 1% of assets vs.
0.17% for Vanguard’s S&P 500 index fund.

Event Study
- A powerful technique to assess the impact of an event on a firm’s stock price.
- Measuring the unexpected return: what is “abnormal return”?

- Event studies estimate the abnormal return around the date that new information is
released to the market and attribute the abnormal return to the new information.
Anomalies
- Evidence on efficient market hypothesis
o Anomalies – patterns that are hard to reconcile with the efficient market
hypothesis and traditional finance paradigm (rational market)
- Return patterns:
o Early studies showed that, over daily, weekly and monthly horizon, stock
returns are almost uncorrelated. This means that whether a stock’s price
went up yesterday has no bearing on whether it will go up tomorrow.
- Momentum:
o Jegadeesh and Titman (1993): Trading on the basis of longer horizon past
returns can yield higher returns without higher systematic risk  Past 6-12
month returns exhibit momentum. Buying a portfolio of high past one-year
return stocks (winners) and shorting low past return stocks (losers) yield high
future returns without extra risk.
- Reversal:
o Past 3-5 year returns exhibit reversal: Selling high past 3-5 year return stocks
(winners), and buying low past 3-5 year stocks (losers) have been a profitable
strategy.
- Small firm effect: Studies have shown that small-firm (low market capitalization) have
historically high returns relative to their systematic risks).
- Value effect: Studies have shown that value firms (low market to book) have
historically high returns relative to their systematic risk.
- Post-earnings announcement drift:
o A strategy of buying stocks with positive earnings surprises yields fairly strong
returns going forward.
o Long-run abnormal performance of the same sign as the initial price reaction:
 Seasonal offerings
 Repurchase announcements
 Public announcement of insider trades
 Analysts buy and sell recommendations
 Stock splits
 Dividend initiations and omissions