Wk 9 Market Hypothesis Summary – Efficient Market Hypothesis
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Efficient Market Hypothesis
Ob 1: What is meant by an efficient market?
Efficiency can be defined under many context, for example, how efficient is a machinery will depend on how many inputs are required to produce a certain amount of output, the less input used, the more efficient the machinery is.
A financial market is said to be efficient if asset respond to relevant information instantaneously (or promptly) and accurately so that no one is able to use information that is already known by the market to earn abnormal returns net of transaction costs and should not deviate from its fundamental true & fair price for a long period of time.
By abnormal, it means the return net of transaction costs is more than justified by its level of risk. Abnormal profit cannot earned from trading based on information already known to the market.
Since information arrives at the market at any time and the content can be good or bad, stock price movements are unpredictable & follow a random walk.
Inefficient market occurs when security prices deviates from its fundamentals over a long period of time where investors can make money out of it.
From time to time, market may be inefficient, but over a long period of time, market is mostly efficient and financial crisis are rare events.
Market efficiency tests are regarded as a joint test for the validity of
market efficiency (what type of information is commonly known by the market and already reflected by the asset prices) &
asset pricing model used to compute expected return as a function of risk (what information is not yet reflected by the asset prices and waiting to be exploited by investors to earn an abnormal return beyond that suggested by an asset pricing model e.g. CAPM)
Regulators want the market to be efficient.
Investors also want the market to be efficient because they want to pay at a true & fair price for stocks at all times. However, investors at certain time may not want the market to be efficient so that they can take arbitrage profits from mispricing.
Three forms of market efficiency and information captured by stock prices (Proposed by Professor Eugene Fama):
Weak form – Asset prices reflect:
all historical price and trading volume data
Pattern inferred from the above time series
Academics believe that market should be at least weak form efficient
Semi-strong form – Asset prices reflect:
Information included in the weak form
All publicly available information regarding the prospects of a firm such as the release of:
Macro-economic data e.g. CAD, growth in GDP, CPI, unemployment figures etc.
Industry specific information: governments policies e.g. first home buyer grant, change in monetary policy etc.
(iii)
Firms specific information e.g. changes in dividend policy, pending lawsuit, earnings announcement, financial restructuring etc.
Academics believe that market should be semi-strong form efficient
Strong form – Asset prices reflect:
Information included in the weak and semi-strong forms
All private information known only by the company insiders. Directors, auditors and major shareholders may have 1st hand knowledge of corporate events unknown to the general public e.g. confidential information on proposed merger that may result in substantial cost savings and earnings growth that is not yet released to the stock exchange and media.
Ob 2: Are there any evidences to support and/or contradict the efficient market hypothesis?
Testing the Market for Weak Form Efficiency
Technical analysis (TAs)/charting: Chartists use historic price and volume data to identify momentum/recurring patterns for the design of trading rules to exploit the trends. The list of trading rules is endless but a few examples include:
Relative strength: buy/sell if the daily ratio of stock price to a market index has been ↑/↓ over the past week (5 working days). This momentum should continue or repeated in the following week.
Filter rule: buy if stock price ↑ by 5% above a prior low, hold the stock until its price ↓ by 5% from a subsequent high
TRIN ratio = Average volume of declining stocks/Average volume of advancing stocks. A TRIN ratio > 1 indicates net selling pressure and the market is considered as bearish. A TRIN ratio < 1 indicates net buying pressure and the market is considered as bullish.
Proponents of market efficiency (or academics) would say that technical analysis is a waste of time and cannot result in abnormal profits. This is because in a weak form, semi-strong or strong form efficient market, share prices should have already reflected historical price and volume data, and no-one can earn an abnormal return from strategies based in this information. Thus, we could also say that technical analysts or chartists do not believe in any form of market efficiency.
Evidence for weak form EMH: include any finding that trading strategies based on past price & volume data cannot be used to earn abnormal returns consistently (can only be used to support the weak form EMH but not other 2 forms). For example, Ball (1978), have suggested that the trading rules that result from technical analysis e.g. filter rule, can hardly beat a simply buy and hold strategy after taking transaction costs into account.
Anomalies (Evidence against the weak form EMH): Overreaction hypothesis suggests that we overreact to unexpected and dramatic new events. Findings by Choper, Lakonishok & Ritter (1992) on overreaction effect:
After constructing two types of portfolios based on stock performance in the last 5 years, they found that the loser portfolio containing worst performing stocks, on average, outperform winner portfolio containing best performing stocks, by 5 to 10% per year over the next 5 years.
The effect is stronger for smaller firms than for larger firms.
Explanations by proponents of EMH to this anomaly: