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Chapter 9 Efficient Market Hypothesis.ppt
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Chapter 9
EFFICIENT MARKET HYPOTHESIS
The Collective Wisdom
Outline• Random Walk
• What is an Efficient Market
• Empirical Evidence on Weak-form Efficient Market Hypothesis
• Empirical Evidence on Semi-strong Form Efficient Market Hypothesis
• Empirical Evidence on Strong-form Efficient Market Hypothesis
• What is the Verdict
• Implications for Investment Analysis
Random Walk
• Maurice Kendall found that stock prices followed a random
walk, implying that successive price changes are
independent of one another.
• A number of researchers have employed ingenious methods to
test the randomness of stock price behaviour.
• Academic researchers concluded that the randomness of stock
prices was the result of an efficient market.
What Is An Efficient Market
• An efficient market is one in which the market price of a security is an unbiased estimate of its intrinsic value
• Market efficiency is defined in relation to information that is reflected in security prices. Fama distinguishes three
levels of market efficiency.
• Weak-form efficiency
• Semi-strong form efficiency
• Strong-form efficiency
Stock Market Efficiency
Strong
Semi-strong
Weak
Misconceptions
1. Emh.. Implies… market has perfect forecasting.2. As prices tend to fluctuate they cannot reflect fair value.3. Inability of institutional portfolio managers to achieve superior investment performance implies that they lack competence.4. The random movement of stock prices suggests that the stock market is irrational.
Foundations of Market Efficiency
Any one of the following three conditions leads to market efficiency
• Investor Rationality
• Independent Deviations from Rationality
• Effective Arbitrage
Profound Impact of a Simple Idea
•Receptive climate for three seminal developments in financial
theory: (a) MM theories, (b) CAPM, (c) OPM
•Important practical developments like indexing, asset
securitisations, and performance measurement
•Growing respect for free markets
Empirical Evidence On Weak-Form Efficient
Market Hypothesis
• Serial correlation test
• Runs test
• Filter rules test
Returns over Short Horizons
Empirical studies done in 1950s, 1960s, and 1970s using daily or monthly returns of individual securities overwhelmingly confirmed the unpredictability of stock returns. So much so that Michael Jensen asserted in 1978 that “The efficient market hypothesis is the best – established fact in all of social science.” Recent research, however, has cast a shadow over the random walk hypothesis. For example, Andrew Lo and Gaig Mackinlay found that : (a) Weekly portfolio returns are strongly positively correlated but the returns to individual securities generally are not .(b) While the daily and weekly returns are strongly positively correlated, the serial dependence for monthly, quarterly, or yearly returns is virtually zero.
Returns over Long Horizons
While returns over short horizons are characterised by minor positive serial correlation, returns over long horizons seem to be characterised by pronounced negative serial correlation. To explain the latter result, a “fads hypothesis” has been proposed, which says that stock prices tend to overreact to news. Such overreaction results in positive correlation over short horizons and negative correlation over long horizons. Put differently, prices overshoot in the short run but correct in the long run. Thus, market prices display excessive volatility in comparison with intrinsic value. Robert J. Shiller and others argue that the presence of mean reversion and excessive volatility in prices imply market inefficiency. Fama and others dispute it. They contend that changing market risk premiums over time, and not market inefficiency, result in mean reversion and excessive volatility.
Empirical Evidence on Semistrong - Form efficient Market Hypothesis
To test this form of market efficiency, specific investment
strategies are examined to see whether they earn excess return. Since excess return represents the difference between the actual return and the expected return, implicit in a test of market efficiency is some model of the expected return. The expected return may be based on the capital asset pricing model or the arbitrage pricing model or some other model. Hence, a test of market efficiency is really a joint test of market efficiency and the model for expected return. If there is evidence of excess return, it may mean that the market is inefficient or that the model used to calculate the expected return is wrong or both. This seems to be an insoluble problem. However, if the results of a study do not vary with different models of expected return, one can argue that the results can be attributed to market inefficiency and not model misspecification.
