Chapter 8 - Efficient Market Hypothesis

Question 1

Is the following phenomena consistent or a violation of the efficient market hypothesis? Explain.
Nearly half of all professionally manages mutual funds are able to outperform the SP 500 in a typical year.

Answer 1

Consistent

Half of all managers should outperform the market based on pure luck.

Question 2

Is the following phenomena consistent or a violation of the efficient market hypothesis? Explain.
Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year.

Answer 2

Violation

Basis for an “easy money” rule: Invest with last year’s best managers.

Question 3

Is the following phenomena consistent or a violation of the efficient market hypothesis? Explain.
Stock prices tend to be predictably more volatile in January than in other months.

Answer 3

Consistent

Predictable volatility doesn’t convey a means to earn abnormal returns.

Question 4

Is the following phenomena consistent or a violation of the efficient market hypothesis? Explain.
Stock prices of companies that announce increased earnings in January tend to outperform the market in February.

Answer 4

Violation

Abnormal performance ought to occur in January, when increased earnings are announced.

Question 5

Is the following phenomena consistent or a violation of the efficient market hypothesis? Explain.
Stocks that perform well in one week perform poorly in the following week.

Answer 5

Violation

Reversals offer a means to earn easy money: Simply buy last week’s losers.

Question 6

Why are the P/E effect, book-to-market effect, momentum effect, and small-firm effect considered efficient market abnormalities?

Answer 6

Historical data says abnormalities produced excess risk-adjusting abnormal returns in the past.

Question 7

Are there rational explanations for the P/E effect, book-to-market effect, momentum effect, and small-firm effect?

Answer 7

Yes, but not everyone agrees.
Some firms are also neglected firms, due to low trading volume and not part of efficient market.
Some firms offer more risk as a result of reduced liquidity.

Question 8

Dollar-cost averaging means that you buy equal amounts of a stock every period, for example, $500 per month. The strategy is based on the idea that when the stock price is low, your fixed monthly purchase will buy more shares, and when the price is high, fewer shares. Averaging over time, you will end up buying more shares when the stock is cheaper and fewer when it is relatively expensive. Therefore, by design, you will exhibit good market timing. Evaluate this strategy.

Answer 8

Implicit is the notion that stock prices fluctuate around a “normal” level.
Otherwise there is no way of knowing what is considered high or low now compared to the future.

Question 9

A market anomaly refers to:
A. An exogenous shock to the market that is sharp but not persistent.
B. A price or volume event that is inconsistent with historical price or volume trends.
C. A trading or pricing structure that interferes with efficient buying and selling of securities.
D. Price behavior that differs from the behavior predicted by the efficient market hypothesis.

Answer 9

D

Question 10

Some scholars contend that professional managers are incapable of outperforming the market. Others come to an opposite conclusion. Compare and contrast the assumption about the stock market that support passive portfolio management.

Answer 10

Information efficiency.

Primacy of diversification motives.

Question 11

Some scholars contend that professional managers are incapable of outperforming the market. Others come to an opposite conclusion. Compare and contrast the assumption about the stock market that support active portfolio management.

Answer 11

Opposite assumptions of passive.

Particularly, pockets of market inefficiency exist.

Question 12

You are a portfolio manager meeting a client. During the conversation that follows your formal review of her account, your client asks the following question:
My grandson, who is studying investments, tells me that one of the best ways to make money in the stock market is to buy the stocks of small-capitalization firms late in December and to sell the stocks one month later. What is he talking about?
Identify the apparent market abnormalities that would justify the purposes strategy.

Answer 12

Small firm anomaly and January anomaly.

Small-firm-in-January anomaly.

Question 13

You are a portfolio manager meeting a client. During the conversation that follows your formal review of her account, your client asks the following question:
My grandson, who is studying investments, tells me that one of the best ways to make money in the stock market is to buy the stocks of small-capitalization firms late in December and to sell the stocks one month later. What is he talking about?
Explain why you believe such a strategy might or might not work in the future.

Answer 13

Limits the potential for diversification.
No assurance that future time periods yield similar results.
Prices may be bid up to reflect the now-known opportunity.

Question 14

Briefly explain the concept of the efficient market hypothesis (EMH).

Answer 14

Market is efficient if security prices immediately and fully reflect all available information.
Investor cannot profit because stock prices already incorporate the information.

Question 15

Briefly explain the weak form of the EHM.

Answer 15

Stock prices reflect all information from examining market trading data.
History of past prices and trading volume.

Question 16

Briefly discuss the degree to which existing empirical evidence supports the weak form of EHM.

Answer 16

Strong evidence of support in the major US securities markets.

Question 17

Briefly explain the semistrong form of EMH.

