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MARKET EFFICIENCYCHAPTER 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 efficiencyis a measure of how
well things function in terms of speed of
execution and accuracy.
Informational efficiencyis a measure of how
quickly and accurately the market reacts to
new information.
The efficient market hypothesis (EMH) dealswith 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 traderandomly, so irrationalities tend to cancel each other
out.
3. To the extent that investors are not randomlyirrational, 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 the
EMH states that future stock
prices cannot be predicted byanalyzing prices from the past.
In other words, the current stock price fully
reflects any information contained in thepast series of stock prices.
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The EMH: Degrees of Informational Efficiency
Insert Figure 10-1 here.
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The EMH: Degrees of Informational Efficiency
Insert Figure 10-2 here.
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An autocorrelation testinvestigates whether
security returns are related through time. A
runs test, for example, measures thelikelihood 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 byx%. 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
Insert Table 10-3 here.
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Tests of Weak Form Efficiency
Insert Table 10-4 here.
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The EMH: Degrees of Informational Efficiency
Semistrong Form Efficiency
Event studies involving phenomena
occurring at known points in time, such as a
stock split or the announcement of corporateearnings, are frequently used in tests ofthe
semistrong form of market efficiency.
Semistrong form efficiency states
that 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 the
EMH 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 markethypothesis 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 walkidea states that
news arrives randomly, not that
stock prices move randomly.
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Anomalies
The low PE effect: Some evidence indicatesthat low PE stocks outperform higher PE
stocks of similar risk.
Low-priced stocks : Many people believe thatthe price of every stock has an optimum
trading range.
The small firm effect: Small firms seem toprovide superior risk-adjusted returns.
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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 degreeson the subject is printed.
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Anomalies
From the individualinvestors perspective, the
US capital markets are informationally andoperationally 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
