204 CHAPTER 6 Brricnivr Carrrat, Mansers | The semistrong-form EMIT asserts that security prices adjust rapidly tothe release ofall public infor- ‘mation. The test ofthis hypotbesis either examine the opportunities to predict future rates of tur ‘ithe time series ofa ross section) or they involve event studies in which investigators analyzed ‘whether investors could derive above-average reuens ftom trading on the basis af public information. ‘The test results for this hypothesis were clearly mixed. On the one hand, the results for almast all the event studies related to economic events such as stock splits inital public olferings, and accounting changes consistently supported the semistrong hypothesis. In contrast, several studies that examined the ability to predic rates of eturn on the bass of unexpected quarterly earnings, PIE ratios, size, neglected stocks, and the BVIMV ratio as wel as several calendar ellects, generally did not support the bypothesis, + The strong-form EMH states that security prices reflect all information. This implies that nobody has private information, sono group should be able to derive above-average returns consistently. Studies that examined the results for corporate insiders and stock exchange specilists do not suppor the strong-form hypothesis. An analysis of individual analysts as represented by Value Line ax by recom- ‘mendations published in The Wall Street Journal give mixed results. The results indicated that the Value Line rankings have significant information but it may not be possible to profit from it, whereas the ree- ‘ommendations by analysts indicated the existence of private information, In contrat, the performance by professional money managers supported the EMH because their risk-adjusted investment perfor ‘mance (whether mutual funds, pension funds, or endowment funds) was typically inferior to results achieved with buy-and-hold polices + Daring the past decade, there has been significant research in behavioral finance by investigators who contend thatthe standard finance theory model is incomplete since it does not consider implications of psychological decisions made by individuals tha both help explain many’ anomalies and the existence ‘of several biases and provide opportunities for excess returns. It is important to be aware of a number ‘of biases for two reasons: frst, they can lead to inferior performance as an analyst and portfolio man- ager: second. itis possible to exploit them for excess returns. + Given the mixed sesuls, its important to consider the implications of all ofthis for tecnica or funda ‘mental analysts and for portfolio managers, The EMH indicates tha technical analysis shouldbe of no value. Al forms of fundamental analysis are useful, bt they are dificult to implement because they equite the ability ro estimate furure values for relevant economic variables. Superior analysis i poss ble bu difficult because it requires superior projections. Those who manage portfolios should con- stantly evaluate investment advice to determine whether itis superior + Without access to superior analytical advice, you should run your portfolio like an index fund. In cone rast, those with superior analytical ability shouldbe allowed to make decisions, but they should con- entra their esfrts on mid-cap firms and neglected firms where there is a higher probability of dis- covering misvalued stocks. The analysis should be paticulasly concemned with a firm's BV/MY ratio, its size, andthe monetary environment. + This chapter contains some good news and some bad news. The good news i thatthe practice of investment analysis and portfolio management is not an art that has been ost tothe great computer in the sky. Viable professions still await those willing to extend the effort and able to accept the pressures ‘The bad news is that many bright, hardworking people with extensive resources make the game tough. In fact, those competitors have created a fairly efficient capital market in which itis extremely difficult, {or most analysts and portfelio managers te achieve superior results Questions 1. Discuss the rationale for expecting an eificient capital market. What factor would you look for to dif- ferentiate the market efficiency for two alternative stocks? 2, Define and discuss the weak-form EMH, Describe the two sets of tests used to examine the weak fora: EMH. 3. Define and diseuss the semistrong-form EMIT. Describe the two set of tests used to examine the semistrong-form EMH, 4. What is meant hy the term abnormal rate of run?10. aL 2 1B 14 15, 16 17 18. 19. 20, 21 26, Questioxs 205 Deseribe how you would compute the abnormal rate of return fora stock fora period surrounding an ‘economic event, Give a brief example fora stock witha beta of 1.40. Assume you want to test the EMH by comparing alternative trading rules to a buy-and-hold policy Discuss the three common mistakes that can bias the results against the EMH. Deseribe the results ofa study that supported the eemistrong-form EMH, Discuss the nature ofthe lest and specifically why the results support the hypothesis. Describe the results ofa study that did nor support the semistrong-form EMH, Discuss the nature of the tes and specifically why the results did nat support the hypothesis, For many ofthe EMH tess it is really a est of a joint hypothesis.” Discuss what is meant by this concept, What ate the joint