Efficient Market Hypothesis Explained

Asset Pricing: EMH & Return Predictability

Aim of the Lecture

• The lecture aims to recap the main contents of the Efficient Market Hypothesis (EMH).
• It considers the predictability of stock returns in detail
• It encourages critical thinking about the practical implications and related evidence in academic journals.

Efficient Market Hypothesis

• Two Nobel Prize winners, Eugene Fama ("rationalist") and Richard Thaler ("behavioralist"), have insightful discussions on the EMH.

Introduction to the Efficient Market Hypothesis

• Maurice Kendall in 1953 found no predictable patterns in stock price changes
• Prices were equally likely to increase or decrease, irrespective of past performance.
• The EMH was developed and first tested in the late 1960s and early 1970s.
• Eugene Fama was awarded the 2013 Nobel Prize as the main formalizer of the EMH.
• The Efficient Market Hypothesis (EMH) stands as a cornerstone concept in modern finance.

What the EMH Means

First interpretation:

• The price is at the correct fundamental level, reflecting all available information.
• New information or "news" is the sole driver of price changes.
• Rational expectations lead individuals to make the best predictions, given available information.
• According to this view, EMH is equivalent to rational expectations in financial markets.

Second interpretation:

• Investors are unable to generate abnormal profits from successive bets.
• Jensen (1978) defined a market as efficient with respect to an information set if using information doesn't generate economic profits after adjusting for risk and costs.

EMH Formally

• All relevant information for predicting returns is denoted as Ωt, while market participants have an information set Ωp.
• In an efficient market: Ωp = Ωt.
• Investors possess full knowledge of the economic model determining future returns.
• They use all available information to make the best possible forecasts of expected returns.

Forecast Error

• Defined as the difference between actual and expected returns: ηPt+1 = Rt+1 – EP[Rt+1 | Ωt]
• Should average out to zero.
• Primarily influenced by reactions to new information.
• News is inherently unforecastable; therefore, price changes or returns cannot be predicted.

Mechanism Behind Market Efficiency

• It is competition as every participant is trying to obtain the best analysis and news, and adjust as quickly as they can.
• Higher investment returns motivate information gathering, making information a valuable commodity.
• The market shifts towards efficiency as informed individuals gain profits over the less informed.

EMH: A Strong Hypothesis

• EMH is a robust assertion suggesting that prices should consistently reflect accurate values across all asset classes.
• Markets are not able to predict direction by themselves
• Markets are not stable

EMH implications

Implications for Asset Prices and Markets

• Technical analysis (chartists): Aim to identify price patterns and markets trends in financial markets and attempt to exploit those patterns): Without merit.
• Fundamental analysis: Only beneficial if analysts can analyze data more effectively than competitors or possess exclusive information, which is often costly.

Implications for portfolio management

• Active portfolio management cannot consistently outperform passive management in risk-adjusted returns.
• Investors should prefer a low-cost, 'buy and hold' strategy focused on market indexes or ETFs.
• Portfolio managers can assist in constructing well-diversified portfolios, such as those with 30 low-correlation stocks.
• Age-based risk preferences: Older investors typically prefer safer portfolio options than younger investors.
• Individual risk profiles should be considered when creating portfolios.

Implications for tax considerations

• Some may favor portfolios emphasizing capital gains over interest income.
• In general, high-tax-bracket investors would like to tilt their portfolios towards capital gains instead of interest income - because this is taxed less.
• Tax-exempt municipal bonds are attractive to high-tax-bracket investors despite lower yields.

Implications for resource allocation

• If markets are inefficient, resources are invariably misallocated.
• Corporations with overvalued securities may acquire capital too cheaply from investors.
• Corporations with undervalued securities might not invest due to excessively high capital costs.

Implications for Corporate Finance

• EMH suggests companies, and companies should not delay physical investments expecting improved financing conditions because the most recent price is correct.
• Firm's cost of capital cannot be lowered by altering the mix of debt and equity finance.
• The Modigliani-Miller theorem states that in an efficient market, cost of capital does not depend on the structure is independent of capital structure
• The proportion of long-debt to short-dated debt will also not alter the cost of capital
• No benefits from issuing a long bond rather than rolling over a series of short bonds.

Politicial Interventions

• If prices reflect true values, there is no rational basis for political interventions in the market.
• Government intervention is justified only if the projected returns from its policies outweigh the associated risks.
• It is important to assess how far a market deviates from efficiency and the implications of government policy on economic welfare.

Empirical Testing of EMH

Testing EMH

• Tests of whether excess returns (or abnormal returns) are independent of the information set available at time t.
• Another test involves checking the significance of γ in the equation Rit+1 = E R it+1 + γ'Ωt + εt+1, which serves as a measure of information efficiency.
• Relevant information used might be historical returns or all publicly available ones.
• Survey data can offer insights into individual preferences over time but need to be carefully interpreted.
• Assume investors follow certain pricing rule when investment decision -> joint test.

