Market Efficiency

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• What do we mean when we say that capital
markets are efficient?
• Why should capital markets be efficient?
• What factors contribute to an efficient market?
• Given the overall efficient market hypothesis
(EMH), what are the three subhypotheses and
what are the implications of each of them?

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• How does one test the three efficient market
subhypotheses, and what are the results of the
tests?
• For each set of tests, which results support the
EMH and which indicate an anomaly related to the
hypothesis?
• What are the implications of the results for stock
strategies and portfolio managers?
• What is the evidence related to the EMH for
markets in foreign countries?
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 Efficient Capital Markets
• In an efficient capital market, security
prices adjust rapidly to the arrival of new
information, therefore the current prices
reflect all information about the security
• Whether markets are efficient has been
extensively researched and remains
controversial

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 Why does it matter
• If prices do fully reflect all current
information, it would not be worth an
investor’s time to use information to find
undervalued securities.
• If prices do NOT fully reflect information,
FIND AND USE THAT INFORMATION,
and perhaps you will be able to make a
killing in the market.
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Investing and Market Efficiency
• Would stock selection
amount to throwing
darts at a wall in an
efficient market?
• Hardly! Risk still
matters. We would
still want to research
the risk-return
properties of
securities.

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Why Should Capital Markets Be
Efficient
• What would be the ingredients of an
“informationally” efficient market?
– A large number of profit-maximizing participants
analyze and value securities
– New information regarding securities comes to the
market in a random fashion
– Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information
• Price adjustments are unbiased – correct on average.
• Under these conditions, a security’s price would be
appropriate for its level of risk.
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 Alternative Efficient Market
Hypotheses
The various forms of the efficient market
hypothesis differ in terms of the
information that security prices should
reflect.
• Weak-form EMH
• Semistrong-form EMH
• Strong-form EMH

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 Weak-Form EMH
• Current prices fully reflect all security-
market information, including the
historical sequence of prices, rates of
return, trading volume data, and other
market-generated information
• This implies that past rates of return and
other market data should have no
relationship with future rates of return
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Implications of the Weak-From
EMH
Examining recent
trends in price and
other market data in
order to predict future
price changes would
be a waste of time if
the market is weak-
form efficient.
A lot of people do
price charting and
other forms of
“technical analysis.”
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 Semistrong-Form EMH
• Current security prices reflect all public
information, including market and non-
market information
• This implies that decisions made on new
information after it is public should not
lead to above-average risk-adjusted profits
from those transactions

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 Implications of the Semistrong-
Form EMH
• If the market is efficient
in this sense,
information in The Wall
Street Journal, other
periodicals, and even
company annual reports
is already fully
reflected in prices, and
therefore not useful for
predicting future price
changes.
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 Strong-Form EMH
• Stock prices fully reflect all information from
public and private sources
• This would require perfect markets in which all
information is cost-free and available to everyone
at the same time (which is clearly not the case)
• Implication: Not even “insiders” would be able to
“beat the market” on a consistent basis

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 Tests and Results: Weak-Form
EMH
Two Approaches
• Tests of “statistical memory” in security
prices and returns
• Tests of trading rules

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 Tests and Results: Weak-Form
EMH
• Statistical tests of independence between
rates of return
– Autocorrelation tests
• Mostly support the weak-form EMH and indicate
that price changes are random
• Some studies using more securities and more
complicated tests cast some doubt
– Runs tests
• Indicate randomness in prices

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 Tests and Results: Weak-Form
EMH
• Comparison of trading rules to a buy-and-
hold policy
– Some filter rules seem yield above-average
profits with small filters, but only before
taking into account the substantial transactions
costs involved
– Trading rule results have been mixed, and
most have not been able to beat a buy-and-
hold policy

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 Tests and Results: Weak-Form
EMH
Problems with tests
• Cannot be definitive since trading rules can be
complex and there are too many to test them all
• Testing constraints
– Use only publicly available data
– Should include all transactions costs
– Should adjust the results for risk (an apparently
successful strategy may just be a very risky strategy)

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 Conclusions:
Weak-Form EMH
• Results generally support the weak-form
EMH, but results are not unanimous
– Some strategies too subjective to test
– Not all trading rules are disclosed
• If you had a trading strategy that worked, would
you reveal it?!

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 Tests and Results: Semistrong-
Form EMH
Three different groups of tests:
• Time series analysis using public information
• Event studies examine how fast stock prices
adjust to significant economic events
• Cross-sectional analysis of returns based on
public information
Tests involve the estimation of “abnormal returns,”
where expected abnormal returns are zero in an
efficient market.

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 Tests and Results:
Semistrong-Form EMH
• Tests often involve “market-adjusted returns,”
created by subtracting the market return from the
security’s return, thereby defining a security’s
“abnormal return:”
ARit = Rit - Rmt
where:
– ARit = abnormal return on security i during period t
– Rit = return on security i during period t
– Rmt = return on a market index during period t

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 Intuition behind market efficiency
• The efficient market hypothesis can be summed
up with an economist joke:
Two economists are walking down the street. One
says to the other, “That looks like a $100 bill over
there.” The other economist says, “Don’t bother
checking it out. If it were real, someone would have
picked it up already.”
• Competition will drive all information into the
price quickly and the stocks will sell for their
true values..

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 Intuition behind market efficiency
(cont.)
• Distinction between financial and real asset markets
– Financial assets are much more similar to each other than
are real assets; and hence it is much easier to compare the
former than the latter.
– The size and transparency of financial markets make it
more competitive than the real asset markets.
– Academic and media coverage on the financial market is
much more intense than that on the real asset markets.
– Innovations and information cannot be patented
– Arbitrage is easy and safe

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 Intuition behind market efficiency
(cont.)
• The markets are quick and the prices are right.
• Firms should assume that the securities they issue
sell for their true values.
– True value does not mean ultimate future value.
– Intrinsic value could reflect a range of future prices.
• Remember the curse of competitive markets: it’s
hard to find exceptionally profitable projects

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 Efficiency Market Theory

Fama’s definition of an “efficient market”

“a market in which prices

always fully reflects
available information.”

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 Random Walk Theory
• Random walk: security prices change
randomly, with no predictable trends or
patterns.
• Random walk theory:
– One element of the efficient market theory
– Security prices change randomly, with no
predictable trends or patterns.

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 Technical Analysts
• Technical analysts attempt to identify over- or
undervalued stocks by searching for patterns in past
prices.
• Some technical analysts are very successful investors,
but we credit this to luck and good judgment, not to
technical trading rules, because technical trading rules
are useless when stock prices follow a random walk.
• Technical analysts help keep the market efficient.
Their trading extinguishes any predictable patterns in
stock prices.

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Beat the Market vs. Ride the Market

“My money was in mutual funds. Several of them.

They worked like this: when the market went
down, my funds went down a lot; when the
market went up, my funds went up a little … I
thought I could do better.”
 
-------- Confessions of a day trader
to the Time magazine

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What does it mean to beat the market?
• Outperforming a passive benchmark (such as a
broad stock market index)

• After accounting for risk.

• Active management: The practice of picking

individual stocks based on fundamental research
and analysis in the expectation that a portfolio of
selected stocks can consistently outperform market
averages.
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