How to test for market efficiency.

FIN 352 – Professor Dow

How to test?

Fama: Test the efficient market hypothesis using different information sets.

Three categories: Weak Semi-Strong Strong

Some tests directly use this categorization, others do not.

Weak form efficiency

All past-price information is fully reflected in stock prices.

Can’t use past prices to forecast future prices.

If true, technical analysis is not useful.

Semi-Strong Efficiency

All public information is fully reflected in stock prices.

If true, fundamental analysis is not useful.

Strong Form Efficiency

All information is reflected in stock prices.

Implies that trading on insider information shouldn’t be profitable.

Not true But not legal

Examples of tests

A) Patterns in stock prices. B) Back-testing trading rules. C) Do categories of stocks earn

abnormal returns? D) Event studies. E) Do stock prices move “too much?” F) Bubbles. G) Do some investors outperform the

market?

A) Patterns in Stock Prices

Serial Correlation > 0, Momentum Serial Correlation < 0, Mean

Reversion Serial Correlation = 0, Random Walk

Weak Form EMH predicts random walk

B) Backtesting Trading Rules

See if trading rules are profitable when applied to historical stock price data.

Data Mining In-Sample vs. Out-of-Sample

C) Do some types of stocks earn abnormal returns

Value stocks

Small stocks

Or is it microcap/neglected stocks?

Is it is risk premium?

D) Event Studies

Abnormal returns: Stocks earn greater returns than they “should”: Ri – E(R)

Theory implies that stocks should earn abnormal returns when news first comes out, but not afterwards (stock prices are quick to adjust to news)

Book gives example where they use excess returns (Ri-Rm) to measure response to event. Response is slower than it should be.

E) Bubbles

Increases in asset prices not justified by “fundamentals”

At some point, bubbles pop!

Shouldn’t have bubbles if markets are efficient.

Recent experience with real estate and stock price bubbles.

F) Do stock prices move “too much”

Theory: Stock price is the present value of expected future dividend payments.

Stock prices shouldn’t vary more than dividends or earnings do.

But there is more variation

Similar idea to bubbles: stock prices move based on psychological reasons rather than fundamental reasons.

G) Do some investors outperform others?

Why do some investors do well? Luck Higher risk Skill

Mutual funds tests

What do we know

Markets are broadly efficient, but some important exceptions.

Bubbles

Some people understand the economy better – but do you?

Implications for investing

Build around index funds: Well-diversified and low cost

Do bubbles imply market timing?

Do you want to engage in fundamental analysis?