F.  Efficient Market Hypothesis

• Stocks already reflect all available information

• Random walk - price changes are random and unpredictable

• Due to competition

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1.  Versions

a.  Weak-form

• Stock prices reflect all information available about past prices and volume

• Implies that trend analysis is pointless

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b.  Semi-strong form

• Stock prices reflect all publicly available information about firm's prospects

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c.  Strong-form

• Stock prices reflect all information about firm, including insider information

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2.  Implications

a.  Technical analysis

• Pointless due to weak-form version

Ex. - Resistance and support levels

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b.  Fundamental analysis

• Pointless due to semi-strong version

• All information already reflected in stock price

• Difficult to find mispriced stock

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c.  Active vs. passive portfolio management

• Active management unlikely to beat market

• Passive management - buy well-diversified portfolio without attempting to find mispriced securities

• Index fund - fund that replicates a broad-based index of stocks

• Roles for portfolio management

(1) Select well diversified portfolio

(2) Tax considerations

(3) Risk should vary depending on investor

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d.  Resource allocation

• Efficient markets mean efficient allocation of resources

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3.  Issues

• Not widely accepted on Wall Street

• Difficult to properly test

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a.  Magnitude

• Market volatile - hard to detect small gains in performance

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b.  Selection bias

• Successful techniques may not be reported to the public

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c.  Lucky event

• Some portfolio managers could outperform just by luck

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4.  Empirical results

a.  Technical analysis (weak-form tests)

• Doesn't generate superior performance

• Exception is momentum-base strategies over the intermediate term

• Momentum effect - good or bad performance of particular stocks continues over time

- Portfolios of best performing stocks offer profit opportunities

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b.  Fundamental analysis (semistrong tests)

• Some anomalies offer profit opportunities

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(1) P/E effect

• Portfolios of low price-earnings ratio stocks have higher returns than portfolios of high price-earnings stocks, even after adjusting for risk

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(2) Small-firm-in-January effect

• Small firms outperform others in the first two weeks of January

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(3) Neglected-firm effect

• Neglected firms have less data available, more opportunity for gains

• January effect largest for neglected firms

• May also be due to less liquidity in neglected firms - higher return needed due to higher trading costs

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(4) Book-to-market ratios

• Calculate ratio of book value of equity to market value of equity

• Firms with higher book-to-market ratios outperform those with lower ratios

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(5)  Bubbles and market efficiency

• Dutch tulips (17th century), South Sea Company (1720), dot-com boom (1995 - 2002)

• Stability and rising prices extrapolated into future - lower risk premiums => rising prices => more optimism => self-fulfilling cycle

• Most bubbles only obvious after the fact

• Valuation is difficult

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(6) Post-earnings-announcement price drift

• Sluggish response to firms' earnings announcements

• Takes a while for information to be fully reflected in price

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c.  Inside information (strong-form tests)

• Prices rise after insiders buy, fall after insiders sell

• More information on insider trades => difficult to make money by following insiders

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d.  Interpretation

• Inefficiencies or risk premiums?

- Abnormal returns could just reflect higher risk

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• Anomalies or data mining?

- Given enough data, some criteria may appear to predict returns

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5.  Professional management

a.  Stock market analysts

• Some value added, but some ambiguity

- Did new information cause revaluation or just increase demand?

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b.  Mutual fund managers

• No evidence that professional managers can beat the market