MARKET EFFICIENCY

CHAPTER TEN

Practical Investment Management

Robert A. Strong

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Outline

The Efficient Market Hypothesis Types of Efficiency Degrees of Informational Efficiency The Semi-Efficient Market Hypothesis Security Prices and Random Walks

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Outline

Anomalies The Low PE Effect Low-Priced Stocks The Small Firm and Neglected Firm Effects Market Overreaction The January Effect The Weekend Effect The Persistence of Technical Analysis Final Thoughts

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The Efficient Market Hypothesis

Operational efficiency is a measure of how well things function in terms of speed of execution and accuracy.

Informational efficiency is a measure of how quickly and accurately the market reacts to new information.

The efficient market hypothesis (EMH) deals with informational efficiency.

Types of Efficiency

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The Efficient Market Hypothesis

ASSUMPTIONS:

1. Investors are rational and value securities in a rational manner.

2. To the extent investors are not rational, they trade randomly, so irrationalities tend to cancel each other out.

3. To the extent that investors are not randomly irrational, they are met in the marketplace by rational arbitrageurs, who eliminate any remaining irrational pricing elements.

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The EMH: Degrees of Informational Efficiency

Weak Form Efficiency

This least restrictive form of theEMH states that future stock prices cannot be predicted by analyzing prices from the past.

In other words, the current stock price fully reflects any information contained in the past series of stock prices.

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The EMH: Degrees of Informational Efficiency

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The EMH: Degrees of Informational Efficiency

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An autocorrelation test investigates whether security returns are related through time. A runs test, for example, measures the likelihood that a series of two variables is a random occurrence.

A filter rule is a trading rule regarding the actions to be taken when shares rise or fall in value by x%. Filter rules should not work if markets are weak form efficient.

Tests of Weak Form Efficiency

autocorrelation tests filter rule tests

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Tests of Weak Form Efficiency

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Tests of Weak Form Efficiency

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The EMH: Degrees of Informational Efficiency

Semistrong Form Efficiency

Event studies involving phenomenaoccurring at known points in time, such as a stock split or the announcement of corporate earnings, are frequently used in tests of the semistrong form of market efficiency.

Semistrong form efficiency statesthat security prices reflect all publicly available information.

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The EMH: Degrees of Informational Efficiency

Strong Form Efficiency

Evidence does not support strong form EMH.Insiders can make a profit on their knowledge, and people go to jail, get fined, or get suspended from trading for doing so.

This most extreme version of theEMH states that security prices fully reflect all relevant public and private information.

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The Efficient Market Hypothesis

The essence of the semi-efficient market hypothesis is the notion that some stocks are priced more efficiently than others. This idea is sometimes used in support of the thesis that the market has several tiers.

The random walk idea states thatnews arrives randomly, not that stock prices move randomly.

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Anomalies

The low PE effect : Some evidence indicates that low PE stocks outperform higher PE stocks of similar risk.

Low-priced stocks : Many people believe that the price of every stock has an optimum trading range.

The small firm effect : Small firms seem to provide superior risk-adjusted returns.

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Anomalies

The neglected firm effect : Neglected firms seem to offer superior returns with surprising regularity.

Market Overreaction : It is observed that the market tends to overreact to extreme news. So, systematic price reversals can sometimes be predicted.

The January effect : In January, stock returns are inexplicably high, and small firms’ stocks do better than large firms’.

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Anomalies

The weekend effect : It is observed that security price changes tend to be negative on Mondays and positive on the other days of the week, with Friday being the best of all.

The persistence of technical analysis : If the EMH is true, technical analysis should be useless. Each year however, an immense amount of literature based in varying degrees on the subject is printed.

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Anomalies

From the individual investor’s perspective, the US capital markets are informationally and operationally quite efficient. Still, much is not yet known about asset pricing, resulting in a fair, but complicated financial battleground.

Final thoughts

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Review

The Efficient Market Hypothesis Types of Efficiency Degrees of Informational Efficiency The Semi-Efficient Market Hypothesis Security Prices and Random Walks

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Review

Anomalies The Low PE Effect Low-Priced Stocks The Small Firm and Neglected Firm Effects Market Overreaction The January Effect The Weekend Effect The Persistence of Technical Analysis Final Thoughts