Chapter 12: CHAPTER OVERVIEW

Market Efficiency

A chapter on market efficiency is a natural sequence to the other two chapters in Part IV dealing with common stocks. It is also desirable for students to be familiar with this topic at this point so that market efficiency can be referred to when discussing other topics, such as technical analysis or fundamental security analysis. Chapter 1 begins by e!plaining the rationale for arguing that the market is efficient. It then proceeds to outline the classic three forms of market efficiency laid out by "ama in 1#$%& weak, semi'strong, and strong. ()idence on market efficiency is presented in some detail, starting with weak form efficiency and concluding with strong form efficiency. *ithin the weak form section the distinction is made between statistical tests and trading rule tests. In the semi'strong form section the concept of e)ent studies is de)eloped, along with abnormal returns. +trong form e)idence is de)eloped in considerable detail. Chapter 1 presents a thorough analysis of the implications of the (,-. .his is important in getting students to think about the real issues in)ol)ed here. .he implications for both technical analysis and fundamental analysis are considered, along with those for money managers. .his discussion ser)es as a good introduction to the last part of the chapter on possible market anomalies. Chapter 1 concludes with a complete discussion of possible market anomalies or e)idence of possible market inefficiency. .his e)idence is di)ided into earnings announcements /which is related to the une!pected earnings concept in Chapter 101, low P2( ratios, the si3e effect, the 4anuary effect, and the Value 5ine results. .he chapter ends with some conclusions about market efficiency. It is important for students to think about what they ha)e learned and the implications for their approach to in)esting in general and to such areas as technical analysis in particular. .he reference to the 6eane article /Financial 169

Analysts Journal, ,arch'April 1#781 is important. .his is a )ery desirable article to read with regard to efficient markets. 9)erall, most instructors will want to lea)e their students with a balanced )iew of the efficient market contro)ersy. Certainly, the e)idence on market efficiency cannot be ignored. It is too well documented, and augmented by such factors as the mediocre performance of professional fund managers. 9n the other hand, to date no one has conclusi)ely e!plained why the anomalies e!ist. .here may in fact be e!planations, but they ha)e not been widely accepted. ,uch work in this area remains to be done. +tudents must reali3e that in the area of efficient markets, as in numerous other areas of in)esting, there is no definiti)e answer, which is uni)ersally agreed upon and no definiti)e, uni)ersal statement that can be made. CHAPTER OBJECTIVES

.o e!plain the rationale for efficient markets and what the concept means. .o present the three forms of market efficiency and well known empirical e)idence concerning each of the three forms. .o consider the possible market inefficiencies /anomalies1 that ha)e been widely discussed to date.

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MAJOR CHAPTER HEA I!"S #C$ntent%& The C$ncept $f an Efficient Market

*hat is an (fficient ,arket: ;prices fully reflect information quickly and accurately< diagram and e!planation of ad=ustments to information> *hy the ?. +. ,arket Can @e (!pected to @e (fficient ;many participants, widely a)ailable information randomly generated, in)estors react quickly to the new information> .he International Perspecti)e ;would seem reasonable that most foreign markets are less efficient, but new e)idence suggests strong contemporaneous relationships among regional e!changes that are open at the same time> "orms of ,arket (fficiency ;weak, semistrong, strong>

E'i(ence On Market Efficiency

*eak'"orm ()idence ;statistical tests of price changes, trading rule tests, weak'form contra'e)idence> +emistrong'"orm ()idence ;e!planation of e)ent study, abnormal return, and cumulati)e abnormal return< re)iew of e)idence in)ol)ing stock splits, money supply changes, accounting changes, di)idend announcements, reactions to other announcements> +trong'form ()idence ;corporate insiders>

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I)p*icati$n% $f the Efficient Market Hyp$the%i%

