Lecture 6: The Efficient Market Hypothesis Flashcards
Random Walk Explanation
The attempt to find recurrent patterns in stock price movements are likely to fail. A forecast about favourable future performance leads instead to favourable current performance, as market participants all try to get in on the action before the price jumps.
Any information that could be used to predict stock performance should already be reflected in stock prices. As soon as there is any information indicating that stock is underpriced, this offers an opportunity for investors to buy the stock. This immediately bids up its prices to a fair level, where only ordinary rates of return can be expected. These ordinary rates are simply rates of return commensurate with the risk of the stock.
On the other hand, if prices are bid immediately to fair levels, given all available information it must be that they increase or decrease only in response to new information. This new information must be unpredictable as if could be predicted then the prediction would be part of today’s information. Any information that could cause a change in a stock’s price should already be reflected in it today.
Stock prices that change in response to new information also must move unpredictably.
This is the essence of the argument that stock prices should follow a random walk. A random walk would be the natural result of prices that always reflect all current
knowledge.
Prices are random walks when prices are perfectly positively correlated with their lags. As our best guess of price today is based on the price yesterday.
If stock price movements were predictable, that would be damning evidence of stock market inefficiency, because the ability to predict prices would indicate that all available information was not already reflected in stock price.
When we move to returns (other side), then we moves price changes (returns) and they are no longer predictable, the only this they depend on is white noise.
Prices cannot be predicted and follow ‘random walks’.
Things are correctly priced, but we are not strict what is priced, such as several different types of risks are priced, including idiosyncratic. It is very difficult to earn (‘risk free’) abnormal returns
Suppose there is a model that predicts with great confidence that XYZ stock price, currently at $100 per share, will rise dramatically in 3 days to $110.
What would all investors with access to the model’s prediction do today?
They would place a great wave of immediate buy orders to cash in on
the prospective increase in stock price.
- However, no one holding XYZ would be willing to sell.
- The net effect would be an immediate jump in the stock price to $110.
- A forecast about favorable future performance leads instead to favorable current performance.
More generally, any information that could cause a change in a stock’s price should already be reflected in it
EMH
The notion that stocks already reflect all available
information is referred to as the EMH.
The Efficient Market Hypothesis (EMH) also predicts that asset prices are `right’.
EMH argues that in an efficient market new information about a stock is quickly incorporated into stock’s price. Belief that prices react really quickly to available information.
There are three form of EMH: weak, semi strong, strong
In the semi strong form, technical analysis and fundamental analysis cannot be helpful in achieving superior returns.
Proponents of EMH argues that a passive investing strategy is no worse (an probably better) than an active investing strategy that tries to identify misplaced securities.
Example. Figure 1.1 : Cumulative abnormal returns before takeover attempts; target companies
Illustrates the response of stock prices to new information in an efficient market.
As during an takeover, the acquiring firms pays a substantial premium over current market prices, causing the stock price to jump dramatically as the news become public. As there are no new drifts in the price, this suggest after the news, the prices reflect the new information.
Example. Evidence of High frequency trading
Patel and Wolfson (1984) show that most of the stock price response to corporate dividend or earnings announcements occurs within 10 minutes of the announcement
Bussee and Green (2002) track minute by minute prices of stocks around the time that they are featured on CNBC’s “Midday Call” segment
The figure on the next slide shows that the market digests positive news within 5 minutes and negative news within 12 minutes.
They also find that traders who lock in prices within 15 seconds of the initial mention make small but significant profits by trading on positive reports.
Competition as source of efficiency.
Should we expect stock prices to reflect “all available information?
Grossman and Stiglitz (1980): Investors will have an incentive to spend time and resources to analyse and uncover new information only if such activity is likely to generate higher investment returns.
Costs vs benefits: Degree of efficiency can differ across stock markets, across firms of different sizes.
Generally, information that is less costly to obtain and is likely to result in a large profit will generally be uncovered. This is why active fund managers are still around.
Versions of the EMH
EMH is typically broken down into three versions:
(“all available information”)
Weak form:
Stock prices reflect all market trading data e.g. past prices, trading volume, short interest.
Semi strong form:
Stock prices reflect all publicly available information
e.g. market data, accounting information, quality of management.
Strong form:
Stock price reflects all information including insider information.
Implications of EMH
- Technical Analysis
- Fundamental Analysis
EMH predict that both analysis is doomed to failure.
It is apparent that casual efforts to pick stocks are not likely to pay off. Competition among investors ensures that any easily implemented stock evaluation technique will be used widely enough so that any insights derived will be reflected in stock prices.
Only serious analysis and uncommon techniques are likely to generate the differential insight necessary to yield trading profits.
Were developed separately, but CAPM and EMH have implications which are consistent with each other.
CAPM: You earn higher returns to compensate for higher systematic risk. CAPM is entirely based on the return of any asset to a single correlation with the return on the market portfolio. - just market risk is priced.
