Investments: Analysis and Management, Second Canadian Edtiion

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Chapter 10
Market Efficiency
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Learning Objectives

• Explain the concept of efficient markets.
• Describe the three forms of market efficiency
  weak, semi-strong, and strong
• Discuss the evidence regarding the Efficient
  Market Hypothesis.
• State the implications of market efficiency for
  investors.
• Outline major exceptions to the Efficient Market
  Hypothesis.

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Efficient Markets

• How well markets respond to new information is a
  very important part of obtaining the equilibrium
  relationship predicted by the capital market
  theory
• Should it be possible to decide between a
  profitable and unprofitable investment given
  current information?
• Efficient Markets
• The prices of all securities quickly and fully
  reflect all available information

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Efficient Markets

• Definition of all available information
• All known information including
• Past information (e.g., last years earnings)
• Current information as well as events that have
  been announced but are still forthcoming (e.g.,
  stock splits and dividends)
• Information that can be reasonably inferred
• For example, if many investors believe that
  interest rates will decline soon, prices will
  reflect this belief before the actual decline
  occurs

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Conditions for an Efficient Market

• Why the markets can be expected to be efficient?
• Large number of rational, profit-maximizing
  investors
• Actively participate in the market
• Individuals cannot affect market prices (i.e.,
  price-takers)
• Information is costless and widely available to
  market participants at approximately the same
  time
• Information is generated in a random fashion
  (e.g., announcements or currency is devalued)
• Investors react quickly and fully to new
  information causing stock prices to adjust
  accordingly

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Consequences of Efficient Market

• Quick price adjustment in response to the arrival
  of random information makes the reward for
  analysis low
• Prices reflect all available information
• Price changes are independent of one another and
  move in a random fashion
• New information is independent of past

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Market Efficiency Forms

• Efficient market hypothesis (EMH)
• The proposition that securities markets are
  efficient, with prices of securities reflecting
  their true economic value
• Three levels of Market Efficiency
• Weak form prices reflect past market data
  (i.e., historical price and volume information
  for stocks and indexes)
• Semi-strong form prices reflect all public
  information
• Strong form prices reflect all information,
  both public and private

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Cumulative Levels of Market Efficiency and the
Information Associated with Each
Strong Form All Information
Semi-Strong Form Public Information
Weak Form Market Data
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Weak Form

• Prices reflect all past price and volume data
• Technical analysis, which relies on the past
  history of prices, is of little or no value in
  assessing future changes in price
• Market adjusts or incorporates this information
  quickly and fully

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Semi-Strong Form

• Prices reflect all publicly available information
• For example earnings, dividends, stock split
  announcements, new product developments,
  financing difficulties, and accounting changes
• Investors cannot act on new public information
  after its announcement and expect to earn
  above-average, risk-adjusted returns
• Encompasses weak form as a subset since market
  data are part of the larger set of all publicly
  available information

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Strong Form

• Prices reflect all information, public and
  private
• No group of investors should be able to earn
  abnormal rates of return by using publicly and
  privately available information
• Encompasses weak and semi-strong forms as subsets
  and represents the highest level of market
  efficiency

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Evidence on Market Efficiency

• Keys to testing the validity of any of the three
  forms of market efficiency
• Consistency of returns in excess of risk
• Length of time over which returns are earned
• Short-lived inefficiencies appearing on a random
  basis do not constitute evidence of market
  inefficiencies, at least in an economic sense
• Economically efficient markets
• Assets are priced so that investors cannot
  exploit any discrepancies and earn unusual
  returns
• Transaction costs matter

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Weak-Form Evidence

• Ways to test for weak-form efficiency
• Test for independence (randomness) of stock price
  changes Random Walk Hypothesis
• If stock prices are independent, trends in price
  changes do not exist
• Knowing and using the past sequence of price
  information is of no value to an investor
• Test for profitability of trading rules after
  brokerage costs
• Simple buy-and-hold better
• Buying a portfolio of stocks and holding it
  until a common liquidation date

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Weak-Form EMH

• Stock price changes in an efficient market should
  be independent
• Statistical tests of price changes are mostly
  supportive of weak-form EMH
• The sign test involves classifying each price
  change by its sign, which means whether it was ,
  0, or
• Then the runs in the series of signs can be
  counted and compared to known information about a
  random series
• Runs tests
• looking for patterns in signs of returns
• i.e. - -

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Weak-Form EMH

• The signs test supports independence of stock
  price changes
• Although some runs do occur, they fall within the
  limits of randomness since a truly random series
  will exhibit some runs
• Technical trading rules
• Technical analysts believe that trends not only
  exist but can also be used successfully
• Little evidence exists that technical trading,
  based solely on past price and volume data, can
  outperform a simple buy-and-hold strategy

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Two Apparent Contradictions to the Weak-Form EMH

• Momentum or persistence in stock returns
• tendency of stocks that have done well over the
  past 6 to 12 months to continue to do well over
  the next 6 to 12 months
• Contrarian Strategies
• Overreaction Hypothesis DeBondt Thaler (1985)
• stocks that have done well over the past 3-5 year
  period, will do poorly over the subsequent 3-5
  year period

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Two Apparent Contradictions to the Weak-Form EMH

