Chapter 6

Efficient Capital Markets

An efficient capital market is one in which security prices adjust rapidly to the arrival of new
information, and, therefore, the current prices of securities reflect all information about the security. Some
of the most interesting and important academic research during the past 30 years has analyzed whether
our capital markets are efficient. This extensive research is important because its results have significant
real-world implications for investors and portfolio managers. In addition, the question of whether capital
markets are efficient is one of the most controversial areas in investment research.

6.1 Why Should Capital Markets be Efficient

As noted earlier, in an efficient capital market, security prices adjust rapidly to the infusion of
new information, and, therefore, current security prices fully reflect all available information. To be
absolutely correct, this is referred to as an informationally efficient market. Although the idea of an
efficient capital market is relatively straightforward, we often fail to consider why capital markets should
be efficient. What set of assumptions imply an efficient capital market?

An initial and important premise of an efficient market requires that a large number of profit-
maximizing participants analyze and value securities, each independently of the others.
A second assumption is that new information regarding securities comes to the market in a
random fashion, and the timing of one announcement is generally independent of others.
The third assumption is especially crucial: the buy and sell decisions of all those profit-
maximizing investors cause security prices to adjust rapidly to reflect the effect of new information.
Although the price adjustment may be imperfect, it is unbiased. This means that sometimes the
market will over adjust and other times it will under adjust, but you cannot predict which will occur at
any given time. Security prices adjust rapidly because the many profit-maximizing investors are
competing against one another to profit from the new information.
Finally, because security prices adjust to all new information, these security prices should reflect
all information that is publicly available at any point in time. Therefore, the security prices that prevail at
any time should be an unbiased reflection of all currently available information, including the risk
involved in owning the security. Therefore, in an efficient market, the expected returns implicit in the
current price of the security should reflect its risk, which means that investors who buy at these
informationally efficient prices should receive a rate of return that is consistent with the perceived risk of
the security.

6.2 Alternative Efficient Market Hypothesis

Most of the early work related to efficient capital markets was based on the random walk
hypothesis, which contended that changes in stock prices occurred randomly. This early academic work
contained extensive empirical analysis without much theory behind it. Fama (1970) presented the
efficient market theory in terms of a fair game model, contending that investors can be confident that a
current market price fully reflects all available information about a security and, therefore, the expected
return based upon this price is consistent with its risk.

In his original article, Fama divided the overall efficient market hypothesis (EMH) and the
empirical tests of the hypothesis into three subhypotheses depending on the information set involved: (1)
weak-form EMH, (2) semistrong-form EMH, and (3) strong-form EMH.

6.2.1 Weak-Form Efficient Market Hypothesis

The weak-form EMH assumes that current stock prices fully reflect all security market
information, including the historical sequence of prices, rates of return, trading volume data, and other
market-generated information, such as odd-lot transactions and transactions by market makers. Because it
assumes that current market prices already reflect all past returns and any other security market
information, this hypothesis implies that past rates of return and other historical market data should have
no relationship with future rates of return (that is, rates of return should be independent). Therefore, this
hypothesis contends that you should gain little from using any trading rule which indicates that you
should buy or sell a security based on past rates of return or any other past security market data.

6.2.2 Semi-Strong Form Efficient Market Hypothesis

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 The semistrong-form EMH asserts that security prices adjust rapidly to the release of all public
information; that is, current security prices fully reflect all public information. The semistrong hypothesis
encompasses the weak-form hypothesis, because all the market information considered by the weak-form
hypothesis, such as stock prices, rates of return, and trading volume, is public. Notably, public
information also includes all nonmarket information, such as earnings and dividend announcements,
price-to-earnings (P/E) ratios, dividend-yield (D/P) ratios, price-book value (P/BV) ratios, stock splits,
news about the economy, and political news. This hypothesis implies that investors who base their
decisions on any important new information after it is public should not derive above-average risk-
adjusted profits from their transactions, considering the cost of trading because the security price should
immediately reflect all such new public information.

6.2.3 Strong-Form Efficient Market Hypothesis

The strong-form EMH contends that stock prices fully reflect all information from public and
private sources. This means that no group of investors has monopolistic access to information relevant to
the formation of prices. Therefore, this hypothesis contends that no group of investors should be able to
consistently derive above-average risk-adjusted rates of return. The strong-form EMH encompasses both
the weak-form and the semistrong-form EMH. Further, the strong-form EMH extends the assumption of
efficient markets, in which prices adjust rapidly to the release of new public information, to assume
perfect markets, in which all information is cost-free and available to everyone at the same time.

6.3 Tests and Results of Efficient Market Hypotheses

Now that you understand the three components of the EMH and what each of them implies
regarding the effect on security prices of different sets of information, we can consider the tests used to
see whether the data support the hypotheses.

6.3.1 Weak-Form Hypothesis: Tests and Results

Statistical Test of Independence

First, autocorrelation tests of independence measure the significance of positive or negative

correlation in returns over time. Does the rate of return on day t correlate with the rate of return on day t −
1, t − 2, or t − 3?2 Those who believe that capital markets are efficient would expect insignificant
correlations for all such combinations.

Several researchers have examined the serial correlations among stock returns for several
relatively short time horizons including 1 day, 4 days, 9 days, and 16 days. The results typically indicated
insignificant correlation in stock returns over time. Some recent studies that considered portfolios of
stocks of different market size have indicated that the autocorrelation is stronger for portfolios of small
market size stocks. Therefore, although the older results tend to support the hypothesis, the more recent
studies cast doubt on it for portfolios of small firms, although these results could be offset by the higher
transaction costs of small-cap stocks and nonsynchronous trading for small-cap stocks.

