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Chapter 10
EFFICIENT CAPITAL MARKETS
Chapter 10 Questions
What do we mean when we say that capital
markets are efficient?
Why should capital markets be efficient?
What factors contribute to an efficient
market?
Given the overall efficient market hypothesis
(EMH), what are the three subhypotheses
and what are the implications of each of
them?
Chapter 10 Questions
How does one test the three efficient market
subhypotheses, and what are the results of
the tests?
For each set of tests, which results support
the EMH and which indicate an anomaly
related to the hypothesis?
What are the implications of the results for
stock strategies and portfolio managers?
What is the evidence related to the EMH for
markets in foreign countries?
Efficient Capital
Markets
In an efficient capital market, security
prices adjust rapidly to the arrival of new
information, therefore the current prices
reflect all information about the security
Whether markets are efficient has been
extensively researched and remains
controversial
Why does it matter?
If prices do fully reflect all current
information, it would not be worth an
investor’s time to use information to find
undervalued securities.
If prices do NOT fully reflect information,
FIND AND USE THAT INFORMATION,
and perhaps you will be able to make a
killing in the market.
Investing and Market
Efficiency
Would stock selection
amount to throwing
darts at a wall in an
efficient market?
Hardly! Risk still
matters. We would still
want to research the
risk-return properties of
securities.
Why Should Capital
Markets Be Efficient?
What would be the ingredients of an
“informationally” efficient market?



A large number of profit-maximizing participants
analyze and value securities
New information regarding securities comes to the
market in a random fashion
Profit-maximizing investors adjust security prices
rapidly to reflect the effect of new information

Price adjustments are unbiased – correct on average.
Under these conditions, a security’s price
would be appropriate for its level of risk.
Alternative Efficient
Market Hypotheses
The various forms of the efficient market
hypothesis differ in terms of the
information that security prices should
reflect.
Weak-form EMH
Semistrong-form EMH
Strong-form EMH
Weak-Form EMH
Current prices fully reflect all securitymarket information, including the
historical sequence of prices, rates of
return, trading volume data, and other
market-generated information
This implies that past rates of return and
other market data should have no
relationship with future rates of return
Implications of the
Weak-From EMH
Examining recent
trends in price and
other market data in
order to predict future
price changes would be
a waste of time if the
market is weak-form
efficient.
A lot of people do price
charting and other
forms of “technical
analysis.”
Semistrong-Form EMH
Current security prices reflect all public
information, including market and nonmarket information
This implies that decisions made on
new information after it is public should
not lead to above-average risk-adjusted
profits from those transactions
Implications of the
Semistrong-Form EMH
If the market is efficient
in this sense,
information in The Wall
Street Journal, other
periodicals, and even
company annual reports
is already fully reflected
in prices, and therefore
not useful for predicting
future price changes.
Strong-Form EMH
Stock prices fully reflect all information from
public and private sources
This would require perfect markets in which
all information is cost-free and available to
everyone at the same time (which is clearly
not the case)
Implication: Not even “insiders” would be able
to “beat the market” on a consistent basis
Tests and Results:
Weak-Form EMH
Two Approaches
Tests of “statistical memory” in security
prices and returns
Tests of trading rules
Tests and Results:
Weak-Form EMH
Statistical tests of independence
between rates of return

Autocorrelation tests
Mostly support the weak-form EMH and
indicate that price changes are random
 Some studies using more securities and more
complicated tests cast some doubt


Runs tests

Indicate randomness in prices
Tests and Results:
Weak-Form EMH
Comparison of trading rules to a buyand-hold policy
Some filter rules seem yield aboveaverage profits with small filters, but only
before taking into account the substantial
transactions costs involved
 Trading rule results have been mixed, and
most have not been able to beat a buyand-hold policy

Tests and Results:
Weak-Form EMH
Problems with tests
Cannot be definitive since trading rules can
be complex and there are too many to test
them all
Testing constraints



Use only publicly available data
Should include all transactions costs
Should adjust the results for risk (an apparently
successful strategy may just be a very risky
strategy)
Conclusions:
Weak-Form EMH
Results generally support the weakform EMH, but results are not
unanimous
Some strategies too subjective to test
 Not all trading rules are disclosed


