The Efficient Markets

Hypothesis

SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT
 Active or Passive
Management?
“Investors, as a group, can do no better than the market,
because collectively they are the market. Most investors trail the
market because they are burdened by commissions and fund
expenses.” —Jonathan Clements, the Wall Street Journal,
June 17, 1997
“Fees paid for active management are not a good deal for investors,
and they are beginning to realize it.” —Michael Kostoff, executive
director, The Advisory Board, a Washington-based market research firm.
Investment News, February 8, 1999
“When you lay on big fees and high turnover, you’re really starting
in a deep hole, one that most managers can’t dig their way out of.
Costs really do matter.” — George “Gus” Sauter, Manager of the
Vanguard S&P 500 Index Fund
 Net (after costs)
Active or Passive
Management?

Gross (before costs)

Net (after costs)
Gross (before costs)
Net (after costs)
Gross (before costs)
 Definition of Efficient
Markets
An efficient capital market is a market that is efficient in
processing information.
We are talking about an “informationally efficient” market,
as opposed to a “transactionally efficient” market. In other
words, we mean that the market quickly and correctly
adjusts to new information.
In an informationally efficient market, the prices of
securities observed at any time are based on “correct”
evaluation of all information available at that time.
Therefore, in an efficient market, prices immediately and
fully reflect available information.
 Definition of Efficient
Markets (cont.)
Professor Eugene Fama, who coined the phrase “efficient
markets”, defined market efficiency as follows:
◦ "In an efficient market, competition among the many
intelligent participants leads to a situation where, at any
point in time, actual prices of individual securities already
reflect the effects of information based both on events that
have already occurred and on events which, as of now, the
market expects to take place in the future. In other words,
in an efficient market at any point in time the actual price
of a security will be a good estimate of its intrinsic value."
 Joke
“There is an old joke, widely told among
economists, about an economist strolling
down the street with a companion when they
come upon a $100 bill lying on the ground.
As the companion reaches down to pick it up,
the economist says ‘Don’t bother — if it were
a real $100 bill, someone would have already
picked it up’.”
 History
Prior to the 1950’s it was generally believed that the use of
fundamental or technical approaches could “beat the
market” (though technical analysis has always been seen as
something akin to voodoo).
In the 1950’s and 1960’s studies began to provide evidence
against this view.
In particular, researchers found that stock price changes (not
prices themselves) followed a “random walk.”
They also found that stock prices reacted to new information
almost instantly, not gradually as had been believed.
 The Efficient Markets
Hypothesis
The Efficient Markets Hypothesis (EMH) is
made up of three progressively stronger
forms:
◦ Weak Form (Random Walk Theory)
◦ Semi-strong Form
◦ Strong Form
The EMH Graphically
All historical prices and returns
In this diagram, the circles
represent the amount of
Strong Form
information that each form of the
EMH includes.
Semi-Strong
Note that the weak form covers the
least amount of information, and
the strong form covers all Weak Form
information.
Also note that each successive form
includes the previous ones.

All information, public and private

All public information
The Weak Form
The weak form of the EMH states that past prices, volume, and
other market statistics provide no information that can be used to
predict future prices.
If stock price changes are random, then past prices cannot be used
to forecast future prices.
Price changes should be random because it is information that
drives these changes, and information arrives randomly.
Prices should change very quickly and to the correct level when
new information arrives (see next slide).
This form of the EMH, if correct, repudiates technical analysis.
Most research supports the notion that the markets are weak form
efficient.
Price Adjustment with New
Information
At 10AM EST, the U.S. Supreme Court refused to hear an appeal from
MSFT regarding its anti-trust case. The stock immediately dropped. This
example, one of hundreds available every day, illustrates that prices adjust
extremely rapidly to new information.
But, did the price adjust correctly? Only time will tell, but it does seem
that over the next hour the market is searching for the correct level.

Notes: Each bar represents high, low, and close for one-minute. Each solid gridline represents the top of an hour, and each dotted
gridline represents a half-hour.
Tests of the Weak Form
 Serial correlations.
 Runs tests.
 Filter rules.
 Relative strength tests.
Many studies have been done, and nearly all support weak form
efficiency, though there have been a few anomalous results.
Serial Correlations
The following chart shows the relationship (there is none)
between S&P 500 returns each month and the returns from
the previous month. Data are from Feb. 1950 to Sept. 2001.
Note that the R2 is virtually 0 which means that knowing last
month’s return does you no good in predicting this month’s
return.
Also, notice that the trend line is virtually flat (slope =
0.008207, t-statistic = 0.2029, not even close to significant)
The correlation coefficient for this data set is 0.82%
Serial Correlations (cont.)
Unlagged vs One-month Lagged S&P 500
Returns
y = 0.008207x + 0.007451
2
20.00% R = 0.000067
Unlagged Returns

