CHAPTER TEN

MARKET EFFICIENCY

Practical Investment Management

Robert A. Strong
 Outline

 The Efficient Market Hypothesis

 Types of Efficiency
 Degrees of Informational Efficiency

 The Semi-Efficient Market Hypothesis

 Security Prices and Random Walks

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 Outline

 Anomalies
 The Low PE Effect
 Low-Priced Stocks

 The Small Firm and Neglected Firm Effects

 Market Overreaction

 The January Effect

 The Weekend Effect

 The Persistence of Technical Analysis

 Final Thoughts

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 The Efficient Market Hypothesis

Types of Efficiency
 Operational efficiency is a measure of how
well things function in terms of speed of
execution and accuracy.
 Informational efficiency is a measure of how
quickly and accurately the market reacts to
new information.
 The efficient market hypothesis (EMH) deals
with informational efficiency.

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 The Efficient Market Hypothesis

ASSUMPTIONS:

1. Investors are rational and value securities in a

rational manner.

2. To the extent investors are not rational, they trade

randomly, so irrationalities tend to cancel each other
out.

3. To the extent that investors are not randomly

irrational, they are met in the marketplace by rational
arbitrageurs, who eliminate any remaining irrational
pricing elements.

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 The EMH: Degrees of Informational Efficiency

Weak Form Efficiency

 This least restrictive form of the
EMH states that future stock
prices cannot be predicted by
analyzing prices from the past.
 In other words, the current stock price fully
reflects any information contained in the
past series of stock prices.

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 The EMH: Degrees of Informational Efficiency

Insert Figure 10-1 here.

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 The EMH: Degrees of Informational Efficiency

Insert Figure 10-2 here.

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 Tests of Weak Form Efficiency

autocorrelation tests filter rule tests

 An autocorrelation test investigates whether

security returns are related through time. A
runs test, for example, measures the
likelihood that a series of two variables is a
random occurrence.
 A filter rule is a trading rule regarding the
actions to be taken when shares rise or fall in
value by x%. Filter rules should not
work if markets are weak form efficient.
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 Tests of Weak Form Efficiency

Insert Table 10-3 here.

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 Tests of Weak Form Efficiency

Insert Table 10-4 here.

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 The EMH: Degrees of Informational Efficiency

Semistrong Form Efficiency

 Semistrong form efficiency states

that security prices reflect all
publicly available information.
 Event studies involving phenomena
occurring at known points in time, such as a
stock split or the announcement of corporate
earnings, are frequently used in tests of the
semistrong form of market efficiency.

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 The EMH: Degrees of Informational Efficiency

Strong Form Efficiency

 This most extreme version of the
EMH states that security prices
fully reflect all relevant public and
private information.
 Evidence does not support strong form EMH.
Insiders can make a profit on their
knowledge, and people go to jail, get fined,
or get suspended from trading for
doing so.

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 The Efficient Market Hypothesis

 The essence of the semi-efficient market

hypothesis is the notion that some stocks
are priced more efficiently than others. This
idea is sometimes used in support of the
thesis that the market has several tiers.

 The random walk idea states that

news arrives randomly, not that
stock prices move randomly.

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 Anomalies

 The low PE effect : Some evidence indicates

that low PE stocks outperform higher PE
stocks of similar risk.
 Low-priced stocks : Many people believe that
the price of every stock has an optimum
trading range.
 The small firm effect : Small firms seem to
provide superior risk-adjusted returns.

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 Anomalies
 The neglected firm effect : Neglected firms
seem to offer superior returns with
surprising regularity.
 Market Overreaction : It is observed that
the market tends to overreact to extreme
news. So, systematic price reversals can
sometimes be predicted.
 The January effect : In January, stock returns
are inexplicably high, and small firms’ stocks
do better than large firms’.

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 Anomalies

 The weekend effect : It is observed that

security price changes tend to be negative on
Mondays and positive on the other days of
the week, with Friday being the best of all.
 The persistence of technical analysis : If the
EMH is true, technical analysis should be
useless. Each year however, an immense
amount of literature based in varying degrees
on the subject is printed.

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 Anomalies

Final thoughts

From the individual investor’s perspective, the

US capital markets are informationally and
operationally quite efficient. Still, much is not
yet known about asset pricing, resulting in a
fair, but complicated financial battleground.

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 Review

 The Efficient Market Hypothesis

 Types of Efficiency
 Degrees of Informational Efficiency

 The Semi-Efficient Market Hypothesis

 Security Prices and Random Walks

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 Review

 Anomalies
 The Low PE Effect
 Low-Priced Stocks

 The Small Firm and Neglected Firm Effects

 Market Overreaction

 The January Effect

 The Weekend Effect

 The Persistence of Technical Analysis

 Final Thoughts

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