FI4007 Investments:

Analysis and Management

Week 4
Tutorial: Questions and Answers

THE EFFICIENT MARKET HYPOTHESIS

Q1
A necessary condition for stock-market efficiency is that changes in stock prices be random
and unpredictable. Is this also a sufficient condition for market efficiency?

A1
No. In the short term, theory and evidence tell us that stock prices are equally apt to rise or fall
in an efficient market. However, in an efficient stock market, changes in stock prices are
random. Stock prices are not random, as if simply affected by investor psychology, moon
spots, or whatever. In an efficient stock market, the price for any given stock effectively
represents the expected net present value of all future profits. In this calculation, profits are
discounted by using a fair or risk-adjusted rate of return. If the stock market is to be perfectly
efficient, there must be a large number of buyers and sellers of essential identical securities,
information must be free and readily available, and entry and exit by market players must be
uninhibited.

Q2
A successful firm like Microsoft is generating profits every year. Is this a violation of the
EMH?

A2
No, this is not a violation of the EMH. Microsoft’s continuing large profits do not imply that
stock market investors who purchased Microsoft shares after its success already was evident
would have earned a high return on their investments.

Q3
‘If all securities are fairly priced, all must offer equal expected rates of return’. Comment.

A3
The phrase would be correct if it were modified to say “expected risk adjusted returns.”
Securities all have the same risk adjusted expected return if priced fairly; however, actual
results can and do vary. Unknown events cause certain securities to outperform others. This is
not known in advance, so expectations are set by known information.

Q4
At a dinner party, your host tells you that he has beaten the market for each of the last five
years. Suppose you believe him. Does this shake your belief in efficient markets?

1
A4
No. The notion of random walk naturally expects there to be some people who beat the market
and some people who do not. The information provided, however, fails to consider the risk of
the investment. Higher risk investments should have higher returns. As presented, it is possible
to believe him without violating the EMH.

Q5
Steady Growth Industries has never missed a dividend payment in its 94 year history. Does
this make it more attractive to you as a possible purchase for your stock portfolio?

A5
No, it is not more attractive as a possible purchase. Any value associated with dividend
predictability is already reflected in the stock price.

Q6
Suppose you find that the prices of stocks before large dividend increases show on average
consistently positive abnormal returns. Is this a violation of the EMH?

A6
No, this is not a violation of the EMH. This empirical tendency does not provide investors with
a tool that will enable them to earn abnormal returns; in other words, it does not suggest that
investors are failing to use all available information. An investor could not use this
phenomenon to choose undervalued stocks today. The phenomenon instead reflects the fact
that dividends occur as a response to good performance. After the fact, the stocks that happen
to have performed the best will pay higher dividends, but this does not imply that you can
identify the best performers early enough to earn abnormal returns.

Q7
Give three essential characteristics of an efficient stock market.

A7
Within the context of the EMH, important characteristics of a perfectly competitive securities
market include the following: (1) new information arrives at the marketplace in an independent
and random fashion; (2) investors rapidly adjust stock prices to reflect new information; (3)
current stock prices reflect all relevant risk and return information.

Q8
Explain which form of the efficient markets represents the toughest or highest hurdle that must
be met for the stock market to be regarded as perfectly efficient.

2
A8
The strong-form hypothesis is the toughest or highest hurdle that must be met for the stock
market to be regarded as perfectly efficient. It encompasses all the various types of
information considered by the weak-form and semi strong-form hypotheses and more. The
securities market can be regarded as perfectly efficient only if all relevant information is
accurately and instantaneously reflected in security prices. For example, to the extent that
insiders such as the company chairman and CEO together earn above-normal rates of return on
their stock market investments in the company, the market would not be judged as perfectly
efficient according to the strong-form hypothesis. If such insiders do, in fact, earn above-
normal rates of return, then one might conclude that they have profited by virtue of their access
to superior or insider information.

Q9
Suppose a highly speculative stock listed on the OTC.BB has risen on each of the last six
Mondays. To exploit this pattern, a speculator decides to buy late Friday afternoon. Is this apt
to be a successful strategy?

A9
No. The fact that a stock has risen on a series of recent Mondays does not predict anything at
all about the probability of rising on a subsequent Monday. In an efficient market, short term
changes in stock prices are random and unpredictable. When it comes to highly speculative
stocks listed on the OTC.BB, investors need to be especially vigilant about the potential for
purposeful manipulation. Manipulators know that lots of naïve investors look for simple
patterns in stock returns. Some stock promoters have been known to “paint the tape” by
creating what looks like a stable pattern of returns to entice easily fooled investors, only to sell
and run leaving unwitting small speculators holding the (empty) bag. This again is an example
of the gamblers fallacy.

Q10
In seminal research, Robert J. Shiller reported that measures of U.S. stock price volatility over
the past century appear to be five- to thirteen-times too high to be attributed to new information
about the fundamental value of the firm as measured by future real dividends. What does such
excess volatility say about market efficiency?

