Efficient Market Theory

Efficient Markets

• In an efficient stock market, the price for any

given stock effectively represents the expected
net present value of all future profits

• Interplay of supply and demand sets prices

• Price for any stock or bond represents collective

wisdom about future prospects
 Efficient Markets Hypothesis

• EMH holds that security prices fully reflect all available

information at any time.
• Individual and professional investors buy and sell
stocks under assumption that intrinsic value differs
from market price.
• Perfectly competitive securities market:
– New information arrives at market independently and
randomly.
– Both buyers and sellers adjust rapidly to new info.
– Current security prices reflect all relevant risk/return info.
 The EMH Graphically
All historical prices and returns
• In this diagram, the circles
represent the amount of Strong Form
information that each form of
the EMH includes.
Semi-Strong
• Note that the weak form
covers the least amount of
information, and the strong Weak Form
form covers all information.
• Also note that each successive
form includes the previous
ones.

All information, public and private

All public information
 Levels of Market Efficiency

• Weak-Form Hypothesis: current prices reflect all stock

market information; trading rules based on past stock
market return or volume are futile.
• Semistrong-Form Hypothesis: current prices reflect all
public information; trading rules based on public
information are futile.
• Strong-Form Hypothesis: current prices reflect all
public information and non-public information. All
trading rules are futile.
 Public vs. Private Information

• Stock Market Information: stock price and

trading volume figures

• Public Information: freely shared information

• Nonpublic Information: proprietary data

• Insider Information: proprietary information

within a firm
 Time Series of Stock Prices

• Time Series: date points over time

• Correlation among stock indexes is strong.
• Daily Returns: stock prices change irregularly
• Daily returns are noisy (highly variable) and random around
a mean of zero
• Distribution of daily returns is normal; follows bell-shaped
curve
• Booms and Busts: reversion to the mean in day-to-day
trading doesn’t work
 Random Walk Theory

• Random Walk: irregular pattern of numbers that

defies prediction

• Random Walk Theory: concept that stock price

movements do not follow any pattern or trend

• Fair Game: even bet; 50-50 chance

• Random Walk With Drift: slight upward bias to

inherently unpredictable daily stock prices
DJIA Prices
Figure 12.4

Random Walk Research

Evidence supports notion of random walk

 Tests of the Weak Form
• Serial correlations.
• Runs tests.
• Filter rules.
• Relative strength tests.
• Many studies have been done, and nearly all
support weak form efficiency, though there
have been a few anomalous results.
 Serial Correlations
• The following chart shows the relationship (there is none)
between S&P 500 returns each month and the returns from
the previous month. Data are from Feb. 1950 to Sept. 2001.
• Note that the R2 is virtually 0 which means that knowing last
month’s return does you no good in predicting this month’s
return.
• Also, notice that the trend line is virtually flat (slope =
0.008207, t-statistic = 0.2029, not even close to significant)
• The correlation coefficient for this data set is 0.82%
 Serial Correlations (cont.)

Unlagged vs One-month Lagged S&P 500

Returns
y = 0.008207x + 0.007451
2
20.00% R = 0.000067
Unlagged Returns

10.00%
0.00%
-10.00%
-20.00%
-30.00%
-30.00% -20.00% -10.00% 0.00% 10.00% 20.00%
One-month Lagged Returns
 Filter Rule
• If a price of a security rises by X percent the
investor will buy and hold the security, till the
price of the security is decline by X
percentage.
• Short sellers uses this concept
 Run Test
• Used to find out whether the series of price
movements is occurred by chance
• E.g. Tossing a coin- HH TT
• Run Test
Z= R-X/ σ
R- number of runs
X- (2n1 n2/ n1+n2) +1
σ- standard deviation
 The Semi-strong Form
• The semi-strong form says that prices fully reflect all publicly
available information and expectations about the future.
• This suggests that prices adjust very rapidly to new
information, and that old information cannot be used to earn
superior returns.
• The semi-strong form, if correct, repudiates fundamental
analysis.
• Most studies find that the markets are reasonably efficient in
this sense, but the evidence is somewhat mixed.
• Simple Regression Technique
r it= ά1+β1. rmt+ eit

Where rit-v realized return of I stock for time

period t
rmt- realized return for index in time period t
ά1+β1- regression coefficients
eit- error term
 The Strong Form
• The strong form says that prices fully reflect all
information, whether publicly available or not.
• Even the knowledge of material, non-public
information cannot be used to earn superior
results.
• Most studies have found that the markets are
not efficient in this sense.
 Tests of the Strong Form
• Corporate Insiders.
• Specialists.
• Mutual Funds.
• Studies have shown that insiders and
specialists often earn excessive profits, but
mutual funds (and other professionally
managed funds) do not.
• In fact, in most years, around 85% of all
mutual funds underperform the market.
 Anomalies
• Anomalies are unexplained empirical results
that contradict the EMH:
– The Size effect.
– The “Incredible” January Effect.
– P/E Effect.
– Day of the Week (Monday Effect).
 The Size Effect
• Beginning in the early 1980’s a number of
studies found that the stocks of small firms
typically outperform (on a risk-adjusted basis)
the stocks of large firms.
• This is even true among the large-
capitalization stocks within the S&P 500. The
smaller (but still large) stocks tend to
outperform the really large ones.
 The “Incredible” January Effect
• Stock returns appear to be higher in January
than in other months of the year.
• This may be related to the size effect since it is
mostly small firms that outperform in January.
• It may also be related to end of year tax
selling.
 The P/E Effect
• It has been found that portfolios of “low P/E”
stocks generally outperform portfolios of
“high P/E” stocks.
• This may be related to the size effect since
there is a high correlation between the stock
price and the P/E.
• It may be that buying low P/E stocks is
essentially the same as buying small company
stocks.
 The Day of the Week Effect

• Based on daily stock prices from 1963 to 1985 Keim

found that returns are higher on Fridays and lower on
Mondays than should be expected.
• This is partly due to the fact that Monday returns actually
reflect the entire Friday close to Monday close time
period (weekend plus Monday), rather than just one day.
• Moreover, after the stock market crash in 1987, this
effect disappeared completely and Monday became the
best performing day of the week between 1989 and
1998.
 Summary of Tests of the EMH
• Weak form is supported, so technical analysis cannot
consistently outperform the market.
• Semi-strong form is mostly supported , so fundamental
analysis cannot consistently outperform the market.
• Strong form is generally not supported. If you have secret
(“insider”) information, you CAN use it to earn excess returns
on a consistent basis.
• Ultimately, most believe that the market is very efficient,
though not perfectly efficient. It is unlikely that any system of
analysis could consistently and significantly beat the market
(adjusted for costs and risk) over the long run.