The Efficient Market Hypothesis

Dr. Himanshu Joshi

The Efficient Market Hypothesis

One of the earliest application of computers in economics was to analyze economic time series. Business theorist felt that tracing the evolution of several economic variables over time would clarify and predict the progress of the economy through boom and bust periods.
Three Types of data: Time Series Cross Sectional Panel Data

Assumption for stock prices..

A natural candidate for analysis was the behavior of stock market prices over time. Assuming that stock market prices reflect prospects of the firm, recurrent patterns of peaks and trough in economic performance ought to show up in these prices.

The Experiment and the Result..

Maurice Kendall examined this proposition in 1953. he found to his great surprise that he could identify no predictable patterns in stock prices. Prices seems to evolve randomly. They were likely to go up as they were to go down on any particular day, regardless of past performance. The data provided no way to predict price movements.

Interpretation..
Kendalls results were disturbing to some financial economists. They seemed to imply that stock market is dominated by erratic market psychology. It follows no logical rules. So result seems to confirmed irrationality of the market.

Random Walks and the Efficient Market Hypothesis

Suppose Kendall had discovered that stock prices are predictable. What a gold mine this would have been. If they could use the Kendalls equations to predict stock prices, investors would reap unending profits simply by purchasing stocks that the computer model implied were about to increase in price and by selling those stocks about to fall in price.

Model predicts???
Suppose model predict with great confidence that infosys share, currently at $100 would increase dramatically in 3 days to $110.

Revised Interpretation of Random Walk.

Any information that could be used to predict stock performance should already be reflected in stock prices. As soon as there is any information indicating that stock is underpriced and therefore offer a profit opportunity, investors flock to buy the stock and immediately bid up its price to a fair level, where only ordinary rates of return can be expected. These ordinary rates are simply rate of return commensurate with the risk of the stock.

Random Walk and EMH..

This is the essence of the argument that stock prices should follow a random walk, that is that price should be random and unpredictable. Therefore, the notion that stocks already reflect all available information is referred to as the efficient market hypothesis. (EMH.)

Application.
On January 9, 2009, Sensex fell from 9586.88 points to 9406.47 points, a decline of 1.88%. However, on Jan 9, 2009, the price of Siemens fell from 298 to 260.7, a decline of 12.52%. On the same day there was new information released in the market about Siemens: Sale of Siemens Information Systems Limited. Beta of Siemens is 0.86. If we assume that on January 9, 2009 the stock market did not get any other value relevant information about Siemens (other than the sale of its 100% subsidiary), then the entire difference of 10.9% decline (12.52% 1.62%) can be attributed to this sale transaction.

Competition as the source of efficiency.

Stock prices fully and accurately reflect publicly available information. Once information becomes available, market participants analyze it. Competition assures prices reflect information.

Why are we Interested in Market Efficiency?

A. If market prices reflect at a given date only information of a particular type, then one can profit by trading based on information relevant for pricing but not yet reflected in the price.

Why are we Interested in Market Efficiency?

B. To assess the level of market efficiency need to know the securitys value; which requires to knowing how assets are priced.

Why are we Interested in Market Efficiency?

C. Joint Test Problem: in Empirical Test of the EMH: Market efficiency per se is not testable because the question whether price reflects a given piece of information always depends on the model of asset pricing that the researcher is using. It is always a joint test of market efficiency and the used pricing model.

Why are we Interested in Market Efficiency?

Despite the joint test problem, tests of market efficiency, i.e., scientific search for inefficiencies, improves our understanding of the behavior of returns across time and securities. It helps to improve existing asset pricing models and the view and practices of financial markets professionals.

Versions of the EMH

Weak Semi-strong Strong

Weak form Efficiency/Lack of Predictability

Price reflects all information contained in market trading data (past prices, volume, dividends, interest rates, etc.) So an investor can not use past prices to identify mispriced securities. So, Technical Analysis: Which refers to practice of using past trends in stock prices (and trades) to identify future patterns in prices. Is not profitable in a market which is at least weak form efficient.

Semi Strong Form/ Events reflected Immediately:

Prices reflects all publicly available information. So an investor can not use publicly available information to identify mispriced securities. So, Fundamental Analysis: a. Which refers to the practice of using financial statements, announcements, and other publicly available information to identify mispriced securities. b. Is not profitable in a market which is at least Semi Strong form efficient. If a market is semi-strong efficient, then it is also weak form efficient.

Example of Semi Strong Efficiency

Market Reaction to Public Announcement stock XYZ Mining closed yesterday at 100. Morning paper reports: XYZ Mining has larger than expected reserves (extra value $10 per share). Suppose this estimation is unanimously and immediately deemed valid and accurate. Stock jumps to 110 immediately (at the open). More likely bid = 109.9 and ask = 110.1. News repot XYZ climbed to 110 today on announcement of a new gold mine.

