Efficient Market Hypothesis (EMH)

• Efficient markets hypothesis (EMH) posits that major financial markets reflect all relevant information at any given time.
• Market efficiency research explores the link between stock prices and available information.
• A key question is whether investors can "beat the market," which EMH suggests is not possible except by chance if the market is efficient.

"Beating the Market"

• Abnormal return is the return exceeding that of investments with similar risk.
• "Beating the market" means consistently achieving a positive abnormal return.

Economic Forces Leading to Market Efficiency

• Rational investors use information rationally, avoiding systematic over or undervaluation of assets and do not earn excess returns.
• Independent deviations from rationality might cancel each other out, acting as noise that is diversified away.
• Arbitrageurs can correct imbalances if irrationality doesn't balance out, maintaining market efficiency.

Forms of Market Efficiency

• Weak-form efficient market: Past prices and volume figures cannot be used to beat the market, rendering technical analysis ineffective.
• Semi-strong-form efficient market: Publicly available information cannot be used to beat the market, making fundamental analysis less useful.
• Strong-form efficient market: No information, public or private, can be used to beat the market.

Market Efficiency and Profit Motive

• Competition and the profit motive drive markets toward efficiency.
• Even small performance enhancements can be very valuable due to the large dollar amounts involved, incentivizing the use of relevant information.

Implications of Market Efficiency

• It is difficult to predict future stock prices based on old information and past returns, though some studies show partial predictability.
• Trading costs can negate any potential profits from systems based on past returns.
• Buy-and-hold strategies involving broad market indexes are hard to outperform.
• Technical analysis is unreliable because past stock price paths are not guaranteed to repeat in the future.

Random Walks

• Stock prices change randomly over time, with increases as likely as decreases.
• Stock price behavior aligns with the concept of a random walk when there is no discernible pattern.

How New Information Impacts Stock Prices

• Stock prices reflect publicly available information, as stated by the semi-strong form of the EMH.
• Prices change as traders react to their view of the stocks future prospects which are influenced by news announcements.
• Efficient Market Reaction sees prices instantaneously adjust to new information.
• Delayed Reaction sees prices partially adjust to new information.
• Overreaction and Correction sees prices over-adjust initially but eventually correct to the appropriate price.

Event Studies

• Event studies are used to research the effects of news announcements on stock prices, focusing on the adjustment process and the size of the stock price reaction.
• Abnormal return is calculated as observed return minus expected return as a way to account for overall market news.

Cumulative Abnormal Returns (CARs)

• CARs are accumulated over a period to evaluate over or under-reaction to an announcement.
• According to EMH, the abnormal return should only relate to information released on that day.
• Researchers can see if there was over or under reaction to an announcement by examining CARS.

Informed and Insider Trading

• In a strong-form efficient market, no information can be used to beat the market.

Legality of Using Non-Public Information

• It is illegal in the U.S. and other countries to make profits from non-public information to maintain investor trust; enforced by the SEC.
• Informed trading is based on public information and analysis.
• Legal insider trading involves company insiders trading their company's stock while complying with SEC reporting rules, based on public information.

Illegal Insider Trading

• An insider is someone with material non-public information that could impact the stock price if known.
• Illegal insider trading involves a tipper (divulges information) and a tippee (uses information to profit).

Testing Market Efficiency

• Testing market efficiency is difficult due to the risk-adjustment problem, the relevant information problem, the dumb luck problem, and the data snooping problem.

Market Efficiency Generalizations

• Short-term stock price movements are hard to predict with accuracy.
• The market reacts quickly to new information, with little exploitable evidence.
• Beating the stock market is not obvious.

Market Efficiency Implications

• Security selection is less important, as securities are fairly priced.
• There is a small role for professional money managers.
• Timing the market is not sensible.

Professional Money Managers

• Professional money managers often struggle to outperform broad-based market indexes like the Vanguard 500 Index Fund.
• A high survivorship bias exists, yet managers still cannot outperform the market.

Role of Portfolio Managers

• In an efficient market, portfolio managers tailor portfolios to individual investors' needs, considering factors like age, tax bracket, and risk aversion.
• Portfolio managers are responsible for maintaining diversified portfolios.

Market Anomalies

• Anomalies are aspects of stock price behavior that are hard to reconcile with market efficiency.
• Market anomalies generally do not involve many dollars relative to overall market size.
• Anomalies are fleeting and disappear when discovered.
• Anomalies cannot be easily used for trading strategies due to transaction costs.

Specific Anomalies

• Day-of-the-Week Effect: Mondays tend to have a negative average return.
• January Effect: Small-cap stocks tend to have large returns in January.
• Turn-of-the-Year Effect: Returns bracketing the end of the year tend to be higher.
• Turn-of-the-Month Effect: Returns from the last day of the month and the following three days tend to be higher.
• Earnings Announcement Puzzle: The market price takes days to fully adjust to earnings surprises.

Bubbles and Crashes

• A bubble occurs when market prices rise far beyond rational analysis.
• Investment bubbles eventually burst resulting in assets plummeting in value.
• A crash is a significant, sudden drop in market values, often associated with a bubble.

Historical Crashes

• The Crash of 1929 had a lengthy aftermath.
• The Crash of 1987 saw the DJIA fall by a significant percentage in one day, leading to infrastructure changes like circuit breakers.
• The Asian Crash, beginning in 1990, turned into a long bear market.
• The Dot-Com Bubble and Crash involved investor euphoria over Internet IPOs and was followed by huge losses and failures.
• More recent crashes include the Crash of 2008 and the COVID-19 Crash of 2020.

Circuit Breakers

• Circuit breakers halt trading to prevent extreme market declines, triggered at 7%, 13%, and 20% drops in the S&P 500 index.