"or .echnical Analysis "or "undamental Analysis "or ,oney ,anagement

E'i(ence $f Market An$)a*ie%

(arnings Announcements ;une!pected earnings, +?( analysis> 5ow P2( Aatios ;@asu studies, Breman arguments> .he +i3e (ffect ;small firms outperform large firms on risk'ad=usted basis> .he 4anuary (ffect ;the strong performance in 4anuary by small'company stocks> .he Value 5ine Aanking +ystem ;the performance of the 0 ranking categories> 9ther Anomalies ;brief mention of others, such as the neglected firm effect>

S$)e C$nc*+%i$n% A,$+t Market Efficiency ;6eaneCs arguments< the 9ctober 1#7$ market crash> POI!TS TO !OTE ABO-T CHAPTER 12 Ta,*e% an( .i/+re% "igures 1 '1 and 1 ' are to help students )isuali3e the ad=ustment process of stock prices to information and the cumulati)e le)els of efficiency, respecti)ely.

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"igure 1 'D on +?( categories is a striking figure. It shows that stocks do not fully ad=ust to quarterly earnings on the day of announcement, or shortly after. It also suggests that insiders are at work before the earnings are announced. "igure 1 'E shows the record for the Value 5ine ranks /without allowing for changes1 for the period 1#80' %%%1. It is an impressi)e record for such a long period. Value 5ine produces an e)en more impressi)e chart that does allow for changes, but such a procedure would ha)e generated a prohibiti)e portfolio turno)er rate, generating large transaction costs and short'term capital gains. "igure 1 '0 is a Value 5ine graph showing a comparison of the relati)e price performance of its Froup 1 stocks with four other strategies& low P2(, low cap /small si3e1, low price2book )alue, and low price2sales. .he period co)ered is 1#80' %%%. .he figure suggests that Value 5ineCs Froup 1 stocks outperformed the other four strategies by a significant amount. B$0e( In%ert% @o! 1 '1 pro)ides some international perspecti)e on the issue of market efficiency. .aken from The Economist, it focuses on @ritish portfolio managers and their success in outperforming the market, or lack of success. .his article is a good discussion of the issues, and shows that other countries, and other in)estment communities besides the ?nited +tates, must wrestle with the issue of market efficiency.

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A!SWERS TO E! 1O.1CHAPTER 2-ESTIO!S 12113 An efficient )arket is defined as one in which the prices of securities fully reflect all known information quickly and accurately. .he three /cumulati)e1 forms of market efficiency are& /a1 .he weak form, which states that market data /price and )olume information1 are reflected in current prices and should be of no )alue in predicting future price changes. .he semistrong form, which states that all publicly known and publicly a)ailable data are incorporated into stock prices. .he strong form, which states that prices fully reflect all information, public and nonpublic /i.e., information that can be restricted to certain groups1

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.he conditions for an efficient market to e!ist are& /a1 /b1 A large number of profit'ma!imi3ing in)estors who acti)ely participate in the market. Information that is costless and widely a)ailable to all at appro!imately the same time. Information that is generated in a random fashion such that announcements are basically independent of one another. In)estors that react quickly and accurately to new information.

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.hese conditions, which appear strict, are met quite closely in reality. "or e!ample, while information is not costless to produce, many market participants recei)e it GfreeH /of course, it has to be paid for in the commissions in)estors pay1.

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.echnical analysis relies hea)ily on known price and )olume data to predict future price changes. .he weak form of the (,- states that such data should already be reflected in current prices and therefore is of no )alue in predicting future price changes. +emistrong form tests are tests of the speed of price ad=ustments to public information. .hey seek to determine if in)estors can use publicly a)ailable information to earn e!cess returns. .wo different ways to test for weak form efficiency are& /a1 +tatistically test the independence of stock price changes, using such techniques as the serial correlation test and the signs test. .est specific trading rules that attempt to use past price and )olume data. 9ne well' known technical trading rule is the filter rule.