Example of Semi Strong Efficiency

a. b. Suppose XYZ Mining Stock only jump to 104. Report might be suspicious (XYZ known to exaggerate). But if deem the information reliable: A price of 104 for XYZ does not accurately reflect all the available information. We can make trading profits by buying at 104 and holding until: Market realizes were right, or XYZ pays out (in dividends or distributions) the value of the reserves. Semi strong efficiency is violated in the sense that 104 does not fully reflect the new information. And we can make trading profits.

Strong- Form/All Private Information is Reflected

Price reflects all available information. If a market is strong form efficient, then it is also semistrong efficient. 1. What is private information? - The information you hold that is not reflected in the market price: a. Inside information: info known to company management but not yet made public. (knowledge of an impeding takeover bid or earnings are going to be lower than market expectations) b. A private assessment based on public information. (An analysts report based on public accounting statements.

Types of Stock Analysis

Technical Analysis - using prices and volume information to predict future prices Weak form efficiency & technical analysis Fundamental Analysis - using economic and accounting information to predict stock prices Semi strong form efficiency & fundamental analysis

Active or Passive Management

Active Management Security analysis Timing Passive Management Buy and Hold Index Funds

Observations about the Perfectly Efficient Markets

Investors should expect to make a fair return on their investment but no more: Fundamental as well as Technical Analysis are not useful in discovering underpriced securities.

Observations..
Paradox: Markets will be efficient only if enough investors believe that they are not efficient. ?? Market will become inefficient if investors believed that they are efficient, yet they are efficient because investors believe them to be inefficient.

Observations
Publicly known strategies cannot be expected to generate abnormal returns. Investors who know the strategy will try to capitalize on it, and in doing so will force prices to the equivalent investment values the moment the strategy indicates a security is mispriced.

Observations
Some investors will display impressive performance record. Is it Efficient Market or Inefficient?? Why?

Observations
Some investors will display impressive performance record. But there performance is merely due to chance. Think of a simple model in which half of the time the stock market has an annual return greater than T-bill (up market) and other half of the time its return is less than T. Bills (down market). With many investors attempting to forecast whether the market will be up or down each year and acting accordingly, in an efficient market about half the investors will be right in any given year and half will be wrong. The next year, half of those who were right in the first year will be right in second year too. Thus 1/4 = (1/2*1/2) will be right in both the years. About half of the surviving will be right in the third years also, total of 1/8 = (1/2*1/2*1/2) Thus it can be seen that ()T investors will be correct every year over a span of T years.

Observations
Professional Investors should fare no better in picking securities than ordinary investors. Price always reflect investment value, and hence the search for mispriced securities is futile. So professional investors do not have an edge on ordinary investors when it comes to identifying mispriced securities and generating abnormally high returns.

EXAMPLE

Money Magazine Oct. 03 Top Picks from 24 Top Pros Invest in the Best
Asked some first-rate investing minds to share their best ideas. We call this gathering of wise minds the Ultimate Investment Club. The 24 top pros identified 34 domestically traded stocks as their top picks. Each pick was backed by brilliant and compelling logic.

31

THE STORY MONEY MAGAZINE NEVER PUBLISHED BUT THE COLORADO SPRINGS BUSINESS JOURNAL DID

The Ultimate Investment Club destroyed 14% vs. the Market!

First Rate Investing Minds

US Stock Market

-2.4%

+11.5%

Twelve months ended August 31, 2004. Source: Calculated from Yahoo Finance - included dividend reinvestment. This included six stock picks listed on US exchanges but not included in the Wilshire 5000 Total Stock Index. The 28 US domiciled stocks had a -7.6% return which lagged the index by 19%. Dr. Himanshu Joshi

Observations
Past Performance is not an indicator of future performance. Historical performance records are useless in predicting future performance records. (of course, if the poor performance was due to incurring high operating expenses, then poor performers are likely to remain poor performers.)

Observations about Perfectly Efficient Markets with Transaction Costs

In a world where it costs money to analyze securities, analysts will be able to identify misprices securities. Gross Return of Active Funds > Gross Return of Passive Funds However, Net Return of Active Funds < /= Net Return of Passive Funds (due to Transaction Costs)

Observations.. With Transaction costs..

