Efficient Market Hypothesis (EMH)

• The efficient market hypothesis (EMH) posits that security prices fully reflect available information.
• In an efficient market, investors should expect to obtain an equilibrium rate of return when buying securities.
• Observed prices in efficient capital markets reflect all available information, adjusting to new information.
• Financial asset prices reflect available information and respond only to unexpected news.
• The basis for the EMH is that stocks follow a random walk, which is an unpredictable path.
• Stock price changes are random and unpredictable, a consequence of investors seeking relevant information before others.
• Technical analysts disagree with EMH because it implies that you can't beat the market.
• A random walk is more restrictive, where successive stock returns are independent and identically distributed.
• Abnormal return relates to an event over one day after systematically removing components.
• Cumulative normal return is calculated from day 0 plus 3.
• Strong competition among investors ensures prices reflect information.
• Investment returns motivate information-gathering.
• Marginal returns on research activity suggest only managers of the largest portfolios will find it useful.

Versions of the EMH

• Weak-form EMH: Stock prices reflect all information contained in the history of past prices.
• Semi-strong-form EMH: Stock prices reflect all publicly available information.
• Strong-form EMH: Stock prices reflect all relevant information, including insider information.

Technical Analysis

• Technical analysis identifies mispriced securities by focusing on recurrent stock price patterns and buy/sell pressure proxies.
• Success depends on a sluggish response of stock prices to supply-and-demand factors.
• Weak-form EMH suggests technical analysis should be fruitless.
• Technical analysis focuses on past stock price movements rather than future profitability determinants.
• Key assumptions of technical analysis include markets discounting everything, price trends, and repeating history.

Fundamental Analysis

• Fundamental analysis assesses firm value based on earnings, dividends, interest rates, and risk evaluation.
• The goal is to find mispriced firms, better-than-expected firms, or undervalued troubled firms.
• Semi-strong-form EMH predicts that most fundamental analysis should be fruitless.
• Fundamental analysis analyzes stock based on the cash flow statement, balance sheet, annual statement, profit loss statement

Active & Passive Management

• Active Management: Attempts to beat the market through timing or security selection, an expensive strategy suited for large portfolios.
• Passive Management: Accepts EMH, uses index funds and ETFs, and employs a low-cost strategy.

Portfolio Management

• Portfolio management is still relevant even if the market is efficient due to diversification, tax considerations, and investor risk profiles.
• Inefficient markets lead to resource misallocation; overvalued securities raise capital too cheaply, undervalued securities miss opportunities.
• Efficient market ≠ perfect foresight market.

Event Study

• An event study measures the impact of an event on stock returns.
• Abnormal return is the difference between the stock’s actual return and its expected return without the event.
• Event studies examine stock price reactions to news.
• Positive earnings surprises lead to positive abnormal returns and a positive drift in stock price after the announcement.

Challenges To Testing EMH

• Magnitude Issue: Only managers of large portfolios can profit from minor mispricing.
• Selection Bias Issue: Only unsuccessful investment schemes are made public; good ones remain private.
• Lucky Event Issue: For every winner, there are many losers that are never heard of.

Returns Over Short & Long Horizons

• Short horizons: Momentum effect is the tendency of stocks short term performance to continue in following periods.
• Long horizons: Reversal effect is the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in following periods.

Predictors of Broad Market Returns

• Fama and French: Return on aggregate stock market is higher when dividend yield is high.
• Campbell and Shiller: Earnings yield can predict market returns.
• Keim and Stambaugh: Bond spreads can help predict broad market returns.

Semi-Strong Tests & Anomalies

• Efficient market anomalies are patterns of returns that contradict the EMH.
• P/E effect: Low P/E ratio stocks yield higher returns.
• Neglected-firm effect: Investments in lesser-known firms generate abnormal returns.
• Liquidity effect: Illiquid stocks tend to exhibit abnormally high returns.
• Price Drift: Delayed stock price response to earnings announcements leads to sustained abnormal returns.

Other Predictors of Stock Returns

• Volatility: Negatively associated with returns.
• Accruals and Earnings Quality: High accruals predict low future returns.
• Growth: Rapidly growing firms tend to have lower future returns.
• Profitability: Gross profitability predicts higher stock returns.
• q-factor: Tobin’s q is a good predictor of average stock returns.

Strong-Form Tests: Inside Information

• Insiders can trade profitably in their own stock, as documented.
• SEC requires insiders to register trading activity, which becomes public.

Interpreting the Anomalies

• Common feature: Small firms, low market-to-book firms, and recent “losers” have falling stock prices.
• Fama and French: Effects explained by risk premiums.
• Lakonishok, Shleifer, and Vishny: Effects are evidence of inefficient markets.
• Book-to-market, size, and momentum may be real anomalies.
• Anomalies should self-destruct in well-functioning markets.
• Liquidity and low trading costs facilitate efficient price discovery.

Bubbles and Market Efficiency

• Bubbles: Rapid price increases create expectations of further rises.
• Analysts tend to be overly positive and recommendations may be too expensive to exploit.
• Evidence does not support that professional managed portfolios consistently beat the market.
• The conventional performance benchmark today is a four-factor model.

Mutual Fund Performance

• Carhart: Finds minor persistence in relative performance across managers, but much of that persistence seems due to expenses and transaction costs.
• Bollen and Busse: Support for performance persistence over short horizons.
• Berk and Green: Skilled managers will attract new funds until the costs of managing those extra funds drive alphas down to zero.