A10
According to Shiller, the amount of excess volatility in U.S. stock prices is so extreme as to be
impossible to attribute the failure of the EMH to such things as data errors, price index
problems, or changes in tax laws. Instead, it appears that overly emotional investors
systematically overreact by selling low and buying high (See Robert Shiller, "Do Stock
Prices Move Too Much to be Justified by Subsequent Changes in Dividends?", American
Economic Review (June 1981), 71(3): 421–436.)

Q11
Are stock market bubbles consistent with the Efficient Market Hypothesis? Why or why not?

3
A11
An economic bubble or speculative mania is an asset market that trades in extraordinary
volume at prices that obviously depart in a significant manner from long-held notions of
intrinsic value. It is a controversial idea in direct conflict with the basic premise of efficient
markets. In efficient markets, assets are traded at prices that reflect the collective unbiased
beliefs of all investors. Pricing episodes that cannot be easily reconciled with the efficient
market hypothesis are often dismissed as the type of rare aberrant behavior that might occur in
sometimes “messy” real-world financial markets. Rare instances of irrational pricing in small
or illiquid asset markets define the reasonable bounds of the efficient market hypothesis; they
do not disprove the general applicability of the concept. Stock market bubbles in large, liquid
markets are another matter. Stock market bubbles have sometimes emerged that reflect a
severe departure between stock market prices and underlying economic fundamentals in large
liquid markets, like the Japanese stock market of the 1980s, Nasdaq during the late-1990s and
the latest financial crisis. In all cases, it appears that irrational expectations about economic
fundamentals caused bubbles in stock prices that are clearly at odds with Random Walk
Theory. Unsustainably high valuations led to big downward price moves (crashes).

Q12
Empirical research has uncovered a series of rate-of-return anomalies related to calendar year
events. Discuss the magnitude and alleged sources of these stock-return anomalies.

A12
During recent years, a number of calendar year anomalies have been discovered. At various
noteworthy points in time, at least some classes of common stocks seem to enjoy above-
average rates of return that cannot be explained by the traditional CAPM and APT models of
asset pricing. Abnormal rates of return have been observed and described as the:
• January Effect: At the turn of the year, common stocks, especially small common
stocks, enjoy significant abnormal returns. Such abnormal returns tend to be concentrated
during the period from the last trading day of the year through the first four trading days of the
New Year.
• Turn-of-the-Month Effect: While not as dramatic as the January effect, turn-of-the-
month returns alone fully account for the positive returns generated by stock market
investments. Here, turn-of-the-month is defined as the last trading day of the month through
the first three days of the new month.
• Day-of-the-Week Effect: The "Blue Monday" effect is alleged because Monday is the
only day of the week where returns are consistently negative. Conversely, returns on Friday
are significantly higher than those earned on any other day.
• Holiday Effect: The average pre-holiday return dwarfs the average daily rate of return.
Returns are especially high before Labor Day, Memorial Day, and Thanksgiving. However,
this effect is only observed when a market closure coincides with the holiday celebration.
• Time-of-Day Effect: Stock returns display intra day as well as inter day patterns.
Returns are typically high at the open, and immediately preceding the close. On Mondays,
negative returns bottom out near 11:00 AM.

4
No simple explanation exists for this pattern, but the upshot is clear: “Buy around 3:00 PM on
the Thursday preceding Labor Day, and never sell on Monday!”

Q13
Suggest at least four reasons why some doubt the very existence of a long-term small-cap
effect.

A13
(1) Modern stock markets may simply be much more efficient than the stock markets of
previous generations;
(2) Measurement errors rather than market inefficiency may explain the perceived out
performance of small-cap stocks. For example, by ignoring the effects of firms that are
delisted for poor performance, previous studies may be infected with delisting bias;
(3) Above-average returns for small-cap stocks may simply reflect a necessary small-cap risk
premium, and the return volatility of large-cap stocks tends to be more precisely measured than
is the volatility of small-cap stocks. Perhaps the CAPM is simply unable to capture their
special risks (i.e., the model is wrong);
(4) Illiquid small-caps involve substantial bid-ask spreads and transaction costs. After
correctly allowing for such costs, small-cap out performance may in fact disappear.

Q14
What is the January Effect?

A14
A January effect has been documented in a number of studies that show unusually large
positive rates of return for stocks during the first few trading days of the year. January
seasonality has been noted in the rates of return earned on a variety of stock characteristics,
including size, yield, and neglect. Small-cap stock performance is especially strong on the last
trading day of the year and on the first four trading days of the New Year.

Q15
Within the context of the literature on stock market anomalies, recount what is meant by the
joint test problem.

A15
A “joint test” problem is implicit in the stock market anomaly literature because such studies
involve an EMH test--abnormal returns may reflect market inefficiency; plus a market model
test--abnormal returns may reflect market model specification error, and thus errors in expected
return estimates. Thus, abnormal returns suggest inefficient markets and/or market model
specification error. Elements of market inefficiency can only be viewed through the imperfect
lens provided by capital markets theory.