Chapter 8

The Efficient Market Hypothesis

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

8.1 Random Walks and the Efficient Market Hypothesis

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Efficient Market Hypothesis (EMH)

Do security prices accurately reflect information? Informational Efficiency price changes consistently predictable? Are _____________________________________ Allocational Efficiency accurately Are prices correct in that they ____________

________________________ associated with the reflect the cash flows security? greater fool theory Gold and the _______________________.

Huge implications concerning the answers to these questions.

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Implications of Efficiency
Allocational efficiency If markets are not allocationally efficient then perhaps there is a ________________________ role for greater government intervention in capital markets. ___________ Possible rules changes to attempt to improve allocational efficiency Tax on trading activity More taxes on short holding period returns Changes in corporate compensation Direct government involvement in capital allocation: Industrial Policy
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Implications of Efficiency
Informational efficiency
If markets are not informationally efficient

Investors may not be able to trust that market prices are up to date and investors should then conduct their own research (or hire a researcher) to validate the price. Privileged groups of investors will be able to consistently take advantage of the general public. Active strategies should outperform passive strategies.
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Implications of Efficiency
Informational efficiency If markets are not informationally efficient Corporations have to rethink their goals and how best to achieve them. Maximize shareholder wealth maximize share price, so how does one go about maximizing shareholder wealth in this case? Lack a benchmark to evaluate corporate decisions.

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EMH and Competition

Competition among investors should imply that stock prices fully and accurately reflect publicly available information very quickly. Why? Else there are unexploited profit opportunities. Once information becomes available, market participants quickly analyze it & trade on it & frequent, low cost trading assures prices reflect information.
Questions arise about efficiency due to:

Unequal access to information

Structural market problems Psychology of investors (Behavioralism)
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Random Price Changes

Why are price changes random?

In very competitive markets prices should react to only NEW information Flow of NEW information is random Therefore, price changes are random Idea that stock prices follow a Random Walk

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Random Walk and the EMH

Random Walk: stock price changes ______________________ are unpredictable
A pure random walk implies informational efficiency

process Stock prices actually follow a submartingale ____________________ Expected price change is positive over time But random changes are superimposed on the positive trend t = time period E(pricej,t) > E(pricej,t-1)

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Random Walk with Positive Trend

Security Prices

Evidence on Random Walk idea later.

Time
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Forms of the EMH

Prices reflect all relevant information information set Vary the ________________ Weak The relevant information is historical prices and other trading data such as trading volume. If the markets are weak form efficient, use of such information provides no benefit at the margin.

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Forms of the EMH

Prices reflect all relevant information Vary the information set: Semi-strong The relevant information is "all publicly available information, including past price and volume data." If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin.
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Forms of the EMH

Prices reflect all relevant information Vary the information set: Strong The relevant information is all information both public and private or inside information. If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin. SEC Rule 10b-5 limits trading by corporate insiders, (officers, directors and major shareholders). Inside trading must be reported.
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Relationships between forms of the EMH

efficiency implies weak Notice that semi-strong _______________________________ form efficiency holds (but ________________) NOT vice versa __________________
Strong form efficiency would imply that both semi-strong and weak form efficiency hold __________________________________________.

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8.2 Implications of the EMH (for Security Analysis)

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Types of Stock Analysis & Relationship to the EMH

Technical Analysis: Technical Analysis or TA is using prices and volume information to predict future price changes TA assumes prices follow predictable trends If the markets are weak form efficient or semistrong form efficient or strong form efficient will technical analysis be able to consistently predict price changes? NO

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Basic Types of Technical Analysis

Identifying common price patterns

One of these patterns is real and one of these is computer simulated with random price changes. Can you tell which is which? Point? Less than meets the eye Data mining

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Basic Types of Technical Analysis

Support and resistance levels Support level: A price level below which it is supposedly unlikely for a stock or stock index to fall. Resistance level: A price level above which it is supposedly unlikely for a stock or stock index to rise.
A resistance level may arise at say $31.25 if a stock repeatedly rises to $31.25 and then declines, indicating that investors are reluctant to pay more than this price for the stock.

A stock price above $31.25 would then indicate a 'breakout' which would be a bullish signal.
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Types of Stock Analysis & Relationship to the EMH

Fundamental Analysis: using economic and accounting information to predict stock price changes If the markets are weak form efficient or semistrong form efficient or strong form efficient will fundamental analysis be able to consistently predict price changes?
If the markets are only weak form efficient? Fundamental Analysis CAN predict price changes If the markets are semi-strong or strong form efficient? Fundamental Analysis CANNOT predict price changes

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Fundamental Analysis
Fundamental analysis assumes that stock prices should be equal to the discounted value of the expected future cash flows the stock is expected to provide to investors. Fundamental analysis is thus the art of identifying over- and undervalued securities based on an analysis of the firm's financial statements and future prospects.

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Fundamental Analysis
Fundamental analysis varies in technique but generally focuses on forecasting the firm's future dividends or earnings,

discounting those future cash flows by the required rate of return (usually obtained from the CAPM),
and comparing the resulting estimated price with the current stock price.

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Fundamental Analysis
If the estimated price is greater ______ than the current price an investor should buy ___ the stock since it is undervalued increase to ___________ and since its price should ________ the "true" or "fundamental" value uncovered by the analyst.
If the estimated price is less ____ than the current price the stock should be sold ____ because the stock is overvalued by the market. currently __________ In either case if the analyst is correct the investor return should receive anabnormal ________________.
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Fundamental Analysis
Forecasts already exist and for FA to add value, your forecast must be better than the consensus forecast. Not enough to find a good company, you must find a company that is better than others believe, i.e., mispriced.

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Implications of Efficiency for Active or Passive Management

Active Management Security analysis Timing strategies Investment Newsletters
Assumes inefficiency, use technical and/or fundamental analysis to pick securities

Passive Management Buy and Hold portfolios Index Funds

Consistent with semistrong efficiency

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Market Efficiency and Portfolio Management

Even if the market is efficient a role exists for portfolio management Identify risk & choose appropriate risk level Tax considerations Other considerations such as liquidity needs or diversify away from the clients industry.

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Selected Problems

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Problem 1
Zero, otherwise returns from the prior period could be used to predict returns in the subsequent period.

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Problem 2
No. Why? One would have to show that Intel investors earned a higher rate of return than they should have for the risk taken.
Many investors bought Intel only after its success was evident. By chance some stocks will perform extremely well.
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