BKM Chapter 11 - Market Efficiency Flashcards
Three versions of Efficient Market Hypothesis (EMH)
If a market is efficient then prices will reflect all currently available information.
- Weak Form — Current prices reflect all information that can be obtained from examining past price history, trading volume, etc.
- Semi-Strong Form — All publicly available information regarding the prospects for the firm is reflected in the stock price, such as product line, earning forecasts, and quality of company mangement.
- Strong Form — All information, including information known only by company insiders, is reflected in the current prices.
Technical Analysis and how it can affect market efficiency
This type of analysis involves extensive examination of past stock prices in the search for recurring and predictable patterns. Since this information is so readily available, we should expect intense competition to uncover patterns to eliminate trends the moment they become evident. So even if technical analysis were capable of discovering trends, it ought to quickly become self destructing as people attempt to exploit the information.
In the end, patterns will not be readily visible and the market will appear to be efficient in the sense that prices will reflect the information content (whatever it may be) in past prices.
Fundamental Analysis and how it can affect market efficiency
Fundamental analysts use valuation methods such as discounted cash flow to constantly value stocks on a ground-up basis. By carefully forecasting the earnings and dividend prospects for the firm and taking full consideration of all available information, they hope to uncover instances where stock prices deviate from this fundamental value and to exploit those differences.
Because investors using this approach are always trying to identify underpriced or overpriced stocks, buying the underpriced ones and selling the overpriced ones, at any point in time it will be quite difficult to find obvious examples of underpriced or overpriced securities. This will make the market appear efficient in the sense that prices will reflect relevant information available.
Different Points of View Regarding Value
Technical Analysis vs. Fundamental Analysis
Technical analysts believe that an asset is worth whatever someone will pay for it and so they focus on trying to predict what others will pay for assets in the future. They will buy assets that they believe others will value more highly in the future, regardless of the reason.
In contrast, fundamental analysts believe that assets have intrinsic value and merely attempt to discover what this value is. They will buy assets when they can pay less than this intrinsic value for them.
Active vs. Passive Strategies
What is a passive investment strategy?
Why proponets of the EMH believe that passive investment strategies are superior to active investment strategies?
A passive investment strategy simply seeks to replicate a market index by holding a well-diversified portfolio of stocks (such as market index funds). There is no attempt to actively look for mispricing.
Proponents of EMH believe stock prices reflect all available information. They point out that active strategies do not performe better than passive strategies. Passive strategies are able to save the costs of actively managing a portfolio.
Are Markets Efficient? - Three Key Issues
- Magnitude Issue — Even if the markets are very nearly efficient, a small degree of inefficiency could still lead to substantial profits to those who are able to exploit it. But given the statistical noise, measuring this tiny degree of inefficiency is likely impossible.
- Selection Bias — It is impossible to know with certainty whether there exist strategies to beat the market because those who possess such abilities are unlikely to want to publicize this. Since we will only hear about the strategies that do not work, we can never know for certain if other strategies do exist.
- Lucky Event Issue — Even if we did identify people who could beat the market on a risk adjusted basis, there’s no way of knowing whether this is just luck or some sort of repeatable outcome.
Tests of Weak Form Market Efficiency
Momentum Effect:
Best and worst performing stocks to continue their performance from the recent past. A strategy of buying winners and selling losers tends to earn abnormal returns after adjusting for risk.
Mean Reversion:
Over a longer period, the best performing stoks tend to under perform and the worst performing stocks tend to over perform. Investors can simply invest in worst performing stocks to earn profit.
Tests of semi-strong form of market efficiency: 5 examples
- P/E effect
- Small firm in January
- Neglected Firms
- Book-to-Market Ratio
- Post-Earning Announcement Drift
Tests of Semi-strong Form Market Efficiency: P/E Effect
P/E Effect:
Low P/E stocks earn higher risk adjusted returns than high P/E stocks.
This is contrary to the EMH:
- ranking stocks based on their P/E ratio is easy
- we would expect people to do this without much effort and then force up the price of low P/E stocks and force down the price of high P/E stocks
- in reality, perhaps beta is simply not fully reflecting the risk differences in the low P/E and high P/E stocks
Tests of Semi-strong Form Market Efficiency: Small Firm in January Effect
Small firms tend to significantly outperform large firms, even after adjusting for betas.
This contradict the EMH since such a simple rule should not be able to result in such excess profits.
Explanation:
It turns out that virtually all of the small firm effect occurs in January, and usually in the first few days.
One explanation of this is the impact of tax loss selling which tends to cause mostly small stocks to be sold in December to lock in tax write-offs and then are repurchased in early January.
Tests of Semi-strong Form Market Efficiency: Neglected Firm Effect
Firms that are less studied have higher than expected returns.
This might be because these firms are less liquid so investors demand a liquidity premium to hold stocks in those firms.
The high trading costs of illiquid small and neglected firms could wipe out any apparent opportunities to earn abnormal returns.
Tests of Semi-strong Form Market Efficiency: Book to Market Ratios
Fama and French have found that firms with the highest book-to-market ratio tend to outperform firms with the lowest ratios.
More importantly, they found that once both the size and the book to market effects are taken into account, the standard CAPM beta seems to have no power to explain average returns.
Tests of Semi-strong Form Market Efficiency: Post Earning Announcement Price Drift
Often there is a sluggish response to earnings announcements.
For firms with positive surprises, the cumulative abnormal returns are positive on the announcement day. For firms with negative surprises, the CAR is negative.
However, the CARs tend to drift further upwards or further downwards after the announcement date. This suggests that people don’t fully reflect the surprises fast enough and that a simple strategy of buying the positive surprise firms and selling the negative surprise firms would have been profitable.
Provide two reasons portfolio management still has a role in an efficient market.
- Investors have to make sure that they have established a well-diversified portfolio that coincides with the level of risk they are willing to accept.
- Make sure that their portfolio are established appropriately considering their time horizon of investment.
Describe the expected impact on market efficiency if every investor were to employ a passive investment strategy.
No effects are then put to exploit the arbitrage opportunity. Therefore, even if there are inefficiencies in the markets, there are no pressure to correct them. Eventually, the market will become inefficient.