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Statistical significance results from formal tests in statistics, such as the calculation of the t statistic or the F statistic. +uch significance relates to the probability of accepting or re=ecting certain hypotheses. Economic significance refers to the possibility of being able to actually e!ploit a statistical dependence. After all costs are accounted for, can e!cess returns be earned through such e!ploitation:

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If the (,- is true, there are se)eral implications for in)estors& /a1 /b1 .echnical analysis has no )alidity or, at the )ery least, is seriously in doubt. Con)entional fundamental analysis''the type done by the ma=ority of analysts''is of little )alue, producing, at best, a)erage results. *hat is necessary is to perform clearly superior fundamental analysis.

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As for money management acti)ities, passi)e strategies would recei)e much more emphasis. Ie)ertheless, se)eral tasks must still be performed, such as di)ersifying, establishing and maintaining the risk le)el, and being concerned with the ta! status of the in)estor and his or her transaction costs.

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.he performance of mutual fund in)estors can be a test of semistrong efficiency in the sense that the managers may be using nothing other than the publicly a)ailable information to which all in)estors ha)e access. .he semistrong form is concerned with publicly a)ailable information. If the managers are unable to outperform the market /after all proper ad=ustments1 using this information, semistrong efficiency is supported. .he money management acti)ities for a portfolio manager who belie)es that the market is efficient will include at least the following& /a1 /b1 /c1 /d1 /e1 ascertain that the correct amount of di)ersification has been achie)ed achie)e a le)el of risk appropriate for the portfolio maintain the desired risk le)el o)er time be constantly aware of the ta! implications of the portfolio seek to reduce transaction costs.

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,arket anomalies are research findings that do not support market efficiency< that is, they are e)idence that inefficiencies do e!ist. .hese results are in contrast to what would be e!pected in a totally efficient market. *ell known anomalies include& /a1 the +?( effect, or the proposition that the ad=ustment of stock prices to quarterly earnings announcements occurs with a lag

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the P2( effect, or the proposition that low P2( stocks will, on a)erage, outperform high P2( stocks the si3e effect, or the proposition that small capitali3ation stocks ha)e earned higher risk' ad=usted returns than ha)e large capitali3ation stocks the seasonal effect, or the proposition that stocks ha)e e!hibited higher returns than e!pected in 4anuary. .his could also include the monthly effect, the weekend effect, and so forth. the Value 5ine results, which seem to indicate that this in)estment ad)isory ser)ice has classified stocks into fi)e groups that ha)e performed in a monotonic fashion, with )ery impressi)e results for the top /e!pected best performers1 two groups

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If all in)estors belie)ed that the market is efficient, and numerous participants ceased the pursuit and study of information about stocks, the result could be less market efficiency. 9b)iously, this statement would depend upon who is left to do the analysis, and how much they do. .he point of this question is to stimulate thinking about what is going on in the market in the way of information gathering and processing. +?( is directly related to fundamental analysis. "irst, earnings are a primary component of fundamental analysis. +econd, stock prices should be e!pected to ad=ust to any une!pected information contained in the earnings, and +?( captures this une!pected element. .he question is how long this ad=ustment takes. Iumerous types of e)ents or information ha)e been used in semistrong form tests. .he te!t discusses the following& stock splits, money supply changes, accounting changes, di)idend announcements, and reactions to )arious announcements such as ma=or world e)ents and the information in the G-eard in the +treetH column of The Wall Street Journal.