Testing actual trading rules

• Test if actual trading rules can earn abnormal profits after taking into account the transaction costs and the risks of the trading activity.
• Need to decide what a suitable benchmark would be
• Look at performances versus mutual funds and similar.
• Test whether market prices always equal fundamental value, look at volatility.
• Calculate the asset's fundamental value is calculated using a dividend discount model.

Problems in EMH Tests

Reasons for Failure of the EMH in Empirical Tests:

• Data complications.
• Inappropriate choice of the model for equilibrium returns
• A true rejection of the original hypothesis (informational efficiency).

Additional complications

• Not being able to see expectations clearly
• Risk Premiums not easily visible
• Transactions can be hard to calculate
• Selection biases (only see failed strategies)
• Luck

Are Markets Efficient?

Arguments supporting EMH

• Evidence supports the notion that active management, on average, consistently fails to outperform the market.

Arguments against EMH

• Bubbles and fads: Stocks may deviate substantially from what fundamentals would indicate.
• Behavioral finance: Assumes that investors are only rational some of the time
• All information is not available all the time for all the investors, plus may be limits in how analysed.
• Trading risks can prevent quick corrections by informed investors, leading to sustained price deviations from fundamental value.
• Anomalies: There may be persistent anomalies from year to year, like the value effect.
• Grossman-Stiglitz (1980)-paradox: prices reflect information, there would be no reason to collect information.

Market efficiency

• Interpretations depend on who is stressing the idea.
• People who support EMH stress it being to hard to beat the market and argue that the the stock market crashes just show how hard it is to beat the market eventually.
• People who dont support EMH stress it being to important that prices should always reflect the fundamentals.
• EMH is a model - all models are wrong but some are useful.

Conclusion

• A competitive market implies that only superior information will lead to profit.
• Beating the market consistently is difficult.
• Intelligent and persistent investors may find higher returns.
• The Efficient Market Hypothesis (EMH) serves as an important foundation for asset pricing analyses.

Adaptive Market Hypothesis

• The AMH, advocated by Prof. Andrew Lo, integrates EMH with behavioral finance.
• Assumes mainly rational investors who sometimes overreact when markets are really volatile
• Assumes people act in self-interest make mistakes and learn form it.
• If strategy does not work they will try another one.
• According to the AMH, EMH can fail when economic shifts or shocks happen.

Predictability of returns

• Predicting what the market will do.

Predictability in general

• Aiming to understand the issues when predicting returns.
• More can be read in Cuthbertson and Nitzsche
• Common literature is time series analysis
• Also related to market timing / recessions / events
• Return predictability is also one of the presentation topics.

Few trivial issues

• Forecasts of the equity premium are subject to a wide margin of error and are not so easy to do.
• The only predictions done are for the long run as it takes account of data estimation / transaction costs and taxes
• Academic research generally does not discuss as the best predictors are not shared, as the potential profit is vast.

Predicting crises

• Important because crises can happen, are can result in big losses.
• People often change to more safer assets such as bonds
• "Why did nobody notice credit crisis" / " it becomes more obvious after one has happened"
• People claim they would have done / there have claims that credit crisis of 2007-2009 were able to foreseen.
• Is the non-acting on a such a predicted crisis a proof of one actually not having predicted a crisis?
• In conclusion, the stock market has falsely called for approximately the double the amount of the last recessions.
• Crisis prediction is not very good and happens so fast that it is not possible to react.

Simple Models

• predictability violates informational efficiency if under constant returns - thus it violates EMH.
• Rt+1 = k + γ'Ωt + εt+1 for early empirical tests, where Oto is the information available at time t
• a test γ' = 0 can be used to test for informational efficiency

These regressions vary depending on the information assumed:

• Data being used can alter interpretations, such as past returns, forecast errors, or the interest rate
• When data on past returns and past forecast errors examined together, gives rise to ARMA models such as ARMA(1,1) model
• If one if concerned with weak-form efficiency, the autocorrelation coefficients looked at.
• Violations of EMH may be found at short horizons, but not others.

Information efficiency tests

• Where the above information efficency tests show that information efficiency does not hold.
• It is very risky to bet on a prediction that may come from that information
• Worth investigating whether the prediction leads to more profits while trading

Univariate Test

• Under short horizons, expected to see constant returns.
• Statistical analysis of S&P500 Share Index (forture, 1991) with 2700 observation.
• The Monday trade day effect is statistically significant.
• The error term serially correlated with the MA(1), MA(4) and MA(5) terms.

EMH Tests

• Does the tested predictability shows fall of the EMH? at least in the "slacker form".
• Only 1% of the stock returns variability explained by the tested regression
• Market beating investment strategy may involve repeated short-selling of stock.
• Taking a bet where it is only 51/49
• The 'supernormal profits' can test the efficiency of EMH
• Should test if the portfolio allows trade of transaction costs and spreads.

Investment to market portfolio

• Using dividend yield, annual inflation, 3M interest rates can help explain market returns.
• Predictable as can explain 60% of yearly quarterly data variability
• Trade based on market conditions (positive invest in a market).
• beat passive strategy while not using transaction costs.
• Some ways of beating the market disappear as more invest.