Magnitude Issue: Bodie and Kane noted that an investment manager overseeing a $5 billion portfolio who can improve performance by only 0.1% per year will increase investment earning by $5 billion*0.1% = $5 million. The manager clearly would worth her salary. Can we statistically measure her contribution? Given the annual SD of S&P 500 portfolio is 20%. All might agree that stock prices are very close to fair values and that only managers of very large portfolios can earn enough trading profits to make the exploitation of minor mis-pricing worth the effort. Are market efficient? Should now be how efficient are markets?

Observations
Investors will do just as well using a passive investment Strategy where they simply buy the securities in a particular index and hold onto that investment. So, if market is efficient and there are transaction costs associated with searching for mispriced securities, then passive funds management is the right strategy.

Market Efficiency & Portfolio Management

Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations

Utility Functions

The Client
Risk Tolerance/Aversion Investment Horizon Tax Status

Tax Code

The Portfolio Managers Job

Views on Markets

Asset Allocation

Asset Classes

Stocks
Domestic

Bonds

Real Estates
International

Countries
Valuations based on: Cash Flows Comparables Technicals

Views on Inflation Rates and Growth

Risk and Return

Security Selection Which Stock? Which Bond? Which Real Estate?

Private Information

Market Efficiency

Trading Codes Commissions Bid/Ask Spreads Price Impacts

Execution How Often Do you Trade? How large are your Trades? Do you use derivatives to manage or enhance risk

Trading Speed

Trading Systems

Market Timings

Performance Evaluation How much Risk the Portfolio Manager take? What Return did the portfolio managers make? Did it underperform or over perform?

Stock Selection

Risk Models: CAPM APT, Multi factor

Testing for Market Efficiency

How to test that if the markets are perfectly efficient, reasonably efficient, or not efficient at all. There are multitude of methodologies, but three stands out. Event Studies Looking for patterns in the security prices. Examining the performance of professional money managers.

Event Studies
Event studies can be carried out to see just how fast security prices actually react to the release of information. Do they react rapidly or slowly? Are the returns after the announcement are abnormally high or abnormally low or just normal.

Event Studies
Empirical financial research that enables an observer to assess the impact of a particular event on a firms stock price Abnormal return due to the event is estimated as the difference between the stocks actual return and a proxy for the stocks return in the absence of the event

How Tests Are Structured

Returns are adjusted to determine if they are abnormal Market Model approach
a. rt = at + brmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = rt - (a + brMt)

Looking for Patterns

Securities can be expected to give a rate of return over given time period in accordance with the asset pricing model. (CAPM or APT or Multifactor Model). If Risk Free Return Rf and Risk Premium(Rm-Rf) are unchanging over time, thus securities having higher returns in past can be expected to earn higher return in future as well. However, risk premium, may be changing over time, making it difficult to see if there are patterns in the security prices, and making prices quite random. Market Anomalies: January effect

Examining Performance of Money Managers

Are more of them are able to earn abnormally high rates of return than one would expect in a perfectly efficient market?

Note
All the test for Efficiency are joint test. Whether market is efficient? Whether used to describe the expected or normal return is appropriate?

Are Markets Efficient?

Magnitude Issue Selection Bias Issue Lucky Event Issue

Are Markets Efficient?

Magnitude Issue: Bodie and Kane noted that an investment manager overseeing a $5 billion portfolio who can improve performance by only 0.1% per year will increase investment earning by $5 billion*0.1% = $5 million. The manager clearly would worth her salary. Can we statistically measure her contribution? Given the annual SD of S&P 500 portfolio is 20%. All might agree that stock prices are very close to fair values and that only managers of very large portfolios can earn enough trading profits to make the exploitation of minor mis-pricing worth the effort. Are market efficient? Should now be how efficient are markets?

Are Market efficient?

The Selection Bias: Suppose that you discover an investment scheme that could really make money. You have two choice: Either publish your technique in wall street journal to win fleeting fame, or Keep your technique secret and use it to earn millions of dollars.

Selection bias..
Only investors who find that an investment scheme can not generate abnormal return will be willing to report their finding to the whole world. This is called selection bias: the outcome we are able to observe are preselected in favor of failed attempts.

Are market efficient?

The Lucky Even Issue: in virtually any month it seems we read an article about some investor or investment company with fantastic investment performance over the recent past. Surely the superior records of such investors disprove the efficient market hypothesis.

The Lucky Even Issue..

Consider a contest to flip the most number of heads out of 50 trials using a fair coin. The expected outcome for any person, is of course, 50% heads and 50% tails. If 10,000 people, however compete in this contest, it would not be surprising if atleast one or two contestant flipped more than 75% heads. In fact statistically there will be 2 contestants flipping more than 75% heads. It would be silly to crown these people the the head flipping champions of the world.