EMH: It is very difficult to earn risk free abnormal returns.
- Technical Analysis
Is a search for recurrent and predictable patterns in stock prices.
They don’t think fundamental analysis is necessary for a successful trading strategy. This is because whatever the fundamental reason for a change in stock price, if the stock price responds slowly enough, the analyst will be able to identify a trend that can be exploited during the adjustment period.
The key to a successful technical analysis is a sluggish response of stock prices to fundamental supply-and-demand factors.
Common components of technical analysis:
These values are said to be price levels above which it is difficult for stock prices to rise, or below which it is unlikely for them to fall, and they are believed to be levels determined by market psychology.
- Resistance level: the level above which it is difficult for a stock’s price to rise.
- Support level: the level below which it is difficult for a stock’s price to fall
The efficient market hypothesis implies that technical analysis is without merit. The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analysing past prices has already been reflected
in stock prices. Thus, investors compete to exploit common knowledge of a stock’s price history, driving stock prices to levels where expected rates of return are exactly commensurate with risk. Here you cannot expect to get abnormal returns.
Example: Example: Consider stock XYZ, which traded for several months at a price of $72 and then declined to $65.
No one would be willing to purchase the stock at price of $71.50, as it leaves no room to increase in price, but allows a-lot of space to fall.
At this price, if no one is willing to buy it would become the resistance level. Using the same analysts no one would buy it at $71, or $70, and so on. The market price falls so that more people can be persuaded to buy it.
Simple resolution is the recognition that if the stock is ever to sell at $71.50, investors must believe that the price can as easily increase as fall. The fact that investors are willing to purchase (or even hold) the stock at $71.50 is evidence of their belief that they can earn a fair expected rate of return at that price.
A clever analyst may occasionally uncover a profitable trading rule. If markets are efficient, once such a rule is discovered, it ought to be invalidated when the mass of traders attempt to exploit it. In this sense, price patterns ought to be self destructing. The mispricing eventually disappears because of this.
Thus, technical analysis doesn’t consistently results in abnormal returns. In the long term this is not feasible.
- Fundamental Analysis
uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. It represents an attempt to determine the present discounted value of all the payments a stockholder will receive from each share of stock.
Start with a study of past earnings and an examination
of company balance sheets. this analysis with further detailed economic analysis, ordinarily including an evaluation of the quality of the firm’s management, the
firm’s standing within its industry, and the prospects for the industry as a whole. They would give a “buy” recommendation, if the stock’s market price is below their fair price estimate.
The efficient market hypothesis predicts that most fundamental analysis also is doomed to failure. The hope is to attain insight into future performance that is not yet recognised by the rest of the market.
If an analyst relies on public information, his/her estimate of the fair value of a stock is unlikely to be more accurate than those of rival analysts. Only analysts with a unique insight will be rewarded. The discovery of good firms does an investor no good in and of itself when the rest of the market also knows those firms are good. The trick is to find firms that are better than everyone else’s estimate. —> Obtaining abnormal returns requires superior information or superior analysis or both.
Active versus passive management
These techniques are only economically feasible for managers of large portfolios. The small investor probably is better off investing in mutual funds.
By pooling resources in this way, small investors can gain from economies of scale.
EMH believe that active management is largely wasted effort and unlikely to justify the expenses incurred by managers of portfolios. Therefore, they advocate passive investment strategy that makes no attempt to outsmart the market.
Suppose AM leads to superior returns: If this is the case, everyone wants to active manager. Then the competition will reduce the margin and benefits, then people will move to passive management. Then the rewards shift to active management. There are waves, they are self-regulating, moves market participants in and out of the spheres.
Passive Management
A passive strategy aims only at establishing a well-diversified portfolio of securities without attempting
to find under- or overvalued stocks.
- is usually characterised by a buy-and-hold strategy.
As EMH indicates that stock prices are at fair levels, given all available information, it makes no sense to buy and sell securities frequently, which generates large trading costs without increasing expected performance.
Common Strategy: to create index funds which is a
fund designed to replicate the performance of a broad-based index of stocks.
Example: Vanguard’s 500 Index Fund
holds stocks in direct proportion to their weight in the Standard
& Poor’s 500 stock price index.
- obtain broad diversification
- relatively low management fees
- fees can be kept to a minimum because does not need to pay analysts to assess stock prospects and does not incur transaction costs from high portfolio turnover
- Typical annual fee for an active fund > 1% of assets. Expense ratios of passive funds are < 0.2% of assets.
Example: ETFs
are a close (and often lower-expense) alternative to indexed mutual funds. These are shares in diversified portfolios that can be bought or sold just like shares of individual stock
- investors who want to hold a diversified sector
Active Management
Example:
A retail investor with $100,000 benefits only by $1,000 from a 1% improvement in performance. But , a mutual fund with $1 billion benefits by $10 million from a same
amount of improvement. Thus, it is easier to justify active management at fund level.
- Even just an increase of 1% than passive