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9f course, earnings announcements ha)e been studied in regard to semistrong efficiency. @ecause +?( is discussed in other sections of the book, it was not included in the list discussed abo)e< howe)er, earnings announcements are one of the ma=or items to be studied in this regard. "urthermore, the other anomalies discussed later in the chapter, such as the P2( ratio, in)ol)e tests of semistrong efficiency. 9ther studies ha)e e!amined management forecasts, new issues, and options. "inally, as discussed elsewhere, tests of mutual fund performance can be regarded as semistrong efficiency tests. 121163 In an efficient market, prices reflect information quickly and accurately. In)estors could e!pect to buy and sell stocks at Gfairly')aluedH prices. Corporations could assume that when they make good decisions, or e!perience fa)orable e)ents, the corporationCs stock price will reflect this. "unds will be better allocated in such a market. "urthermore, resources would not be de)oted to pursuits of dubious or no )alue, such as technical analysis. IoJ ?pward trends are not inconsistent with weak form efficiency. Price changes can be random around an upward trend. Any random series can show clear trends. +ecurity analysts are still needed in an efficient market to disseminate information and )alue securities based on their estimates. If this were not being done, the market could become inefficient. .he important question here in)ol)es the number of analysts needed to perform this role, and the type of analysis they do. .he fact that a mutual fund, or any portfolio, has outperformed the market for the last four years is not a )ery significant finding. .o be potentially significant, we must show first of all that the results are on a risk'ad=usted basis, and that all e!penses relati)e to a buy'and'hold strategy has

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been accounted for. ?ntil this is done, the statement is basically meaningless. 1211:3 .o conduct a fair test of a technical trading rule, certain ad=ustments must be made, including& /a1 /b1 /c1 /d1 1212;3 risk transaction and other costs consistency out'of'sample )alidity

.i*ter r+*e% are related to timing strategies, indicating when to be long or short. "ilter rules should be compared with a buy'and'hold strategy. An analysis of specialists is a test of strong form efficiency. .hey possess information /such as a knowledge of limit orders1 not publicly a)ailable, and the issue is whether they can earn e!cess returns. +ome researchers writing about the si3e anomaly, in particular @an3 and Aeinganum, ha)e attributed it to a misspecification of the CAP,. +i3e may be a pro!y for some other )ariable, or may be highly correlated with other )ariables and be picking up part of their effects. Birectly testing the profitability of insider trading in)ol)es strong form efficiency. And tests of insider acti)ity indicate that they do earn returns in e!cess of those e!pected. In)estors can use the insider reports that must be filed with the +(C and are, therefore, publicly a)ailable. +e)eral ad)isory ser)ices report these transactions. A test of whether in)estors can use such publicly a)ailable information to earn e!cess returns is a test of semistrong efficiency.

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,utual fund data can be used to test strong form efficiency by assuming that mutual fund managers are in possession of non'public information. +ince they are full'time managers with staffs to assist

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them, ha)e adequate resources for research, and offer the potential for brokers to earn large commissions, it is reasonable to e!pect them to disco)er information more quickly than the a)erage in)estor. ,utual fund data can also be used to test semistrong form efficiency. If all publicly a)ailable information is quickly reflected in stock prices, and mutual funds use only publicly a)ailable information, they should not be able to earn e!cess returns. 121263 If the market is semistrong efficient, you would e!pect to see an immediate ad=ustment at the time the information becomes a)ailable. 9n a graph with stock price as the )ertical a!is and time as the hori3ontal a!is, think of the price between period % and period 1 as a hori3ontal line e!tending from the stock price on the )ertical a!is. At time period 1, the price would ad=ust immediately to the new /and assumed1 higher price< therefore, on the graph there would be a small )ertical line representing this immediate ad=ustment to the new and higher =ustified le)el. "or completeness in this simple situation, you could then draw a new hori3ontal line representing the price between period 1 and period . P r i c e K K K K LMMMMM NMMMMMO K K PMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMM.ime % 1 D

If there is a lag in the ad=ustment of the price to this information, there would not be the sharp, immediate ad=ustment at period 1. Aather, this ad=ustment would be gradual.

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.he +?( analysis is not related to technical analysis, which uses market data in an attempt to forecast future price changes. +?( is part of fundamental analysis because it is concerned with the ad=ustment of stock prices to earnings announcements, and earnings are a primary fundamental )ariable. .he standard definition of an operationally efficient market is one with the lowest possible prices for transactions ser)ices. .his is different from the informational efficiency discussed in this chapter. According to 6eane, an operationally efficient market is one in which only a relati)ely few in)estors ha)e the skill to detect a di)ergence between price and semistrong )alue. .hese few in)estors can earn economic rents. +uch opportunities are not a)ailable for most in)estors.

