Efficient Capital Markets
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Efficient Capital Markets




Stock prices are in equilibrium or are “fairly” priced
If this is true, then you should not be able to earn
“abnormal” or “excess” returns, in expectation.
Efficient markets DO NOT imply that investors
cannot earn a positive return in the stock market.
They do mean that, on average, you will earn a
return that is appropriate for the risk undertaken
and there is not a bias in prices that can be
exploited to earn excess returns.
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What is the Efficient Market
Hypothesis (EMH)?



Securities are normally in equilibrium
and are “fairly priced.”
Investors cannot “beat the market”
except through good luck or better
information.
Levels of market efficiency



Weak-form efficiency
Semistrong-form efficiency
Strong-form efficiency
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3 Levels of Market Efficiency

Weak Form Efficiency


Semi-Strong Form Efficiency


Market prices reflect all historical price
information
Market prices reflect all publicly available
information
Strong Form Efficiency

Market prices reflect all information, both
public and private
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Weak-form efficiency


Can’t profit by looking at past price
trends. A recent decline is no reason
to think stocks will go up (or down) in
the future. There is no predictable
price pattern based on price path.
Real world evidence supports weakform EMH, but “technical analysis” is
still used by some people.
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Random Walk Theory


The movement of stock prices from day
to day DO NOT reflect any pattern.
Statistically speaking, the movement of
stock prices is random (skewed positive over
the long term).
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Random Walk Theory
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Efficient Market Theory

Technical Analysts

Forecast stock prices based on the watching
the fluctuations in historical prices (thus
“wiggle watchers”)
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Semistrong-form efficiency


All publicly available information is
reflected in stock prices, so it doesn’t
pay to over-analyze annual reports
looking for undervalued stocks.
Largely true in real world, but
superior analysts can still profit by
finding and using new information
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Semi-strong form efficiency

Fundamental Analysts


Research the value of stocks by delving into
detailed accounting and operating numbers.
These guys do not believe in semi-strong form
of market efficiency.
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Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and the
Market Index
40
30
10
0
-10
Funds
Market
-20
-30
19
92
19
77
-40
19
62
Return (%)
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Implications of market efficiency

You hear in the news that a medical research
company received FDA approval for one of its
products. If the market is semi-strong
efficient, can you expect to take advantage of
this information by purchasing the stock?

No – if the market is semi-strong efficient, this
information will already have been incorporated
into the company’s stock price. So, it’s probably
too late …
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2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
1966
1965
1964
1963
Hedge return across small and big
stocks.
SMB Factor %
60
50
40
30
20
10
0
-10
-20
-30
Year
14
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
1966
1965
1964
1963
Hedge return across high B/M and low
B/M stocks.
HML factor %
40
30
20
10
0
-10
-20
-30
-40
-50
Year
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Hedge return across low accrual stocks and
high accrual stocks.
Size adjusted return between lowest and hiest accrual deciles
0.6
0.5
0.4
Size adjusted return
0.3
0.2
0.1
0
69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
-0.1
-0.2
-0.3
Year of portfolio formation
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One-year-ahead hedge returns based on
capital investment levels. ©Donglin Li 2004
1 year ahead hedge returns between lowest and highest deciles of investment (d_PPE) firms

Go long the lowest investment
stocks.

Go short the highest investment
stocks.
0.35
0.3
0.25

Hedge Portfolio Return
0.2
12 month size adjusted buy and
hold hedge returns after May each
year.
0.15

0.1
Positive in 36 out of 39 years,
average 12.6%
0.05

0
1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-0.05
-0.1
Pattern is consistent with
market mispricing and
against semi-strong
efficiency.
Year
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Strong-form efficiency


All information, even inside
information, is embedded in stock
prices. That is, one cannot profit
even on private information.
Not true--insiders can gain by
trading on the basis of insider
information, but that’s illegal.
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Is the stock market efficient?

Empirical studies have tried to test the
three forms of efficiency.



Highly efficient in the weak form.
Reasonably efficient in the semistrong form.
Not efficient in the strong form. Insiders could
and did make abnormal (and sometimes
illegal) profits.
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What Makes Markets Efficient?

There are many investors out there
doing research


As new information comes to market, this
information is analyzed and trades are
made based on this information
Therefore, prices should reflect all available
public information, and almost instantly.
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Exercises
1. You purchase a stock expecting the price to rise 10% in
the coming year. After one year, the stock has actually
increased in value by 30%, due primarily to new
information released during the year concerning
unexpectedly higher sales. Which of the following
describes this result?
A) This is a violation of weak form efficiency.
B) This is a violation of semi-strong form efficiency.
C) This is a violation of strong form efficiency.
D) This is not a violation of market efficiency.
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2. You track the liquidity of companies and find that you can
consistently earn unusually high returns by purchasing the shares
of firms whose stock price falls below the cash value per share as
indicated on the balance sheet. Which of the following describes
this strategy?
A) This would not be a violation of market efficiency.
B) This would be a violation of weak form efficiency.
C) This would be a violation of semi-strong form efficiency.
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3. You have discovered from looking at charts of past stock prices that
if you buy just after a stock price has declined for three
consecutive days, you make money every time! This is clearly a
violation of _________ market efficiency.
A) weak form
B) semi-weak form
C) semi-strong form
D) strong form
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