SECURITY ANALYSIS &

PORTFOLIO MANAGEMENT

TOPIC- Empirical tests of EMH & Negative evidence

of EMH
GROUP-C

GROUP MEMBER

PURVI SHAH
KALYANI SHAH
JALPA BHUVIR
MAMTA JADEJA
 WHAT IS EMH?
 An investment theory that states it is impossible To
"beat the market" because stock market efficiency causes
existing share prices to always incorporate and reflect all
relevant information.

 According to the EMH, stocks always trade at their

fair value on stock exchanges, making it impossible for
investors to either purchase undervalued stocks or sell
stocks for inflated prices. As such, it should
be impossible to outperform the overall market through
expert stock selection or market timing, and that the only
way an investor can possibly obtain higher returns is by
purchasing riskier investments
 Empirical Tests of EMH

There are some methods which are useful in

empirical tests of EMH. EMH via testing of
correlations, relative strengths, stock spilt,
earnings announcements, book value, time
series test etc.

Methods of testing
 1.Semi-strong method

The semi-strong form can be tested in two ways.

1. Trying to predict future price movements by
using currently available public information.
These tests can be based on time series analysis
of returns for individual stocks or cross-
sectional data for different stocks.

2. Seeing how quickly stock prices react to new

information, to establish if there is a profit
window. These tests are known as event
studies.
 2.Time series tests
1. Test based on ratio
Time series test have indicated that it is possible to predict
returns and make superior profits by looking at various
ratios such as price to book, dividend yields, yield spreads
of lower grade bonds over high grade bonds.

2. Tests based on earnings reports.

 Tests have looked at factors such as quarterly earnings

report, aiming to establish whether it is possible to predict

future stock price returns based on published earnings
reports.

 It has been found that it is possible to make abnormal

returns when there are positive abnormal surprises in
More recent tests have looked at the difference
between actual earnings and predicated earnings as a
percentage of the estimate, based on a regression line
predicting earnings using time series analysis.

These studies suggest that it is possible to make

abnormal returns through trading based on earnings
surprises. This evidence goes against the Efficient
market hypothesis.
 3.Calendar studies
 Other tests have looked at whether it is possible to
make superior profits by following rules such as
buying stocks in December and selling them in
January.

 This is to make advantage of tax-based trading in the

market around the year-end when investors sell stocks
in December and repurchase them in January.

 This is referred to as the January effect (or anomaly),

stating that stock prices fall in December and then rise
in January. It has been established that this is possible,
but any gain may be eliminated by transaction costs.
 The effect worked for stocks that had suffered
large declines in the previous year, but not for
those which had large gains, supporting the tax
motivation for this trading.

 A weekend effect that has been tested is that

returns on Mondays' are negative, whereas
returns on the other four working days are
positive.
 4.Cross-sectional tests

 Cross-sectional tests are based on the assumption that in an

effect market all stocks should earn a risk adjusted return
given their betas.

 Tests based on the size of the companies have indicated that

small firms earn consistently higher risk adjusted returns
than large firms.

 If the small firm actually has a higher beta than that

measured for capital asset pricing model purposes, then its
predicted position on the security market line will be lower
than it should be. Therefore, it will appear to be offering high
risk adjusted returns although this is not actually the case.
 5. Information Announcements

 Information announcements can trading in

share immediately following announcements
of new information. E.g.- announcement on
dividends or profit.
 6. Stock splits
 When stock splits are made. No new money raised by
the company and existing shareholders receive more
shares in proportion to the number of shares that they
hold.

 Researchers have shown that share price rise by

abnormal amount before the split. following the split,
they observed no evidence of abnormal stock price
performance. Investors would not be able to profit by
purchasing the stock on split date. This evidence is
consistent with the ‘efficient market hypothesis.’
 7. Manipulation of earnings
 market efficiency tests have shown that
investors are aware of the nature of the
accounting change, but doubts have been
raised about market efficiency if there is
wholesale creative accounting.

 The accounts that are published are an

important sources of information about a
company.