10.00%
0.00%
-10.00%
-20.00%
-30.00%
-30.00% -20.00% -10.00% 0.00% 10.00% 20.00%
One-month Lagged Returns
 Run Test
The run test is another approach to test and detect
statistical dependencies (randomness) which may not be
detected by the auto-correlation test.
We prefer the well-known run test to prove the Random-
walk Model because the test ignores the properties of
distribution.
The null hypothesis of the test is that the observed series
is a random series. A run is defined by Siegel (1956), as
“ a succession of identical symbols which are followed
or preceded by different symbols or no symbol at all”
Run Test Cont…..
The number of runs is computed as a
sequence of the price changes of the same
sign (such as; ++, _ _, 0 0). When the
expected number of run is significantly
different from the observed number of runs,
the test reject the null hypothesis that the
daily returns are random.
As defined by Poshokwale, (1996); “a lower
than expected number of runs indicates
market’s overreaction to information,
subsequently reversed, while higher number of
runs reflect a lagged response to information.
Either situation would suggest an opportunity
to make excess returns.”
Run Test
It is non-parametric technique to find randomness of
data (which may not be detected by autocorrelation test)
It is seen that whether successive price changes are
independent or not
When the expected number of runs is significantly
different from the observe number of runs, it means the
market suffers from over or under reaction to
information, providing an opportunity to make excess
return for traders
Run Test Hypotheses
H0: The observed series are random (the number of
expected runs is about the same as the number of
actual runs)
H1: the observed series are not random
(significantly different counts of runs)
The Semi-strong Form
The semi-strong form states that prices fully reflect all
publicly available information and expectations about the
future.
This suggests that prices adjust very rapidly to new
information, and that old information cannot be used to earn
superior returns.
The semi-strong form, if correct, repudiates a part of
fundamental analysis.
Most studies find that the markets are reasonably efficient in
this sense, but the evidence is somewhat mixed.
Tests of the Semi-strong
Form
Event Studies
Stock splits
Earnings announcements
Analysts recommendations
Cross-Sectional Return Prediction
Firm size
BV/MV
P/E
Analysts’ Performance

This chart from the Wall Street Journal, shows that when analysts issue sell
recommendations, those stocks frequently outperform those with buy or hold
ratings. If the professionals can’t get it right, who can?
Mutual Fund Performance
Generally, most academic studies have found that mutual funds do not
consistently outperform their benchmarks, especially after adjusting for risk
and fees.
Even choosing only past best performing funds (say, 5-star funds by
Morningstar) is of little help. A study by Blake and Morey finds that 5-star
funds don’t significantly outperform 3- and 4-star funds over time.
However, it does seem that you can “weed out” the bad funds (1- and 2-stars).
Funds that have performed badly in the past seem to continually perform
badly in the future.
The Strong Form
The strong form states that prices fully reflect
all information, whether publicly available or
not (Inside information).
Even the knowledge of material, non-public
information cannot be used to earn superior
results.
Most studies have found that the markets are
not efficient in this sense.
 Tests of the Strong Form
◦ Corporate Insiders
◦ Specialists
◦ Mutual Funds
Studies have shown that insiders and specialists
often earn excessive profits, but mutual funds (and
other professionally managed funds) do not.
In fact, in most years, around 85% of all mutual
funds underperform the market.
 Anomalies
Anomalies are unexplained empirical results
that contradict the EMH:
The Size effect.
The “Incredible” January Effect.
P/E Effect.
Day of the Week (Monday Effect).
 The Size Effect
Beginning in the early 1980’s a number of
studies found that the stocks of small firms
typically outperform (on a risk-adjusted basis)
the stocks of large firms.
This is even true among the large capitalization
stocks within the S&P 500. The smaller (but
still large) stocks tend to outperform the really
large ones.
 The “Incredible” January
Effect
Stock returns appear to be higher in January
than in other months of the year.
This may be related to the size effect since it is
mostly small firms that outperform in January.
It may also be related to end of year tax sell ing.
 The P/E Effect
It has been found that portfolios of “low P/E”
stocks generally outperform portfolios of “high
P/E” stocks.
This may be related to the size effect since there
is a high correlation between the stock price and
the P/E.
It may be that buying low P/E stocks is essentially
the same as buying small company stocks.
 The Day of the Week
Effect
Based on daily stock prices from 1963 to 1985 Keim found
that returns are higher on Fridays and lower on Mondays
than should be expected.
This is partly due to the fact that Monday returns actually
reflect the entire Friday close to Monday close time period
(weekend plus Monday), rather than just one day.
Moreover, after the stock market crash in 1987, this effect
disappeared completely and Monday became the best
performing day of the week between 1989 and 1998.
 Summary of Tests of the
EMH
Weak form is supported, so technical analysis cannot
consistently outperform the market.
Semi-strong form is mostly supported, so fundamental analysis
cannot consistently outperform the market.
Strong form is generally not supported. If you have secret
(“insider”) information, you CAN use it to earn excess returns on
a consistent basis.
Ultimately, most believe that the market is very efficient, though
not perfectly efficient. It is unlikely that any system of analysis
could consistently and significantly beat the market (adjusted for
costs and risk) over the long run.
Videos
https://www.youtube.com/watch?v=h5JDftgykcg
https://www.youtube.com/watch?v=pwWX02WwrWU
https://www.youtube.com/watch?v=JnTLY_w_RjY
Thank You