Two News Report & Summary

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8.1 Random Walks and Efficient Market Hypothesis

Competition as Source of Efficiency

Investor competition should imply stock prices reflect available information

Investors exploit available profit opportunities

Competitive advantage can verge on insider trading

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8.1 Random Walks and Efficient Market Hypothesis

Versions of EMH

Weak-form EMH

Stock prices already reflect all information contained in history of trading

Semistrong-form EMH

Stock prices already reflect all public information

Strong-form EMH

Stock prices already reflect all relevant information, including inside information

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8.2 Implications of the EMH

Technical Analysis

Research on recurrent/predictable price patterns and on proxies for buy/sell pressure in market

Resistance Level

Unlikely for stock/index to rise above

Support Level

Unlikely for stock/index to fall below

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Implications of the EMH

Fundamental Analysis

Research on determinants of stock value, i.e. earnings, dividend prospects, future interest rate expectations and firm risk

Assumes stock price equal to discounted value of expected future cash flow

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Implications of the EMH

Active versus Passive Portfolio Management

Passive investment strategy

Buying well-diversified portfolio without attempting to find mispriced securities

Index fund

Mutual fund which holds shares in proportion to market index representation

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8.2 Implications of the EMH

Role of Portfolio Management in Efficient Market

Active management assumes market inefficiency

Passive management consistent with semistrong efficiency

Inefficient market pricing leads to inefficient resource allocation

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8.3 Are Markets Efficient?

Issues

Magnitude issue

Efficiency is relative, not binary

Selection bias issue

Investors who find successful investment schemes are less inclined to share findings

Observable outcomes preselected in favor of failed attempts

Lucky event issue

Lucky investments receive disproportionate attention

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8.3 Are Markets Efficient?

Weak-Form Tests: Patterns in Stock Returns

Returns over short horizons

Momentum effect: Tendency of poorly- or well-performing stocks to continue abnormal performance in following periods

Returns over long horizons

Reversal effect: Tendency of poorly- or well-performing stocks to experience reversals in following periods

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8.3 Are Markets Efficient?

Predictors of Broad Market Performance

1988—Fama and French: Return on aggregate stock market tends to be higher when dividend yield is low

1988—Campbell and Shiller: Earnings yield can predict market returns

1986—Keim and Stambaugh: Bond market data (spread between yields) can predict market returns

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8.3 Are Markets Efficient?

Semistrong Tests: Market Anomalies

Anomalies

Patterns of returns contradicting EMH

P/E effect

Portfolios of low P/E stocks exhibit higher average risk-adjusted returns than high P/E stocks

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8.3 Are Markets Efficient?

Semistrong Tests: Market Anomalies

Small-firm effect

Stocks of small firms can earn abnormal returns, primarily in January

Neglected-firm effect

Stock of little-known firms can generate abnormal returns

Book-to-market effect

Shares of high book-to-market firms can generate abnormal returns

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8.3 Are Markets Efficient?

Semistrong Tests: Market Anomalies

Post-earnings announcement price drift

Sluggish response of stock price to firm’s earnings announcement

Abnormal return on announcement day, momentum continues past market price

Bubbles and market efficiency

Speculative bubbles can raise prices above intrinsic value

Even if prices are inaccurate, it can be difficult to take advantage of them

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Figure 8.3 Average Annual Return: Ten Size-Based Portfolios, 1926-2010

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Figure 8.4 Average Annual Return as Function of Book-to-Market Ratio, 1926-2010

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Figure 8.5 Cumulative Abnormal Returns after Earnings Announcements