Efficient Capital Markets (Eugeme Fama, 1970) Efficient financial markets are those markets that do not allow

investors to earn above-average returns without accepting above-average risks. Theres no free lunches. Stated that security markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. When information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. It lead to either technical analyst (study past stock prices) nor fundamental analyst (analyze financial information) would enable an investor achieve returns greater than those that could be obtained due to a random walk by holding a randomly selected portfolio of individual stock. Random walk relates to the EMH as its logic says that the flow of information of today will only be reflected in todays stock price and tomorrows Price change will reflect only tomorrows news (with independence of todays price changes) Market Efficiency Burton Malkiel does the following statements regarding market efficiency. Markets are efficient. They dont allow investors to earn above-average risk adjusted returns. There are no $100 bills lying around for the taking (ergo, no free lunches) Though Inexistence of perfect market pricing (i.e. bubbles). Mainly due to psychological factors influencing securities prices. True value will win in the end

Key words: reflected information, technical analysis, fundamental analysis, random walk, no free lunches, no perfect market pricing, bubbles.

Patterns of possible predictability Nonrandom Walk

Short-Term Momentum. Momentum strategies refer to buying stocks that display positive serial correlation and/or positive relative strength. In the long-run these dont outperform the market due to trading expenses. Its randomness was first explained by saying that the stock market has no memory, thus, past stock price are not useful in divining how these will behave in the future. Its non-randomness could be explained by two studied factors: Sophisticated statistics. Techniques show that short-run serial correlations arent zero. Though, Burton criticizes that theres difference between mathematical significant and economic significant

Bandwagon effect. Tendency of investors to underreact to new information regardless of the underlying evidence.

Long-Run Return Reversals A study argues that investors are subject to waves of optimism and pessimism that cause prices to deviate systematically from their fundamental values and later to exhibit mean reversion. This overreaction could be explained due to investors are systematically overconfident in their ability to forecast either future stock prices or corporate earnings, (Kahneman and Tversky, 1979). These findings support contrarian strategies way of investing. Another explanation for return reversal could be due to volatility of interest rates and the tendency of interest rates to be mean reverting over time. Burton concludes that there was a statistically strong pattern of return reversal, but not one that implied an inefficiency in the market that would enable investors to make excess returns. Seasonal and Day-of-the-Week Patterns The so called January effect states that an equally weighted stock index have tended to be unsually high during the first two weeks of the year. There also are the Monday returns and some patterns in returns around the turn of the month as well as around holidays. Though, these not appear to offer arbitrage opportunities that would enable investors to make excess risk adjusted returns as they are transactions costs involved in trying to exploit them are higher.

Predictable Patterns Based on Valuation Parameters

Predicting Future Returns from: Initial Dividend Yields The use of dividend yields to predict future returns has produced very low forecasted returns. It could be due to U.S. corporations behavior may have changed. Therefore it may not be as meaningful as in the past as a useful predictor of future equity returns since companies are more likely to do a share repurchase program. In addition, the Dogs of the Dow Strategy no longer works. That is, purchasing a portfolio of individual stocks with the highest dividend yields in the market wont earn a particularly high rate of return. Price-Earnings Multiple It states that investors have tended to earn larger long-horizon returns when purchasing the market basket of stocks at relatively low P/E ratios.

Though experiments taken by experienced investors suggest that assessment on this basis are far from predict stock market return. High-yield corporate bonds & short rates Both are also claim to be predictable patterns.

Patterns Based on Firm Characteristics and Valuation Parameters

The Size Effect Thats the tendency over long periods of time for smaller-company stocks to generate larger returns that those of large-company stocks. Burton states that Fama and French suggest that size may be a far better proxy for risk than beta (according to CAPM and its correct measure of risk beta). Though, in most world markets, large-caps stocks produced larger rates of return perhaps due to the growing institutionalization of the market that led portfolio manager to prefer large caps for its higher liquidity. In addition it could also be explained as the Survivorship bias that is the tendency for failed companies to be excluded from performance studies because they no longer exist. Value Stocks Method of identifying value stocks are low P/E and low P/BV ratios (below the averages for the whole stock market). Studies suggest that value stocks have higher returns than so-called growth stocks. That is due to the tendency of investors to be overconfident of their ability to project high earnings growth and end up overpaying for the growth stocks (high P/E) or fail to live up the expectations of a companys assets (high P/BV). Burton though states that such findings do not necessarily imply inefficiency but that they actually indicate a failure of the CAPM to capture all dimension of risk (i.e. firms in financial distress are likely to sell at low P/BV) The Equity Risk Premium Puzzle This puzzle is used to suggest that markets are less than fully rational. It refers to the lack of consensus among economists on why demand for government bonds( which return much less than stocks) is as high as it is which seems inconsistent with the actual riskiness of common stocks, and even why the demand exists at all. Conclusions on Patterns Burton concludes that any truly repetitive and exploitable pattern that can be discovered in the stock market and can be arbitraged away will self-destruct (i.e. January effect, tendency on

selling earlier and earlier than the first 5 days due to its publicity). The more potentially profitable a discoverable pattern is, the less likely it is to survive.

Seemingly Irrefutable Cases of Inefficiency

The Market Crash of October 1987 The drop in prices could be explained by an increase from 9 to 10.5% of long-term T-bonds, a threat by the Congress to impose a merger tax that almost prohibited merger activity (in the middle of a merger boom), a threat by Secretary of the Treasury to further fall in the exchange value of the dollar, etc. Burton states that share prices can be highly sensitive as a result of rational responses to small changes in interest rates and risk perceptions. Therefore declines during October 1987 could be explained both by psychological factors and the external environment (which rationally would explain the decline). The Internet Bubble of the Late 1990s Many Wall Streets most respected firms were recommending Internet stocks to the firms institutional and individual clients as being fairly valued based on unsustainable growth rate projections. It leads professionals to overweight their portfolios with high-tech stocks. Even Alan Greenspan was singing the praises of the new economy. As a result, there were no profitable and predictable arbitrage opportunities available during the Internet bubble and while stock prices eventually did adjust to levels that more reasonably reflected the likely PV of their cash flows. Its said that asset prices did remain incorrect for a period of time reflecting the overflow of new capital to Internet companies which led market to temporarily failed in its role as an efficient allocator of equity capital Other Illustrations of Irrational Pricing