Answer 17

Stock price reflects all publicly available information about a firm’s prospects.

Question 18

Briefly discuss the degree to which existing empirical evidence supports the semistrong form of EMH.

Answer 18

Evidence strongly supports, but occasional studies and events are inconsistent with it.

Question 19

Briefly explain the strong form of EMH.

Answer 19

Current market prices reflect all information (private and public) relevant to the valuation of firm.

Question 20

Briefly discuss the degree to which existing empirical evidence supports strong EMH.

Answer 20

Empirical evidence suggests it doesn’t hold.

Question 21

Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to technical analysis in the form of charting.

Answer 21

Involves the search for recurrent and predictable patterns in stock price to enhance returns.
EMH implies its without value.
If past prices contain no useful information for predicting prices, there is no point in any technical trading rule.

Question 22

Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to fundamental analysis.

Answer 22

Uses earnings and dividend prospects to determine proper stock prices.
EMH predicts most is doomed for failure.

Question 23

Briefly explain the roles or responsibilities of portfolio managers in an efficient market environment.

Answer 23

Most important is identify risk/return objectives given constraints.
Tailoring portfolio to meet investor’s needs, rather than beat the market.
Examining the investor’s constraints.

Question 24

Growth and value can be defined in several ways. Growth usually conveys the idea of a portfolio emphasizing or including only companies believed to posses above-average future rates of per-share earnings growth. Low current yield, high price-to-book ratios, and high price-to-earnings ratios are typical characteristics of such portfolios. Value usually conveys the idea of portfolios emphasizing or including only issues currently showing low price-to-book ratios, low price-to-earnings ratios, above-average levels of dividend yield, and market price believed to be below the issues’ intrinsic values.
Identify and provide reasons why, over an extended period of time, value-stock investing might outperform growth-stock investing.

Answer 24

Earnings growth rate of growth stocks may be consistently overestimated.
Growth stocks are likely to revert to lower mean returns.
Value stocks are likely to revert to higher mean returns.

Question 25

Growth and value can be defined in several ways. Growth usually conveys the idea of a portfolio emphasizing or including only companies believed to posses above-average future rates of per-share earnings growth. Low current yield, high price-to-book ratios, and high price-to-earnings ratios are typical characteristics of such portfolios. Value usually conveys the idea of portfolios emphasizing or including only issues currently showing low price-to-book ratios, low price-to-earnings ratios, above-average levels of dividend yield, and market price believed to be below the issues’ intrinsic values.
Explain why the outcome in (a) suggested should not be possible in a market widely regarded as being highly efficient.

Answer 25

The current prices of stocks already reflect all known, relevant information.
Growth stocks and value stocks provide the same risk-adjusted expected return in this situation.

Question 26

Your investment client asks for information concerning the benefits of active portfolio management. She is particularly interested in the question of whether active managers can be expected to consistently exploit inefficiencies in the capital markets to produce above-average returns without assuming higher risk.
The semistrong form of the efficient market hypothesis asserts that all publicly available information is rapidly and correctly reflected in securities prices. This implies that investors cannot expect to derive above-average profits from purchases made after information has become public because security prices already reflect the information’s full effects.
Identify and explain two examples of empirical evidence that tend to support the EMH implication stated above.

Answer 26

Passive index strategies
Studies show stocks respond immediately to public release of relevant news.
Difficult to identify price trends than can be exploited to earn superior risk-adjusted investment returns.

Question 27

Your investment client asks for information concerning the benefits of active portfolio management. She is particularly interested in the question of whether active managers can be expected to consistently exploit inefficiencies in the capital markets to produce above-average returns without assuming higher risk.
The semistrong form of the efficient market hypothesis asserts that all publicly available information is rapidly and correctly reflected in securities prices. This implies that investors cannot expect to derive above-average profits from purchases made after information has become public because security prices already reflect the information’s full effects.
Identify and explain tow examples of empirical evidence that tend to refute the EMH implication stated above.

Answer 27

Low P/E stocks
High book-to-market ratio stocks
Small firms in January
Firms with poor stock performance in last few months.

Question 28

Your investment client asks for information concerning the benefits of active portfolio management. She is particularly interested in the question of whether active managers can be expected to consistently exploit inefficiencies in the capital markets to produce above-average returns without assuming higher risk.
The semistrong form of the efficient market hypothesis asserts that all publicly available information is rapidly and correctly reflected in securities prices. This implies that investors cannot expect to derive above-average profits from purchases made after information has become public because security prices already reflect the information’s full effects.
Discuss reasons why an investor might choose not to index even if the markets were, in fact, semistrong-form efficient.

Answer 28

May want to tailor a portfolio to specific tax considerations or specific risk management issues.