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a3 .he notion that stock prices already reflect all a)ailable information is referred to as the efficient market hypothesis /(,-1. It is common to distinguish among three )ersions of the (,-& the weak, semi'strong, and strong forms. .hese )ersions differ by their treatment of what is meant by Gall a)ailable information.H .he weak'form hypothesis asserts that stock prices already reflect all information that can be deri)ed from studying past market trading data. .herefore, Gtechnical analysisH and trend analysis, etc., are fruitless pursuits. Past stock prices are publicly a)ailable and )irtually costless to obtain. If such data e)er con)eyed reliable signals about future stock performance, all in)estors would ha)e learned already to e!ploit such signals. .he semi'strong form hypothesis states that all publicly-available information about the prospects of a firm must be reflected already in the stockCs price. +uch information includes, in a ition to past prices, all fundamental data on the firm, its

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products, its management, its finances, its earnings, etc., that can be found in public information sources. .he strong'form hypothesis states that stock prices reflect all information rele)ant to the firm, even inclu ing information available only to company !insi ers"# .his )ersion is an e!treme one. 9b)iously, some GinsidersH do ha)e access to pertinent information long enough for them to profit from trading on that information before the public obtains it. Indeed, such trading ' not only by the GinsidersH themsel)es, but also by relati)es and2or associates ' is illegal under rules of the +(C. "or the weak'form or the semi'strong forms of the hypothesis to be )alid does not require the strong' form )ersion to hold. If the strong'form )ersion was )alid, howe)er, both the semi'strong and the weak'form )ersions of efficiency would also be )alid. ,3 ()en in an efficient market, a portfolio manager would ha)e the important role of constructing and implementing an integrated set of steps to create and maintain appropriate combinations of in)estment assets. 5isted below are the necessary steps in the portfolio management process& 11 Counseling the client to help the client to determine appropriate ob=ecti)es and identify and e)aluate constraints. .he portfolio manager together with the client should specify and quantify risk tolerance, required rate of return, time hori3on, ta!es considerations, the form of income needs, liquidity, legal and regulatory constraints, and any unique circumstances that will impact or modify normal management procedures2goals. ,onitoring and e)aluating capital market e!pectations. Aele)ant considerations, such as economic, social, and political conditions2e!pectations are factored into the

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decision making process in terms of the e!pected risk2reward relationship for the )arious asset categories. Bifferent e!pectations may lead the portfolio manager to ad=ust a clientCs systematic risk le)el e)en if markets are efficient. D1 .he abo)e steps are decisions deri)ed from2implemented through portfolio policy and strategy setting. In)estment policies are set and implemented through the choice of optimal combinations of financial and real assets in the marketplace ' i.e., asset allocation. ?nder the assumption of a perfectly efficient market, stocks would be priced fairly, eliminating any added )alue by specific security selection. It might be argued that an in)estment policy which stresses di)ersification is e)en more important in an efficient market contest because the elimination of specific risk becomes e!tremely important. ,arket conditions, relati)e asset category percentages, and the in)estorCs circumstances are monitored. Portfolio ad=ustments are made as a result of significant changes in any or all rele)ant )ariables.

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A!SWERS TO E! 1O.1CHAPTER PROB<EMS 12313 +?( Q /Actual (arnings ' (!pected (arnings1 2 +tandard (rror of (stimate Q /.0% ' .D%1 2 .%0 Q E.%

.his would be a good buy on the basis of the research that has been done because +?( )alues o)er D.% ha)e, on a)erage, been associated with positi)e e!cess returns, and the higher the +?( )alue, other things equal, the better. A +?( of E or better would put this stock in the top decile of +?( stocks based on pre)ious studies.

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