If you had a trading strategy that worked, would
you reveal it?!
Reality Check!
If someone writes a
book on how to “beat
the market,” you can
bet that book sales are
more lucrative than the
trading strategy!
Even if it once worked,
if it’s widely known, it
won’t work any more!
Don’t quit your day job
to trade on-line using a
published strategy!
Tests and Results:
Semistrong-Form EMH
Three different groups of tests:
Time series analysis using public information
Event studies examine how fast stock prices
adjust to significant economic events
Cross-sectional analysis of returns based on
public information
Tests involve the estimation of “abnormal
returns,” where expected abnormal returns
are zero in an efficient market.
Tests and Results:
Semistrong-Form EMH
Tests often involve “market-adjusted returns,”
created by subtracting the market return from
the security’s return, thereby defining a
security’s “abnormal return:”
ARit = Rit - Rmt
where:
 ARit = abnormal return on security i during period t
 Rit = return on security i during period t
 Rmt = return on a market index during period t
Tests and Results of
Semistrong-Form EMH
Another definition of abnormal return is a
“risk-adjusted return” or “market model” which
adjusts for the security’s own required rate of
return, given its systematic risk (as measured
by beta):
ARit = Rit - E(Rit)
where:
 E(Rit) = the expected rate of return for stock i
during period t based on the market rate of return
and the stock’s normal relationship with the market
(its beta)
Tests and Results:
Semistrong-Form EMH
Time series tests for predictability of returns and
profit opportunities
Short-horizon returns have shown very
limited predictability
Long-horizon returns analysis shown some
predictability of returns based on:



Dividend yield (D/P)
Default spread
Term structure spread
Tests and Results:
Semistrong-Form EMH
Time series tests for predictability of returns and
profit opportunities
Quarterly earnings reports information

Unanticipated earnings changes or “earnings
surprises” are not immediately reflected in security
prices
The January Anomaly (A “calendar” effect)

Large returns in January present opportunities to
purchase in December, and sell in January and
earn abnormal returns.
Tests and Results:
Semistrong-Form EMH
Time series tests for predictability of
returns and profit opportunities
Other calendar effects
Monthly effect
 Day-of-the-week effects


Monday returns were significantly negative
Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
In an efficient market, all securities should
have equal risk-adjusted returns
Studies examine alternative measures of size
or quality as a tool to rank stocks in terms of
risk-adjusted returns

These tests include a joint hypothesis of both
market efficiency and the asset pricing model used
to generate abnormal returns
Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
Price-earnings ratios



Examine historical P/E ratios and returns
Low P/E stocks had higher risk-adjusted returns
than high P/E stocks
Publicly available P/E ratios could be used for
abnormal returns
Price-earnings/Growth ratios

Mixed results
Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
The size effect


The risk-adjusted returns for extended periods
indicate that the small firms consistently
experienced significantly larger risk-adjusted
returns than large firms
Abnormal returns could occur because either
markets are inefficient or the market model is not
properly specified and provides incorrect
estimates of risk and expected returns (joint test)
Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
The size effect

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Adjustments for riskiness of small firms did not
explain the large differences in rate of return
The impact of transactions costs of investing in
small firms is substantial (takes away the
differential with a short-term trading strategy)
Even after risk and transaction costs, small firms
outperform large firms with annual trading
The small-firm effect is not stable
Firm size is an important anomaly
Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
Neglected firms and trading activity
Is there an effect related to the number of
analysts following a stock and how
frequently a stock trades?
 Mixed results, mostly any apparent effects
explained by taking the size effect into
consideration

Tests and Results:
Semistrong-Form EMH
Predicting cross-sectional returns
Book value-market value (BV/MV) ratio

Significant positive relationship between the
current values for this ratio and future stock
returns
Although various measures including the P/E
ratio seem to help predict future returns, the
size effect and BV/MV ratio have the greatest
predictive ability.
Tests and Results:
Semistrong-Form EMH
Event studies
Event studies examine abnormal returns
surrounding various events
The EMH is that abnormal returns are zero
Stock split studies

Mostly show no positive impact on returns
because of a stock split
Initial public offerings

Significant IPO underpricing, but it quickly adjust
away in the first day, consistent with the EMH
Tests and Results:
Semistrong-Form EMH
Event studies
Exchange listings

Some evidence of short-term profit potential
following the “listing announcement”
Unexpected world events and economic
news

Quickly reflected in security prices, do not provide
opportunities
Tests and Results:
Semistrong-Form EMH
Event Studies
Announcements of accounting changes

Quickly reflect in security prices and do not seem
to provide abnormal profit opportunities
Corporate events


Prices react quickly to announcements of
mergers, financing decisions, etc.
No systematic profit opportunities
Summary on the
Semistrong-Form EMH
Evidence is mixed
Strong support of the EMH from numerous
event studies with the exception of exchange
listing studies
Strong evidence against the EMH from both
time series and cross-sectional studies


Dividend yields, earnings surprises, calendar
effects
The size effect, BV/MV, P/E ratios, etc.
Tests and Results:
Strong-Form EMH
Testing Groups of Investors
Tests usually center on whether any
group of investors consistently earn
abnormal profits.
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
Tests and Results:
Strong-Form EMH
Corporate Insiders
Insiders include major corporate officers,
directors, and owners of 10% or more of any
equity class of securities
Insiders must report to the SEC each month
on their transactions as insiders
These insider trades are made public about
six weeks later and allow for study
Tests and Results:
Strong-Form EMH
Corporate Insiders
Mixed results
Corporate insiders generally experience
above-average profits especially on purchase
transactions