Empirical Evidence On Semi-Strong Efficient
Market Hypothesis
• Possible to earn superior risk-adjusted return by trading
on information events? (Event study)
• Possible to earn superior risk-adjusted return …by trading
on an observable characteristic of a firm? (Portfolio study)
Event Study1. Identify the announcement date of the event
Announcement date
2. Collect returns data around the announcement date Rj -n Rj,O Rj, +n
-n TO +n
3. Calculate the excess returnERj t = Rj t - BETAj x Rmt
4. Compute the average and the standard error of excess returns across all firms
5. Assess whether the excess returns around the announcement date are different from zero
Average excess return T Statistic for excess return on day t = Standard error
Results of Event Studies
• Stock Splits
• Announcement of Accounting Changes
• Corporate Events
• Unexpected World Events and Economic News
Results of Portfolio Studies
• Price-Earnings Ratios
• PEG Ratios
• Size Effect
• BV/MV Ratios
Gradual Adjustments To Earnings Announcements
Portfolio Study1. Define the variable (characteristic) on which firms will be
classified
2. Classify firms into portfolios based upon the magnitude of the variable
3. Compute the returns for each portfolio
4. Calculate the excess returns for each portfolioE Rji = Rji - BETAj x RMt
5. Assess whether the average excess returns are different across the portfolios
Returns By P - E Multiple Class
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00% LOWEST 2 3 4 5 6 7 8 9
HIGHEST
Time Series Analysis
The time series analysis starts with the assumption that in an
efficient market long-term historical rates of return represent the
best estimate of future rates of return. The studies of this genre
determine whether any public information will provide superior
estimates of returns over different time horizons, short-term or long
term.
Results of Time Series Analysis
•A Positive relationship exists between dividend yield and future long-run stock market returns.
•Stock prices adjust gradually, not rapidly, to announcements of unanticipated changes in quarterly earnings.
•Stock returns tend to be negative over, the period from Friday’s close to Monday’s opening.
•Stock prices seem to rise more in January than in any other month of the year.
•The volatility of stock prices is too large to be justified by the volatility of dividends.
•Market interest rates move in a normal range.
Empirical Evidence On Strong-Form
Efficient Market Hypothesis
Empirical evidence broadly suggests the following:
• Corporate insiders earn superior returns, after adjustment for risk.
• Mutual fund managers, on average, do not earn superior returns after adjustment for risk.
Other Evidence
• Price overreactions
• Calendar anomalies
• Excess volatility
• Normal range of interest
The Crash Of 1987October 19, 1987 DJIA 23%
P ≃ IV Appears less appealing
Difficulty . . valuing equities …
3100 =
0.16 - 0.13
375 =
0.16 - 0.12
Difficulty in valuing equity stocks … two implications :
1. Investors typically price an equity stock in relative terms
2. Almost impossible . . test the hypothesis … p ≃ iv
Absolute efficiencyvs
relative efficiency
Empirical Evidence on Strong-Form efficient Market Hypothesis
The strong-form efficient market hypothesis holds that all available
information, public as well as private, is reflected in the stock prices.
To test this hypothesis, researchers have analysed the returns earned
by certain groups who have access to information which is not
publicly available or ostensibly possess greater resources and
expertise to intensively analyse information which is in the public
domain. More specifically, researchers have tested this form of EMH
by analysing the performance of corporate insiders, stock exchange
specialists, security analysts, and professional money managers.
Empirical Evidence on Strong-Form efficient Market Hypothesis
• Corporate insiders consistently enjoy superiors risk-adjusted returns.
• Stock exchange specialists (or market makers)seem to earn superior risk-adjusted returns.
• While there are some superior security analysts, the majority of them seem to make recommendations that are not helpful
• Professional money managers do not, on average, earn a superior risk-adjusted return.
Semi-efficient Market Hypothesis
The EMH has a cousin, the semi-efficient market hypothesis
(SEMH). SEMH holds that some stocks are priced more efficiently
than others extending this idea, one may argue that the market
perhaps has several tiers. Put differently, there is a pecking order of
efficiency.
Micro Efficiency and Macro Inefficiency
Paul Samuelson has argued that modern markets show considerable micro
efficiency because the minority that spots deviations from micro efficiency
can make money by exploiting those deviations and, in doing so, they
eliminate persisting inefficiencies. In contrast, Paul Samuelson
hypothesised that markets display considerable macro inefficiency in the
sense that aggregate indexes of security prices remain below or above
various definitions of fundamental values for long periods of time. There
seems to be substantial evidence in support of Samuelson’s dictum where
inefficiency is defined as predictability of future (excess) returns.