• Contrarian strategies are trading strategies
  designed to exploit the overreaction hypothesis
• Since the underlying rationale is to purchase or
  sell stock in anticipation of achieving future
  results that are contrary to their past
  performance record
• DeBondt and Thaler are testing whether the
  overreaction hypothesis is predictive
• In other words, knowing past stock returns
  appears to help significantly in predicting
  future stock returns

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Semi-Strong-Form Evidence

• Event studies
• Empirical analysis of stock price behaviour
  surrounding a particular event
• Usually use an index model of stock returns such
  as single-index model
• Examine company unique returns
• The residual error between the securitys actual
  return (Rit ) and that given by the index model
  E(Rit)
• Abnormal return (Arit) Rit - E(Rit)
• n
• Cumulative abnormal return (CAR) S Arit
• t1
• CAR is the sum of the individual abnormal returns
  over the period of time under examination

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Semi-Strong-Form Evidence

• Stock splits
• (Fig 10.4 pg 281) Implications of split
  reflected in price immediately following the
  announcement and not the event itself
• Accounting changes
• Quick reaction to real change in economic value
  (e.g., depreciation, inventory reporting LIFO
  vs. FIFO)

• Initial public offerings
• Only issues purchased at offer price yield
  abnormal returns
• This is attributed to underpricing by the
  underwriters
• Announcements and news
• Little impact on price after release
• Involving economic news (e.g., inflation or Bank
  of Canada rate)

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Professional Portfolio Manager Performance

• There is substantial evidence that portfolio
  managers do not outperform the market (or earn
  abnormal risk-adjusted returns) over the long run
• The average active portfolio manager may
  underperform the market index by 50 to 200 basis
  points
• Based on fund averages (US-based equity mutual
  funds pension funds)

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Strong-Form Evidence

• Test performance of groups which have access to
  nonpublic (private) information
• Corporate insiders have valuable private
  information
• A corporate insider is an officer, director, or
  major stockholder of a corporation who might be
  expected to have valuable inside information
• Evidence that many have consistently earned
  abnormal returns on their stock transactions
  (strong-form efficiency is not supported)
• Insider transactions must be publicly reported
  (OSC requires reporting y the tenth day of the
  next month)

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Implications of Efficient Market Hypothesis

• What should investors do if markets are
  efficient?
• 1- Technical analysis
• Not valuable if weak-form holds
• The evidence accumulated to date overwhelmingly
  favors the weak-form EMH and casts doubt on
  technical analysis

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Implications of Efficient Market Hypothesis

• 2- Fundamental analysis
• Seeks to estimate the intrinsic value of a
  security
• Not valuable if semi-strong-form holds (since
  stock prices reflect all relevant publicly
  available information, gaining access to
  information others already have is of no value)
• EMH suggests that investors who use the same data
  and make the same interpretations as other
  investors will experience average results

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Implications of Efficient Market Hypothesis

• 3- Money Management
• For professional money managers (assuming that
  the market is efficient)
• Less time spent on assessing individual
  securities
• Passive investing favored (one passive investment
  strategy that is becoming increasingly popular is
  indexing, which involves the construction of
  portfolios designed to mimic the performance of a
  chosen market benchmark portfolio, such as
  SP/TSX Composite Index)
• Otherwise, must believe in superior insight

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Implications of Efficient Market Hypothesis

• 3- Money Management
• Tasks that portfolio managers have to perform if
  markets are informationally efficient
• Maintain correct amount of diversification
• Achieve and maintain a desired level of portfolio
  risk
• Manage tax burden
• Control transaction costs (can be done through
  index funds)

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Market Anomalies

• Exceptions (techniques or strategies) that appear
  to be contrary to market efficiency
• Regardless of how persuasive the case for market
  efficiency is, debate of this issue id likely to
  persist

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Market Anomalies

• Size effect
• Tendency for small firms to have higher
  risk-adjusted returns than large firms
• Market betas could not account for the abnormal
  returns
• Bid-ask spreads, which are higher for smaller
  stocks, could not account for the abnormal
  returns
• As a result, when trading on the TSX, the
  small-firm strategy may be a viable strategy for
  increasing portfolio returns without an
  offsetting increase in risk

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Market Anomalies

• Seasonality in stock returns
• January effect
• Tendency for small firm stock returns to be
  higher in January
• Of the 30.5 small-size premium, half of the
  effect occurs in January
• Referred to as the small firm in January effect
  because it is most prevalent for the returns of
  small-cap stocks
• More than half of the excess January returns
  occurred during the first five trading days of
  that month

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Market Anomalies

• Seasonality in stock returns
• Day-of-the-week effect
• The average Monday return is negative and
  significantly different from the average return
  of the other four days
• Day-of-the-month effect
• Returns tend to be higher on the last trading day
  of each month

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Conclusions about Market Efficiency

• Support for market efficiency is persuasive
• Much research using different methods
• Also many anomalies that cannot be explained
  satisfactorily
• Markets are quite efficient, but not totally
• To outperform the market, superior fundamental
  analysis (beyond the norm) must be done
• The fundamental analysis that is done everyday is
  already reflected in stock prices

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Conclusions about Market Efficiency

• If markets are operationally efficient, some
  investors with the skill to detect a divergence
  between price and semi-strong value (price based
  on all available public information) earn profits
• Excludes the majority of investors
• Anomalies offer opportunities
• Controversy about the degree of market efficiency
  still remains
• The evidence to date suggests that investors face
  an operationally efficient market