hypotheses being tested? Define and discuss the stroug-form EMH. Why do some observers contend tha the strong-for hypothesis really requires a perfect marke in addition to an efficient market? Be specific, Discuss how you would test the strong-form EMH, Why are these tests relevant? Give a brief example Deseribe the results ofa study that did no support the strong-form EMH. Discuss the test involved and specifically why the results reported didnot support the hypothesis. Deseribe the results ofa study that supported the strong-form EMH. Discuss the test involved and specifically why these results suppor the hypothesis. Describe the general goal of behavioral finance ‘Why do the advocates of behavioral finance contend thatthe standard finance theory is incomplete? ‘What does the EMH imply forthe use of teclnical analysis? What does tke EMH imply for fundamental analysis? Discuss specifically what it does not imply Ina world of efficient capital mackets, what do you have to do to be a superior analyst? How would you test whether an analyst was superio:? ‘What advice would you give to your superior analysts in terms ofthe set of firms to analyze and variables that shouldbe considered in the analysis? Discuss your reasoning for this advice. How should a portfolio manager without any superior analysts rus his or her portfolio? Describe the goals of an index fund. Discuss the contention that index funds ae the ultimate answer ina world with efficient capital markets, ‘Ata social gathering, you meet the portfelio manager for the tust department ofa local bank. He confides to you that he has been following the recommendations of the department's six analysts for an extended period and has found that two are superics, two are average, and two are clealy inferior ‘What wuld you recommend that he do to run his pertfolio? Discuss your reaction to Hawawini's summary of findings related to the EMH for the European ‘equity markets. Were you surprised?” Describe a test of the weak-form EMH for the Japanese stock market and indicate where you would get the required data, CEA Examination Level I a. List and belly deline the three forms ofthe ellicient mazket hypothesis, [6 minvtes] b. Discuss the role of «portfolio manager ina perfectly efficient market. [9 minutes] CEA Examination Level IT ‘Tom Max, TMP’s quantitative analyst, has developed a portfolio construction model about which be is excited. To create the model, Max made a list of the stocks curently inthe SAP 500 Stock Index snd obtained annual operating cash flow, price, and total return data for each issue forthe pat five years, As of each year-end, this universe was divided into five equal-weighted patfalios of 100, issues each, with selection based solely on the price/cash flow rankings ofthe individual stocks [Bach pertfoio’s average annual return Was then calculated Dring this five-year period, the linked returns from the portfolios with the lowest prcefcash flow ratio generated an annualized total return of 19.0 percent, or 3.1 percentage points better than the 15.9 percent return on the SAP 500 Stock Index. Max also noted that the lowest price—cash-flow portfolio had a below-market beta of 0.91 over this same time span. a, Briefly comment on Max's use of the beta measure as an indicator of portfolio visk in light of recent academic tests of ts explanatory power with respect to stock retums. (5 minutes] by. You are familiar withthe iteratuze on market anomalies and ineficiencies. Against this back: ground, discuss Max's use ofa single-actor model (price-cash flow) in his research, (8 minutes}206 CHAPTER 6 Brricnivr Carrrat, Mancers Problems «. Identify and briefly describe four specific concems about Max's test procedures and model design. (The issues already discussed in your answers to Parts a and b may not be used in answer- ing Parc.) (12 minutes} 27, CPA Examination Level Ill a. Briefly explain the concept of the eficient marker hypothesis (EMH) and each of its tree forms— weak, semisirong. and strong—acu briefly discuss the degree to which existing empirical evidence supports eac ofthe thtee forms of the EMH, [8 rsinutes) b. Briefly discuss the implications ofthe efficient market hypathess for investment policy as it applies to (@) technical analysis in the form of charting, and () fundazental analysis. [4 minutes) ¢. Briefly explain nwo major roles or responsibilities of portfolio managers in an eflicient market environment. [4 minstes] 4 Briefly discuss whether active asset allocation among countries could consistently outperform a world market index. Include 2 discussion of the implications of integration versus segmentation of international financial markets as it pertains to portfolio diversification, but ignore the issue of stock selection, [6 minutes] 1. Compote the abnormal rates of retumn fo the following stocks during period r ignore differential systematic risk): Stock R, Be B use 40% F 100 8S r 140 96 c 10 153 B 159 ne ‘Ronen frac dg paar 2. Compute the abnormal rates of return forthe five stocks in Problem 1 assuming the following sys lemaic risk measures betas): Stock . B 095 FE Las T Las c 070 E 030 3, Compare the abnormal returns in Problems 1 and 2 and discuss te reason forthe diference in each 4. You are given the following data regarding the performance ofa group of stocks recommended by an analyst an a set of stocks with matching betas