3. Definition of Efficient Markets
An efficient capital market is a market that is efficient in
processing information.
We are talking about an “informationally efficient” market,
as opposed to a “transactionally efficient” market. In other
words, we mean that the market quickly and correctly
adjusts to new information.
In an informationally efficient market, the prices of
securities observed at any time are based on “correct”
evaluation of all information available at that time.
Therefore, in an efficient market, prices immediately and
fully reflect available information.
4. Definition of Efficient Markets
(cont.)
Professor Eugene Fama, who coined the phrase “efficient
markets”, defined market efficiency as follows:
"In an efficient market, competition among the many intelligent
participants leads to a situation where, at any point in time, actual
prices of individual securities already reflect the effects of
information based both on events that have already occurred and on
events which, as of now, the market expects to take place in the
future. In other words, in an efficient market at any point in time the
actual price of a security will be a good estimate of its intrinsic
value."
5. Efficient Market
Stock prices fully reflect available information
Developed by Professor Eugene Fama
Argues that stocks trade at their fair value
Impossible for investors to either purchase
undervalued stocks or sell stocks for inflated prices
Only way an investor can possibly obtain higher
returns is by purchasing riskier investments
6. Strong Form
Efficient Markets
Semi Strong Form
Efficient Markets
Weak Form
Efficient Markets
All information is
reflected on prices
All Public
information is
reflected on security
prices
All Historical
information is
reflected on security
prices
Variants of the Hypothesis
7. Weak Form of EMH
Historical Prices used
Current prices reflect all information found in the past
prices and trade volumes.
Future prices cannot be predicted by analyzing prices
from past
Technical analysis techniques do not provide excess
returns, fundamental analysis in some form may still
provide some returns
Share prices exhibit no serial dependencies (there are no
patterns to asset prices)
8. The Random Walk Theory
Maurice Kendall : stock prices followed a random
walk, each successive change is independent of the
previous one.
Academic researchers : the randomness of stock prices
was the result of an efficient market.
9. Semi Strong Form of EMH
Prices fully reflect all publicly available information
(economic news, political news, annual report) and
expectations about the future
Prices adjust rapidly to new information
Old information cannot be used to earn superior returns
Neither technical analysis nor fundamental analysis
provide excess returns
10. Strong Form of EMH
Prices fully reflect all information whether publicly
available or not.
Private information is available with companies but is
not disclosed.
No one can earn superior returns.
12. Empirical Tests for Weak Form of
Market efficiency
Filter Rule
Runs Test
Serial Correlation
13. 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%
14. Serial Correlations (cont.)
Unlagged vs One-month Lagged S&P 500
Returns
y = 0.008207x + 0.007451
R
2
= 0.000067
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
-30.00% -20.00% -10.00% 0.00% 10.00% 20.00%
One-month Lagged Returns
Unlagged
Returns
15. Tests of the Semi-strong Form
Fama, Fisher, Jensen & Roll
Event Studies
Stock splits
Earnings announcements
Analysts recommendations
Cross-Sectional Return Prediction
Firm size
BV/MV
P/E
16. Empirical Evidence of strong form
of Efficiency
Mutual Fund performances.
Difference in return of informed buyer and naïve buy-
and-hold approach is not much.
Not able to forecast returns properly even after getting
the information.
17. Types of market efficiency
Types of
Efficiency
Reflect What works What does not
work
Strategy to be
used
Weak Form Past Price and
Volume
Fundamental
Analysis &
Insider
Information
Technical
Analysis
Active portfolio
management
Strategy
Semi Strong
Form
Past Price,
Volume &
Publically held
information
Insider
Information
Fundamental
Analysis &
Technical
Analysis
Passive portfolio
management
Strategy
Strong Form Past Price,
Volume,
Publically and
privately held
information
Nothing Fundamental
Analysis,
Technical
Analysis & Insider
Information
Passive portfolio
management
Strategy
18. Market Inefficiencies
Market prices of common stocks are not always
accurately priced.
Opposes efficient market hypothesis.
Drives asset above or below their true value.
Example Dotcom bubble, recent market crashes.
19. 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 : Average closing price
of Monday is lower than average closing price of Friday).
PEG Ratio Effect
P/B ratio effect
Dividend yield Effect
20. 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.
Greater amount of growth and opportunities.
More volatility.
21. 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.
22. 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.
Historical data of PE ratios helps in generating
superior returns.
Contradicts semi strong form of efficient market
hypothesis.
23. 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.
24. Review
The Efficient Market Hypothesis
Types of Efficiency
Degrees of Informational Efficiency
The Semi-Efficient Market Hypothesis
Security Prices and Random Walks
Anomalies
The Low PE Effect
Low-Priced Stocks
The Small Firm and Neglected Firm Effects
Market Overreaction
The January Effect
The Weekend Effect
The Persistence of Technical Analysis
25. The persistence of technical analysis: If the
EMH is true, technical analysis should be useless.
Each year however, an immense amount of
literature based in varying degrees on the subject is
printed.