The Lucky Even Issue

The analogy to efficient market is clear. Under the hypothesis that any stock is fairly priced given all available information, any bet on a stock is a simply a coin toss. The winners, though, turn up in Wall Street Journal as the latest STOCK MARKET GURUS. Then they can make fortune publishing market newsletters and providing market buy, sell or hold advice.

Weak-Form Tests: Pattern in Stock Return

Returns over the Short Horizons: could speculators find trends in past prices that would enable them to earn abnormal profits? Momentum & Serial Correlation Serial correlation refers to the tendency for stock returns to be related to past returns. Positive serial correlation means that positive returns tend to follow positive returns (Momentum property) Negative serial correlation means that negative returns tend to be followed by positive returns. (A reversal or correction property).

Returns over short Horizons Empirical Evidences

Conrad and Kaul and Lo and MacKinlay examine weekly returns of NYSE stocks and find positive serial correlation over short horizons. However correlation coefficient of weekly returns tends to be fairly small, at least for large stocks for which price data are the most reliably up-to-date. There appears to be stronger momentum in performance across market sectors exhibiting best and worst recent returns. In an investigation of intermediate horizon stock price behaviour (3-12 months) Jagdeesh and Titman found a momentum effect in which good or bad recent performance of particular stock continues over time.

Returns over Long Horizons

Long term horizon returns (i.e., return over multiyear periods) have found suggestions of pronounced negative long term serial correlation in the performance of aggregate market. fad hypothesis: it asserts that stock market may over react to relevant news. Such overreaction leads to positive serial correlation (momentum) over short time horizons. Subsequent correction of the overreaction leads to poor performance following good performance and vice versa.

Cumulative Abnormal Returns in Response to Earnings Announcements

A fundamental principle of efficient market is that any new information ought to be reflected in stock price very rapidly. When good news is made public, the stock price should jump immediately. A puzzling anomaly, is therefore, sluggish response of stock prices to firms earning announcements, as discovered by Ball and Brown.

Cumulative Abnormal Returns in Response to Earnings Announcements

Randleman, Jones and Latane provide influential study of sluggish price response to earning surprises for a large sample of firms, rank the magnitude of the surprise, divide firms into 10 deciles based on size of surprise, and calculate abnormal returns for each decile.

Figure 11.5 Cumulative Abnormal Returns in Response to Earnings Announcements

Results
There is a large abnormal return (a jump in cumulative abnormal return) on the earning announcement day (day 0). The abnormal return is positive for positivesurprise firm and negative for negative-surprise firms. The more remarkable result of the study is that even after the announcement date stock price of positive-surprise firms continue to rise. In other words, exhibits momentum-even after the earning information become public.

Predictors of Broad Market Returns

Fama and French Aggregate returns are higher with higher dividend ratios Campbell and Shiller Earnings yield can predict market returns Keim and Stambaugh Bond spreads can predict market returns

Semistrong Tests: Anomalies

P/E Effect (Sanjoy Basu) Small Firm Effect (Banz) Neglected Firm Effect and Liquidity Effects (Arbel and Strebel) Book-to-Market Ratios Post-Earnings Announcement Price Drift

The Neglected Firm Effect and Liquidity Effect

Arbel and Strebel gave another interpretation of smallfirm-in-January effect. Because small firms tend to be neglected by large institutional investors, information about smaller firms is less available. This information deficiency makes smaller firms riskier investments that command higher returns. Brand name firms are after all subject to considerable monitoring from institutional investors, which promises high quality information, and investors presumably do not purchase generic stocks without prospects of greater returns.

Figure 11.3 Average Annual Return for 10 SizeBased Portfolios, 1926 2006

Average Return as a Function of BookTo-Market Ratio (FAMA and FRENCH Model)

Fama and French showed that a powerful predictor of returns across securities is the ratio of the book value of the firms equity to the market value of equity.

Figure 11.4 Average Return as a Function of BookTo-Market Ratio, 19262006

Result..
The deciles with highest book-to-market ratio had an annual return of 16.84%, while the lowest decile averaged only 11.12%. The dramatic dependence of return on book to market ratio of the firm is independent of beta, suggesting either that: High book-to-market ratio firms are relatively underpriced (inefficient market) Or that the book-to-market ratio is serving as a proxy for a risk factor that affects equilibrium expected return.

Strong-Form Tests: Inside Information

The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon SEC requires all insiders to register their trading activity

Interpreting the Evidence

Risk Premiums or market inefficiencies disagreement here Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets

Interpreting the Evidence Continued

Anomalies or Data Mining The noisy market hypothesis and Fundamental indexing

Stock Market Analysts

Do Analysts Add Value Mixed evidence Ambiguity in results