This implies that many insiders had private
information from which they derived aboveaverage returns on their company stock
Later studies indicate that insiders may no
longer be able to generate abnormal returns
Tests and Results:
Strong-Form EMH
Stock Exchange Specialists
Specialists have monopolistic access to
information about unfilled limit orders
You would expect specialists to derive
above-average returns because of their
superior information, and this appears
to be the case.
Tests and Results:
Strong-Form EMH
Security Analysts
Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
This looks at whether, after a stock selection
by an analyst is made known, a significant
abnormal return is available to those who
follow their recommendation
Tests and Results:
Strong-Form EMH
Security Analysts
The Value Line Enigma

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Firms ranked 1 for “timeliness” substantially
outperform the market; firms ranked 5
substantially underperform the market
Prices now adjust quickly to changes in rankings
Net of transaction costs, rankings do not appear to
have value in terms of producing abnormal returns
There is some evidence of superior analysts
who apparently posses private information
Tests and Results:
Strong-Form EMH
Professional Money Managers
Trained professionals, working full time at
investment management
If any investor can achieve above-average
returns, it should be this group
If any non-insider can obtain inside
information, it would be this group due to the
extensive management interviews that they
conduct
Tests and Results:
Strong-Form EMH
Professional Money Managers
Most tests examine mutual funds
Risk-adjusted returns of mutual funds
generally show that most funds did not
match aggregate market performance
Summary on the
Strong-Form EMH
Mixed results
Some strong support

Professional money managers
Some strong evidence against the EMH

Tests for corporate insiders and stock exchange
specialists do not support the hypothesis

Both groups seem to have monopolistic access to
important information and use it to derive above-average
returns
Behavioral Finance
A growing field of study in finance.
Rather than assuming ultra-rational behavior,
the area of behavioral finance seeks to
incorporate how humans actually behave.


Incorporates the ways in which psychology may
impact investment decisions
It has been useful for explaining various
“anomalies” that we observe in decision-making
that are difficult to reconcile with rationality
Behavioral Finance
Using psychological biases to explain behavior

Why do investors persistently “ride” losers and sell
winners?
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Why do investors display overconfidence in
forecasts?
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Can be explained by prospect theory
Can be explained by the confirmation bias
Why do investors tend to put more money into
failing investments?

Can be explained by the escalation bias
Implications of Market
Efficiency
Overall results indicate the capital markets
are efficient as related to numerous sets of
information
There are substantial instances where the
market fails to rapidly adjust to public
information


So, what techniques will or won’t work?
What do you do if you can’t beat the market?
Efficient Markets
and Technical Analysis
Assumptions of technical analysis directly
oppose the notion of efficient markets
Technicians believe that stock prices move in
patterns that persist and are predictable to
the informed investor.
Technical analysts develop systems to detect
trends and patterns in prices
If the capital market is weak-form efficient, a
trading system that depends on past trading
data can have no value
Efficient Markets and
Fundamental Analysis
Fundamental analysis involves determining
an investment’s intrinsic values based on
company and economic “fundamentals”

The intrinsic value is compared to the market price
to determine whether the investment is
undervalued or overvalued
In an efficient market, prices already reflect
public information, so determining “intrinsic
value” using that information is not a
worthwhile exercise
Efficient Markets and
Fundamental Analysis
Past vs. Future

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The EMH, importantly, considers the incorporation
of available information, which is primarily historic
in nature.
Much of what is involved in fundamental analysis,
including aggregate market analysis and industry
analysis, involves estimating future values.
Superior analysts are those who will be better at
predicting this uncertain future.
Efficient Markets and
Portfolio Management
Does active portfolio management pay
off?

Research indicates that most money
managers do keep pace with the market
Certainly with a superior analyst,
recommendations should be followed

Opportunities may be present in smaller,
neglected stocks (although risk must be
taken into account)
Efficient Markets and
Portfolio Management
Without superior analysts, passive
management may outperform active
management
Build a globally diversified portfolio with a
risk level matching client preferences
 Minimize transaction costs (taxes, trading
turnover, liquidity costs)

The Rationale and
Use of Index Funds
Efficient capital markets and a lack of
superior analysts imply that many portfolios
should be managed passively (so their
performance matches the aggregate market,
minimizes the costs of research and trading)
Institutions created market (index) funds
which duplicate the composition and
performance of a selected index series
Insights from Behavioral
Finance
There may be trading opportunities
created by persistent investor biases
and “herd mentality”
Supports the notion of contrarian
investment strategies
 Some mutual funds employ behavioral
finance strategies

Efficiency in European
Equity Markets
Hawawini study indicates behavior of
European stock prices is similar to U.S.
common stocks
Despite market differences, most results
are essentially similar
 Appropriate to assume a similar level of
efficiency in European markets to those in
the United States