Verdict
• True, the efficient market hypothesis, like all theories, is an imperfect and limited description of the stock market. However, here does not, at least for the present, seem
to be a better alternative.
• Merton miller : “it is closer to being a ‘paradigm’ than a mere hypothesis, bringing a common and coherent explanatory framework to a wide variety of seemingly unrelated phenomena. Like all scientific paradigms, it will survive until displaced by a better one. At the moment, at least no better paradigm is in sight”
Data Mining
The advocates of efficient market hypothesis argue that it is not surprising
that several anomalies and puzzles have been discovered. When data is
mined extensively, one is bound to find a number of patterns. As Bradford
Cornell put it: “Even a set of random numbers generated by a computer
will appear to have some pattern after the fact. Those patterns, however,
are spurious and will not be replicated in another generation of random
numbers. Many scholars feel that the same is true of stock prices.” William
Sharpe puts it more vividly: “If you torture the data long enough it will
confess to any crime.” As an extreme example of data mining, Leinweber,
who sifted through United Nations CD-Rom, found that historically the
best predictor of the S&P 500 was butter production in Bangladesh!
Difficulty in Exploiting
Even if inefficiencies exist, it is difficult to take advantage of them.
As Richard Roll says: “Over the past decade, I have attempted to
exploit many of the seemingly most promising ‘inefficiencies’ by
actually trading significant amounts of money according to a trading
rule suggested by the ‘inefficiencies’ … I have never yet found one
that worked in practice, in the sense that it returned more after cost
than a buy-and-hold strategy.”
Impossibility of Informationally Efficient Markets
In a classic paper published in 1980, Grossman and Stieglitz pointed
toward the “impossibility of informationally efficient markets.”
Their argument is fairly straightforward and goes as follows: If
market prices reflect all information about stocks, no one would do
equity research (as it involves cost) and everyone will simply accept
market prices as the best estimates of intrinsic values. And if no one
does equity research to obtain and analyse information about
companies, how can market prices reflect all information about
stocks?
Bottom Line on Market Efficiency
What is the bottom line on market efficiency? Jay Ritter suggests that it is useful to classify events into two categories, high – frequency events and low-frequency events. High-frequency events occur often and the market is efficient with respect to them. That is why it is hard to identify a trading strategy which is reliably profitable and mutual funds have difficulty outperforming their benchmarks. Low frequency events occur infrequently and the market seems to be inefficient with respect to them. Here are some examples of massive mispricing: • The stock price and land price bubble of Japan in the 1980s
• The stock market crash of October 1987.
• The TMT (technology, media, and telecom) bubble of 1999-2000.
Implications For Investments• Substantial evidence in favour of randomness suggests that technical analysis is of dubious value.
• Routine and conventional fundamental analysis is not of much help in identifying profitable courses of action
• The key levers for earning superior rates of returns are:
• Early action on any new development.
• Sensitivity to market imperfections and anomalies.
• Use of original, unconventional, and innovative modes of analysis.
• Access to inside information and its sensible interpretation
• An independent judgment that is not affected by market psychology.
Summing Up
• Stock prices appear to follow a random walk. The
randomness of stock prices is the result of an efficient market
• It is useful to distinguish three levels of market efficiency :
weak form efficiency, semi-strong form efficiency, and
strong form efficiency.
• The weak form efficient market hypothesis says that the
current price of a stock reflects all information found in
the record of past prices and volumes.
• The semi-strong form efficient market hypothesis holds
that stock prices adjust rapidly to all available public
information.
• The strong form efficient market hypothesis holds that all available information, public and private is reflected in
stock prices.
• Empirical evidence seems to provide strong support for weak- form efficiency, mixed support for semi-strong form efficiency, and weak support for strong-form efficiency.
• The efficient market hypothesis is an imperfect and limited description of the stock market. however, at least for the present, there does not seem to be a better alternative.
• The key implications of the efficient market hypothesis are that technical analysis is of dubious value and routine fundamental analysis is not of much help.