The second statistical test of independence as discussed by DeFusco et al. (2004), is the runs test.
Studies that have examined stock price runs have confirmed the independence of stock price changes over
time. The actual number of runs for stock price series consistently fell into the range expected for a
random series. Therefore, these statistical tests of stocks on the NYSE and on the NASDAQ market have
likewise confirmed the independence of stock price changes over time.

6.3.2 Semistrong-Form Hypothesis: Tests and Results

Recall that the semistrong-form EMH asserts that security prices adjust rapidly to the release of
all public information; that is, security prices fully reflect all public information. Studies that have tested
the semistrong-form EMH can be divided into the following sets of studies:

1. Studies to predict future rates of return using available public information beyond pure market
information such as prices and trading volume considered in the weak-form tests. These studies
can involve either time-series analysis of returns or the cross-section distribution of returns for
individual stocks. Advocates of the EMH contend that it would not be possible to predict future
returns using past returns or to predict the distribution of future returns (e.g., the top quartile or
decile of returns) using public information.
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 2. Event studies that examine how fast stock prices adjust to specific significant economic events. A
corollary approach would be to test whether it is possible to invest in a security after the public
announcement of a significant event (e.g., earnings, stock splits, major economic data) and
experience significant abnormal rates of return. Again, advocates of the EMH would expect
security prices to adjust rapidly, such that it would not be possible for investors to experience
superior risk-adjusted returns by investing after the public announcement and paying normal
transaction costs.

The evidence from tests of the semistrong EMH is mixed. The hypothesis receives almost
unanimous support from the numerous event studies on a range of events including stock splits, initial
public offerings, world events and economic news, accounting changes, and a variety of corporate finance
events. About the only mixed results come from exchange listing studies.
In sharp contrast, the numerous studies on predicting rates of return over time or for a cross
section of stocks presented evidence counter to semistrong efficiency. This included time-series studies
on risk premiums, calendar patterns, and quarterly earnings surprises. Similarly, the results for cross-
sectional predictors such as size, the BV/MV ratio (when there is expansive monetary policy), and P/E
ratios indicated anomalies that are not consistent with market efficiency.

6.3.3 Strong-Form Hypothesis: Tests and Results

The strong-form EMH contends that stock prices fully reflect all information, public and private.
This implies that no group of investors has access to private information that will allow them to
consistently experience above-average profits. This extremely rigid hypothesis requires not only that
stock prices must adjust rapidly to new public information but also that no group has access to private
information.
Tests of the strong-form EMH have analyzed returns over time for different identifiable
investment groups to determine whether any group consistently received above-average risk-adjusted
returns. Such a group must have access to and act upon important private information or an ability to act
on public information before other investors, which would indicate that security prices were not adjusting
rapidly to all new information.
Investigators have tested this form of the EMH by analyzing the performance of the following
three major groups of investors: (1) corporate insiders, (2) security analysts at Value Line and elsewhere,
and (3) professional money managers.

Conclusions Regarding the Strong-Form EMH The tests of the strong-form EMH have generated mixed
results. The result for corporate insiders did not support the hypothesis because these individuals
apparently have monopolistic access to important information and use it to derive above-average returns.
Tests to determine whether there are any analysts with private information concentrated on the
Value Line rankings and publications of analysts’ recommendations. The results for Value Line rankings
have changed over time and currently tend toward support for the EMH. Specifically, the adjustment to
rankings and ranking changes is fairly rapid, and it appears that trading is not profitable after transaction
costs. Alternatively, individual analysts’ recommendations and changes in overall consensus estimates
seem to contain significant information.
Finally, recent performance by professional money managers provided mixed support for the
strong-form EMH. Most money manager performance studies before 2002 have indicated that these
highly trained, full-time investors could not consistently outperform a simple buy and-hold policy on a
risk-adjusted basis. In contrast, the recent results show that about half the non-mutual fund universe beat
the broad Russell 3000 index, while the equity mutual fund results supported the EMH for long-term
periods. Because money managers are similar to most investors who do not have access to inside
information, these latter results are more relevant to the hypothesis. Therefore, there is mixed support for
the strong-form EMH as applied to most investors.

6.4 Behavioral Finance

Behavioral finance considers how various psychological traits affect how individuals or groups
act as investors, analysts, and portfolio managers. As noted by Olsen (1998), behavioral finance
advocates recognize that the standard finance model of rational behavior and profit maximization can be
true within specific boundaries, but they assert that it is an incomplete model since it does not consider
individual behavior. It is argued that some financial phenomena can be better explained using models
where it is recognized that some investors are not fully rational or realize that it is not possible for
arbitrageurs to offset all instances of mispricing (Barberis and Thaler, 2003). Specifically, according to
Olsen (1998), behavioral finance

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 seeks to understand and predict systematic financial market implications of psychological
decisions processes … behavioral finance is focused on the implication of psychological and
economic principles for the improvement of financial decision-making. (p. 11)

In the preface for Wood (2010), the editor provides a helpful description of behavioral finance,
alluding to a river with three tributaries that form the river of behavioral finance: (1) psychology that
focuses on individual behavior, (2) social psychology, which is the study of how we behave and make
decisions in the presence of others, and (3) neurofinance, which is the anatomy, mechanics, and
functioning of the brain. It is contended that the goal of research in this area is to help us understand how
and why we make choices.