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Market Efficiency

Market Efficiency

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Published by Dani Ordinary

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Published by: Dani Ordinary on Jul 25, 2012
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Market Efficiency
Market efficiency - championed in theefficient market hypothesis(EMH) formulated by EugeneFama in 1970, suggests that at any given time, prices fully reflect all available information on aparticular stock and/or market. Thus, according to the EMH, no investor has an advantage inpredicting a return on a stock price because no one has access to information not alreadyavailable to everyone else.The assumption of market efficiency is central to capital market research. Why is theassumption if information efficiency so important for capital market research in accountingbecause unless such an assumption of efficiency is accepted, it is hard to justify effort to linksecurity price movements to information releases. A great deal of capital market researchconsiders the relationship between share prices and information releases.
The Effect of Efficiency: Non-Predictability
The nature of information does not have to be limited to financial news and research alone;indeed, information about political, economic and social events, combined with how investorsperceive such information, whether true or rumored, will be reflected in the stock price.According to EMH, as prices respond only to information available in the market, and, becauseall market participants are privy to the same information, no one will have the ability to out-profit anyone else.
How Does a Market Become Efficient?
In order for a market to become efficient, investors must perceive that a market isinefficient and possible to beat. Ironically, investment strategies intended to take advantage of inefficiencies are actually the fuel that keeps a market efficient.A market has to be large andliquid.Information has to be widely available in terms of accessibility and cost and released to investors at more or less the same time. Transaction costshave to be cheaper than the expected profits of an investment strategy. Investors must alsohave enough funds to take advantage of inefficiency until, according to the EMH, it disappearsagain. Most importantly, an investor has to believe that she or he can outperform the market.
Degrees of Efficiency
Accepting the EMH in its purest form may be difficult; however, there are threeidentified classifications of the EMH, which are aimed at reflecting the degree to which it can beapplied to markets.1.
Strong efficiency 
This is the strongest version, which states that
information in amarket, whether public or private, is accounted for in a stock price. Not even insiderinformation could give an investor an advantage.2.
Semi-strong efficiency 
This form of EMH implies that all public information is calculatedinto a stock's current share price. Neitherfundamentalnortechnical analysiscan be used to achieve superior gains.3
Weak efficiency 
This type of EMH claims that all past prices of a stock are reflected intoday's stock price. Therefore, technical analysis cannot be used to predict and beat amarket.
The Relationship between Earnings and Stock Returns
The relation between earnings and contemporaneous stock returns is based on the fundamentalequality in finance that prices are discounted cash flows. Positive earnings news generate higherexpected cash flows and in turn higher prices, i.e. positive stock returns. Indeed, one of the key findingsin the accounting literature, first documented by Ball and Brown (1968), is that higher earnings changesare associated with higher stock returns. This result is mostly reflected in firm-level and portfolio-levelestimations, using both cross-sectional (Ball and Brown, 1968) and time-series (Teets and Wasley, 1996)analyses.While firm-level observations con.rm the hypothesized positive relation between earningschanges and returns, aggregate-level tests do not. In fact, several recent studies (Kothari, Lewellen, and
Warner, 2006, and Sadka, 2007) document that aggregate earnings changes are negatively correlatedwith contemporaneous aggregate stock returns. This surprising result stands in contrast with robustfirm-level results. If the market expects higher cash flows then stock prices should increase. Yet, theempiric
al evidence suggests that “good” news about future cash fl
ows result in a negative marketreaction. While Kothari, Lewellen, and Warner (2006) allude discount-rate explanations to reconcile thiscon.ict, this paper provides an alternative rational explanation that relies on the markets ability topredict earnings and returns.The first possible relation, that is, earnings changes are associated with changes in expectedreturns, can be explained through the following example. Assume an annuity with payments of $100and 10% discount rate. The value of the annuity is $1,000 (=100/0.10). If the expected paymentincreases by $20 to $120 and at the same time the discount rate increases by 10% to 20%, the value of the annuity will decline to $600 (=120/0.20). Thus, if higher earnings changes re.ect both higher futurecash flows and higher expected returns, it is possible that earnings changes will be negatively correlatedwith stock returns. The second possible relation is that earnings changes at time t and expected returnsat time t-1 are negatively correlated. Such a relation can be interpreted as when investors expect highfuture earnings changes, they also demand a low risk premium (and therefore expected returns arelow). Sadka (2007) finds evidence consistent with this interpretation, in that a high dividend-price ratio(dividend yield) predicts both high future returns and low future profitability. Sadka also finds that long-run earnings and returns are highly negatively correlated.
Earnings/return relation
market model
Used to separate out firm-specific share price movements from market-widemovements
derived from the Capital Asset Pricing Model
assumes investors are risk averse and have homogeneous expectations
its use allows the researcher to focus on share price movements due to firm-specificnews
Total or actual returns can be divided into:
abnormal returns used as an indicator of information content of announcements
normal (expected) returns given market-wide movements
abnormal (unexpected) returns due to firm-specific share price movements

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